Emissions Pricing Policies and Business Cycles: Fixed vs. Variable Tax Regimes

• Author: Fariba Ramezani,Amir Arjomandi,Charles Harvie
• DOI: http://doi.org/10.1111/1467-8462.12347
• Published date: 01 March 2020
• Date: 01 March 2020

The Australian Economic Review, vol. 53, no. 1, pp. 76–92 DOI: 10.1111/1467-8462.12347

Emissions Pricing Policies and Business Cycles: Fixed vs.

Variable Tax Regimes

Fariba Ramezani, Charles Harvie and Amir Arjomandi*

Abstract

As by‐products, emissions follow economic

fluctuations. Ignoring this fact in environ-

mental policies can lead to unexpected

emissions fluctuations and an increase in

intervention costs. Using a real business cycle

model, we compare two policies: a fixed tax

policy where the price is constant over time

and a variable tax regime where the tax rate is

set at the beginning of each period. We find

that while both programs result in lower

emissions, a variable tax regime is preferable

since first, it can ensure that the maximum

welfare is always achieved, and second, it is

more effective in stabilising emissions.

1. Introduction and Background

Although several global conventions have

resulted in countries agreeing to control global

warming by limiting greenhouse gas (GHG)

emissions, the debate on the appropriate

policy to achieve environmental targets with

the lowest economic costs still continues

(among others, see Simshauser and Doan

2009; Stern, Pezzey and Lambie 2011; Ergas

2012). In addition to political reasons, this can

be due to the fact that there is still uncertainty

about the two‐way relationship between

economic activity and environmental quality.

This article contributes to this debate by

studying the relationship between macroeco-

nomic fluctuations (in terms of business

cycles) and emissions variations. We investi-

gate how environmental policies should be

adapted to macroeconomic fluctuations to

control emissions fluctuations.

Economic growth can be affected by global

warming, which in turn has a direct relation-

ship with the atmospheric concentration of

emissions. The emissions concentration

(or stock) has an extremely slow decay rate.

This can raise the question of why we need to

consider variations in emissions if the mean

level of emissions stock does not change

significantly. We can point to three reasons.

First, global environmental pledges are de-

fined in terms of limiting the flows of GHG

emissions in a particular period. Following

economic growth, the flows of emissions have

a long‐term growing trend and any variations

in their long‐term growing trend can increase

the costs of intervention to achieve the

commitments. Second, while the ultimate

* Ramezani: SMART Infrastructure Facility, Faculty of

Engineering, University of Wollongong, Wollongong,

Australia; Harvie: School of Accounting, Economics and

Finance, Faculty of Business, University of Wollongong,

Wollongong, Australia; Arjomandi: School of

Accounting, Economics and Finance, Faculty of

Business, University of Wollongong, Wollongong,

Australia. Corresponding author: Ramezani, email

<faribark@uow.edu.au>.The authors wish to thank anon-

ymous reviewers and the editor for very helpful

comments on earlier drafts of the paper.

© 2019 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research,

Faculty of Business and Economics

Published by John Wiley & Sons Australia, Ltd

benefit of environmental policies is reducing

damages from global warming and pollution

(which is a long‐term outcome), designing

environmental policies that consider fluctua-

tions caused by business cycles can bring

cost‐saving benefits to those who bear the

costs of such policies via smoothing the

abatement path (Heutel 2012). Third, as a

Pigovian tax, emissions reduction policies

intend to correct emissions externality by

forcing polluters to pay for the externality of

pollution they produce and motivating them to

control their emissions. As the result of this

article shows, during business cycles (which

can be controlled, but are inevitable), the

impacts of macroeconomic fluctuations on the

output and primary factor markets can be so

significant that they can diverge producers’

attention from environmental activities and

reduce the effectiveness of emissions price as

a Pigovian tax. An environmental policy that

considers business cycles and responds to

them can increase the success of this moti-

vating tool. Thus, while the ultimate goal of

emissions reduction policies is stabilising

atmospheric concentrations, policymakers

should consider variations in the flows of

emissions and design policies that can control

emissions fluctuations.

This article contributes to the theoretical

debate on environmental policy by analysing

the macroeconomic transition effects of busi-

ness cycles under alternative emissions pri-

cing regimes. We compare fixed and variable

emissions pricing systems via the responses of

different economic and environmental vari-

ables to real shocks.

Literature on the emissions pricing comparison

was first introduced by Weitzman (1974), who

shows that uncertainty, in terms of asymmetric

information about abatement cost, can result in a

difference between a tax and a cap system.

Subsequently, many researchers have focused on

asymmetric information as the main source of

uncertainty using partial equilibrium models

(e.g., Newell and Pizer 2003; Quirion 2005;

Fell, MacKenzie and Pizer 2012) and general

equilibrium models (e.g., Pizer 2002; Dissou

2005; Jotzo and Pezzey 2007). Investigating the

relationship between business cycles and

environmental policies requires specifying un-

certainty in terms of real shocks which cause real

business cycles. Such an investigation can be

carried out using a dynamic stochastic general

equilibrium (DSGE) model.

DSGE modelling in environmental analysis

was introduced by Fischer and Springborn

(2011) and Heutel (2012) who both use real

business cycle (RBC) models

1

where total factor

productivity (TFP) shocks cause economic

fluctuation.

2

Hassler and Krusell (2012) also

introduced TFP shocks into a regional integrated

model of climate and the economy (RICE) to

provide an integrated investigation of climate

policies on oil‐producing and oil‐importing

countries. The environmental DSGE modelling

literature has been extended to include

other shocks, such as environmental shocks

(Angelopoulos, Economides and Philippopoulos

2013), energy price shocks (Roach 2014),

consumption shocks (Argentiero et al. 2017)

and nominal shocks (Annicchiarico and Di Dio

2015). The contribution of the current article to

the literature is not introducing a new type of

shock, but comparing the economic and envir-

onmental effects of two popular emissions

reduction regimes of fixed and variable emis-

sions taxes when a shock occurs.

Previous studies mostly focus upon variable

emissions taxes in which the tax rate is estimated

via maximising social welfare in each period. For

instance, in Heutel (2012) and Angelopoulos,

Economides and Philippopoulos (2013), the tax

rate changes in every period. Hassler and Krusell

(2012) specify climate policies in terms of

taxation on oil, Fischer and Springborn (2011)

and Annicchiarico and Di Dio (2015) include

variable tax, cap and an intensity target, and

Tumen et al. (2016) and Argentiero et al. (2017)

consider taxes on fossil fuels and subsidies on

renewable energy. A review of implemented tax

policies in countries such as Finland, Norway,

Switzerland and Japan (World Bank 2016),

however, indicates that the tax rates in their

programs have been estimated and pre‐an-

nounced a few periods (even years) in advance,

and have been kept constant over several periods.

Hence the volatility of the tax rate is very limited,

and is more fixed than variable. On the other

hand, in a cap‐and‐trade system the price is

77Ramezani, Harvie and Arjomandi: Emissions Pricing Policies

© 2019 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business

and Economics