Fiscal limits on first-best climate policy: A CGE analysis for Europe

We use a standard computable general equilibrium model to explore the fiscal implications of stringent carbon dioxide emission reduction in Europe. Both the immediate targets (20-30% by 2020) and the medium-term targets (80-90% by 2050) for abatement can be met with a carbon tax that is modest to sizeable. Imposing budget neutrality, a carbon tax that would allow all other taxes to fall by 5% (20%) would cut emissions by about 40% (80%). For 80% emission reduction, the carbon tax would only be the third largest tax in terms of revenue. A 40% emission reduction would cost about 1.5% of GDP. Costs are roughly exponential in abatement. The economic impact of emission reduction is minimized if the carbon tax revenue is preferentially used to reduce taxes on intermediates and import tariffs; such taxes, however, bring in little revenue at present. Emission reduction in Europe affects trade patterns across the world. It hampers the economies of West Asia and Africa, but has stimulating effect elsewhere. Economies everywhere outside Europe become more carbon-intensive. About one in four of emissions avoided in Europe are emitted elsewhere.