What is it going to take to achieve 2020 Emission Targets? Marginal abatement cost curves and the budgetary impact of CO taxation in Portugal (*) 2 Alfredo Marvão Pereira* The College of William and Mary, CASEE, University of the Algarve Rui M. Pereira University of the Algarve and CASEE College of William and Mary Department of Economics Working Paper Number 105 Previous Version: January 2011, May 2013 This version: January 2014 COLLEGE OF WILLIAM AND MARY DEPARTMENT OF ECONOMICS WORKING PAPER # 105 January 2014 What is it going to take to achieve 2020 Emission Targets? Marginal abatement cost curves and the budgetary impact of CO taxation in Portugal (*) 2 Abstract The objective of this paper is to study CO taxation in its dual role as a climate 2 and fiscal policy instrument. It develops marginal abatement cost curves for CO 2 emissions using a dynamic general equilibrium model of the Portuguese economy which highlights the mechanisms of endogenous growth and includes a detailed modeling of the public sector. It also considers complementary cost curves corresponding to the impact of CO taxes on GDP and on the public budget. 2 Simulation results show that a tax of 17.00 Euros per tCO has the capacity to 2 limit emissions to 62.6 Mt CO in 2020, consistent with the existing climate policy 2 target for Portugal. In turn, changes in tax revenues, together with reductions in public spending, lead to a 2.7% decline in public debt. These desirable outcomes come at the cost of a 0.7% reduction in GDP. In general, stricter emission targets imply greater equilibrium CO tax levels and larger GDP losses, although these 2 are accompanied by greater reductions in public debt. Finally, the paper highlights the importance of public spending behavior for projecting the impact of CO taxes on public revenues and the public account and designing policies to 2 promote fiscal consolidation. Keywords: Marginal Abatement Costs, Economic Effects, Budgetary Effects, Carbon Taxation, Dynamic General Equilibrium, Portugal. JEL Classification: Q41, Q43, Q54, Q58, C68, D58, H20, H50, H60. Alfredo Marvão Pereira Department of Economics, The College of William and Mary, Williamsburg, USA CASEE – Center for Advanced Studies in Economics and Econometrics, Universidade do Algarve, Portugal [email protected] Rui M. Pereira Dept. of Economics, University of the Algarve, Faro, Portugal CASEE – Center for Advanced Studies in Economics and Econometrics, [email protected] 1. Introduction Marginal abatement cost curves are a standard tool for evaluating environmental policies [see, for example, Ellerman and Decaux (1998), Klepper and Peterson (2006), Bovenberg et al. (2008), Metcalf and Weisbach (2008), Böhringer et al. (2009), and Morris et al. (2012)]. The objective of this paper is to construct marginal abatement cost curves for CO emissions 2 associated with carbon (CO ) taxes in a framework that explicitly incorporates the interactions 2 among endogenous economic growth, public sector behavior and accounts, and the energy system. This framework allows us to examine the role of CO taxes in reducing emissions and 2 contributing to fiscal consolidation efforts. The impact of climate policy on economic performance has been a central part of the climate change debate [see, for example, Babiker et al. (2009), Congressional Budget Office (2003, 2009, 2010), Dissou (2005), Ekins et al. (2011), Meng et al. (2013), Morris et al. (2008), Nordhaus (1993a, 1993b, 1993c), Rivers, (2010), and Stern (2007)]. More importantly, from the standpoint of this paper, we have witnessed a growing concern over mounting public debt in recent years and the need to promote fiscal sustainability. In this context, CO taxes and 2 auctioned emissions permits have emerged as potentially important fiscal policy instruments for increasing public revenues [see, for example, Metcalf and Weisbach (2008), Galston and MacGuineas (2010), Metcalf (2010) and Nordhaus (2010)]. The interactions between climate policy, economic growth and the public sector account are fundamental since they correlate to some of the most important policy constraints faced by energy-importing economies in their pursuit of sound climate policies: the need to enact policies that promote long-term growth and budgetary consolidation. These policy constraints are particularly relevant for the less developed energy-importing economies in the European Union 1 (EU). As EU structural transfers have shifted towards new members, countries such as Ireland, Greece, and Portugal have been forced to rely on domestic public policies to promote real convergence. This poses a challenge since growing public spending, pro-cyclical policies, and more recently, falling tax revenues have contributed to rapidly increasing levels of public debt and a sharp need for budgetary consolidation. In this context, the focus of this paper is on the budgetary implications of CO taxes and 2 everything included in this paper is filtered through this lens. Generally, analyses of the public debt implications of climate policies focus on using CO tax revenue to finance the purchase of 2 financial assets, paying down debt [see, for example, Shackelton et al. (1996), Farmer and Steininger (1999) and Conferey et al. (2008)]. In this paper, we examine the economic and budgetary impact of CO taxation, with revenues directed to the general public account, in an 2 endogenous growth framework with optimal public sector adjustments to both public consumption and investment activities. We develop marginal abatement cost curves for CO taxes in a small, open, energy- 2 importing economy, Portugal, using a dynamic general equilibrium model with endogenous growth and a detailed modeling of public sector activities. In addition to the traditional marginal abatement cost curve, describing the relationship between the CO tax level and the reduction in 2 emissions, we present a pair of complementary marginal abatement cost curves which highlight the impact CO taxation on economic performance and public debt. 2 Our model incorporates fully dynamic optimization behavior, endogenous growth, and a detailed modeling of the public sector activities, both tax revenues and public consumption and investment spending. The model is calibrated to replicate the stylized facts of the Portuguese economy over the last decade. Previous versions of this model have been used to evaluate the 2 impact of tax policy [see Pereira and Rodrigues (2002, 2004)], social security reform [see Pereira and Rodrigues (2007) and environmental fiscal reform [see Pereira and Pereira (2013)]. This model brings together two important strands of the taxation literature [see the above applications of this model for a detailed list of the references]. On one hand, it follows in the footsteps of computable general equilibrium modeling. It shares with this literature the ability to consider the tax system in great detail. This is important given the evidence that the costs and effectiveness of climate policies are influenced by existing tax distortions [see Goulder (1995), Goulder et al (1999) and Goulder and Parry (2008)]. On the other hand, it incorporates many of the insights of the endogenous growth literature. In particular, it recognizes that public policies have the potential to affect the fundamentals of long term growth and not just for generating temporary level effects [see Xepapadeas (2005)]. While the economic impact of financing reductions in public debt with CO tax revenue 2 has been explored in a general equilibrium framework [see, for example, Barker et al. (1993), Koeppl et al. (1996), Farmer and Steininger (1999), and Conefrey et al. (2008)], the key distinguishing feature of our methodological approach is our focus on endogenous growth – in contrast to endogenous technical change – and the associated treatment of public sector behavior [see Conrad (1999) and Bergman (2005) for literature surveys]. Productivity enhancing investments in public and human capital, which have been largely overlooked in applied climate policy [Carraro et al. (2009)], are, in addition to private investment, the drivers of endogenous growth. Furthermore, the analysis of the interaction between fiscal policies, public capital, economic growth, and environmental performance has garnished little attention and then only in a theoretical framework [Bovenberg and de Mooij (1997), Greiner (2005), Fullerton and Kim (2008), Glomm et al. (2008) and Gupta and Barman (2009)]. 3 The remainder of this paper is organized as follows. Section 2 provides a description of the model and a discussion of implementation issues. Section 3 presents the marginal abatement cost curves for CO emissions in Portugal. Section 4 analyzes the equilibrium tax levels for, and 2 the economic and budgetary impacts of compliance with, existing, and potentially more stringent, emissions targets. Section 5 provides a deeper look at the mechanisms behind the economic and budgetary impacts of CO taxes. Finally, Section 6 provides a summary and 2 policy implications. 2. The Dynamic General Equilibrium Model We consider a decentralized economy in a dynamic general-equilibrium framework. All agents are price-takers and have perfect foresight. With money absent, the model is framed in real terms. There are four sectors in the economy – the production sector, the household sector, the public sector and the foreign sector. The first three have an endogenous behavior but all four sectors are interconnected through competitive market equilibrium conditions, as well as the evolution of the stock variables and the relevant shadow prices. All markets are assumed to clear. The trajectory for the economy is described by the optimal evolution of eight stock and five shadow price variables - private capital, wind energy capital, public capital, human capital, and public debt together with their shadow prices, and foreign debt, private financial wealth, and human wealth. In the long term, endogenous growth is determined by the optimal accumulation of private capital, public capital and human capital. The last two are publicly provided. 2.1. The Production Sector Figure 1 presents an overview of the production structure of the economy. Aggregate output, (cid:1851), is produced with a Constant Elasticity of Substitution (CES) technology, as in (Eq. 1), (cid:3047) 4 linking value added, (cid:1848)(cid:1827) , and aggregate primary energy demand, (cid:1827)(cid:1833)(cid:1833)_(cid:1831) . Value added is (cid:3047) (cid:3047) produced with a Cobb-Douglas technology (Eq. 2), exhibiting constant returns to scale in the reproducible inputs – effective labor, (cid:1838)(cid:3031)(cid:1834)(cid:1837) , private capital, (cid:1837) , and public capital, (cid:1837)(cid:1833) . Only (cid:3047) (cid:3047) (cid:3043),(cid:3047) (cid:3047) the demand for labor, (cid:1838)(cid:3031), and the private capital stock are directly controlled by the firm, (cid:3047) meaning that if public investment is absent then decreasing returns set in. Public infrastructure and the economy-wide stock of knowledge, (cid:1834)(cid:1837) , are publicly financed and are positive (cid:3047) externalities. The capital and labor shares are (cid:2016) and (cid:2016) , respectively, and (cid:2016) (cid:3404) 1(cid:3398)(cid:2016) (cid:3398)(cid:2016) is (cid:3012) (cid:3013) (cid:3012)(cid:3008) (cid:3012) (cid:3013) a public capital externality parameter. (cid:1827) is a size parameter. Figure 1: Overview of the Production Structure Production CES Value Added Energy CD CES Capital Labor Crude Oil Non Transportation Fuels CD CES - Constant Elasticity of Substitution CD - Cobb Douglas Coal Natural Gas Wind 5 Private capital accumulation is characterized by (Eq. 3) where physical capital depreciates at a rate (cid:2012) . Gross investment, (cid:1835) , is dynamic in nature with its optimal trajectory (cid:3012) (cid:3043),(cid:3047) induced by the presence of adjustment costs. These costs are modeled as internal to the firm - a loss in capital accumulation due to learning and installation costs - and are meant to reflect rigidities in the accumulation of capital towards its optimal level. Adjustment costs are assumed to be non-negative, monotonically increasing, and strictly convex. In particular, we assume adjustment costs to be quadratic in investment per unit of installed capital. The firms’ net cash flow, (cid:1840)(cid:1829)(cid:1832), (Eq. 4), represents the after-tax position when revenues from sales are netted of wage payments and investment spending. The after-tax net revenues reflect the presence of a private investment and wind energy investment tax credit at an effective rate of (cid:2028) and (cid:2028) , respectively, taxes on corporate profits at a rate of (cid:2028) , and Social (cid:3010)(cid:3021)(cid:3004) (cid:3010)(cid:3021)(cid:3004)(cid:3019) (cid:3004)(cid:3010)(cid:3021) Security contributions paid by the firms on gross salaries, (cid:1875) (cid:1838)(cid:3031)(cid:1834)(cid:1837) , at an effective rate of (cid:2028) . (cid:3047) (cid:3047) (cid:3047) (cid:3007)(cid:3020)(cid:3020)(cid:3004) Buildings make up a fraction, 0 (cid:3407) (cid:4666)1(cid:3398)(cid:2025) (cid:4667) (cid:3407) 1, of total private investment expenditure. (cid:3010) Only this fraction is subject to value-added and other excise taxes, the remainder is exempt. This situation is modeled by assuming that total private investment expenditure is taxed at an effective rate of (cid:2028) . The corporate income tax base is calculated as (cid:1851) net of total labor costs, (cid:3023)(cid:3002)(cid:3021)(cid:3006)(cid:3021),(cid:3010) (cid:3047) (cid:4666)1(cid:3397)(cid:2028) (cid:4667)(cid:1875) (cid:1838)(cid:3031)(cid:1834)(cid:1837) , and net of fiscal depreciation allowances over past and present capital (cid:3007)(cid:3020)(cid:3020)(cid:3004) (cid:3047) (cid:3047) (cid:3047) investments, (cid:2009)(cid:1835) . A straight-line fiscal depreciation method over (cid:1840)(cid:1830)(cid:1831)(cid:1842) periods is used and (cid:3047) investment is assumed to grow at the same rate at which output grows. Under these assumptions, depreciation allowances simplify to (cid:2009)(cid:1835) , with (cid:2009) is obtained by computing the difference of two (cid:3047) infinite geometric progression sums, and is given by (Eq. 5). Optimal production behavior consists in choosing the levels of investment and labor that maximize the present value of the firms’ net cash flows, (Eq. 4), subject to the equation of 6 motion for private capital accumulation, (Eq. 3). The demands for labor and investment are given by (Eq. 6) and (Eq. 7), respectively, and are obtained from the current-value Hamiltonian function, where (cid:1869)(cid:3012) is the shadow price of private capital, which evolves according to (Eq. 8). (cid:3047)(cid:2878)(cid:2869) Finally, with regard to the financial link of the firm with the rest of the economy, we assume that at the end of each operating period the net cash flow is transferred to the consumers. 2.2. The Energy Sector We consider the introduction of CO taxes levied on primary energy consumption by 2 firms. This is consistent with the nature of the existing policy environment in which CO permits 2 may now be auctioned to firms. Furthermore, evidence suggests that administrative costs are substantially lower the further upstream the tax is administered. By considering taxation at the firm level, the additional costs induced by CO taxes are transmitted through to consumers and 2 consumer goods in a fashion consistent with the energy content of the good. Not levying the CO 2 tax on consumers therefore avoids double taxation of the carbon content of a good. The energy sector is an integral component of the firms' optimization decisions. We consider primary energy consumption by firms, (cid:1827)(cid:1833)(cid:1833)_(cid:1831) , for crude oil, coal, natural gas and wind (cid:3047) energy. Primary energy demand refers to the direct use of an energy vector at the source in contrast to energy resources that undergo a conversion or transformation process. With the taxation of primary energy consumption by firms, costs are transmitted through to consumers and consumer goods in a fashion consistent with the energy content of the good. Primary energy consumption provides the most direct approach for accounting for CO 2 emissions from fossil fuel combustion activities. The hydrogen and carbon contained in fossil fuels generates the potential for heat and energy production. Carbon is released from the fuel upon combustion; 99.0% of the carbon released from the combustion of petroleum, 99.5% from 7 natural gas, and 98.0% from coal, oxidizes to form CO . Together, the quantity of fuel 2 consumed, its carbon factor, oxidation rate, and the ratio of the molecular weight of CO to 2 carbon are used to compute the amount of CO emitted from fossil fuel combustion activities in a 2 manner consistent with the Intergovernmental Panel for Climate Change (2006) reference approach. These considerations suggest a linear relationship between CO emissions and fossil 2 fuel combustion activities. Computation of CO emissions from fossil fuel combustion is given 2 in (Eq. 19). Aggregate primary energy demand is produced with a CES technology (Eq. 9) in which crude oil, (cid:1829)(cid:1870)(cid:1873)(cid:1856)(cid:1857)(cid:1841)(cid:1861)(cid:1864) , and non-transportation fuels, (cid:1840)(cid:1846)(cid:1832) , are substitutable at a rate less than (cid:3047) (cid:3047) unity reflective of the dominance of petroleum products in transportation energy demand and the dominance of coal, natural gas and wind energy, in electric power and industry. Non- transportation fuels are produced with a Cobb-Douglas technology (Eq. 15) recognizing the relatively greater potential substitution effects in electric power and industry. The accumulation of wind energy infrastructure is characterized by a dynamic equation of motion (Eq. 16) where the physical capital, wind turbines, depreciates at a rate of (cid:2012) and investment, (cid:1835) , is subject to (cid:3050),(cid:3047) (cid:3050),(cid:3047) adjustment costs as private capital. Wind energy investment decisions are internal to the firm while coal, natural gas and oil are imported from the foreign sector. Optimal primary energy demand is derived from the maximization of the present value of the firms' net cash flows as discussed above. The first order condition for crude oil demand and non-transportation energy demand are given by (Eq. 13) and (Eq. 14). In turn, the demand for coal and natural gas are defined through the nested dual problem of minimizing energy costs (Eq. 10) given the production function (Eq. 15) and optimal demand for these energy vectors in electric power and industry. Finally, the variational condition for optimal wind energy 8