My colleagues Jack Pezzey and Frank Jotzo have a forthcoming paper in JEEM: "Tax-versus-trading and efficient revenue recycling as issues for greenhouse gas abatement" on the relative performance of emissions taxes versus emissions trading under uncertainty about both abatement costs and BAU emissions as well as different levels of revenue recycling. Uncertainty about future costs of abating emissions is well known to lead to a welfare advantage of emissions taxes over permit trading. They show that uncertainty about BAU emissions is more important and further increases the advantage of taxes. I think this is important because the massive fluctuations in the price of carbon in the EU market for example seems to be largely due to fluctuations in economic activity. They write: "overall our results substantially boost the welfare case for using a carbon tax instead of trading."
However, they argue that whether the raised revenue is efficiently recycled through cuts in existing distorting taxes will be practically of much greater significance than these differences between taxes versus trading. In the presence of existing distorting taxes an emissions tax can have negative impacts on welfare if those taxes are not also reduced - the so called "tax-distortion effect". However, I would have thought that the giving away of free permits or exclusion of activities from control is likely to be greater in extent than exemptions under a carbon tax. This would further increase the advantages of taxes. Or maybe I'm wrong about that?
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