Regional effects of an emissions-reduction policy in China : taxes, subsidies and the method of financing

The issue of the possible adverse effects of a reduction in pollution on the economy is a very real one for China, given its public commitment to substantial cuts in CO2 emissions by 2020. An important part of this issue is the regional dimension - the pollution reduction is likely to have significantly different effects across the regions and so possibly exacerbate the already large and persistent inter-regional disparities in China. Policy choices will therefore be complicated and will need to be carried out with a clear understanding of the impact of alternative policies at national and regional levels. One important policy choice which has received little, if any, attention in the regional context is the one between a tax on pollution and a subsidy on abatement activity. We help elucidate this policy choice by exploring the tax-subsidy issue in a small theoretical model which captures some of the salient features of the Chinese regions and the tax/expenditure system. We also use the model to address closely related questions regarding the importance of alternative methods of financing the tax or subsidy. We solve the model numerically based on Chinese data. We find that if revenue-recycling via lump-sum taxes and subsidies is possible, a centrally imposed emissions tax has the same effects on all relevant variables (except for the distribution of income between wages and profits) as an equivalent abatement subsidy. The move from recycling to more realistic financing methods results in differences between the effects of an emissions tax and an abatement subsidy -- more for economic variables such as wages, profits, incomes and output than for welfare. Generally, welfare falls in both regions for both instruments under all financing assumptions. But the regional welfare disparity narrows in all cases except where recycling is assumed. The disparities in other variables generally widen for all central government policies without recycling but are reduced for regional government subsidies financed by output taxes or infrastructure. In the last two case, however, the narrowing of the gaps is achieved by a greater reduction in the variable in the coast than in the interior, an outcome which may please no one.