Environmental Fiscal Reform and Fiscal Consolidation - William & Mary

Environmental Fiscal Reform and Fiscal Consolidation: The Quest for the Third Dividend in Portugal*

Alfredo Marvão Pereira** The College of William and Mary Rui M. Pereira University of the Algarve

College of William and Mary Department of Economics Working Paper Number 114 April 2011

*

This paper is part of a project sponsored by the Fundação de Ciência e Tecnologia do Ministério de Ciência e Tecnologia, Lisbon, Portugal. Reference: PTDC/ECO/72065/2006. ** Corresponding author. . .

COLLEGE OF WILLIAM AND MARY DEPARTMENT OF ECONOMICS WORKING PAPER # 114 April 2011

Environmental Fiscal Reform and Fiscal Consolidation: The Quest for the Third Dividend in Portugal Abstract This paper explores the capacity for environmental reform to reduce CO2 emissions, stimulate economic performance, and promote fiscal sustainability. Simulation results suggest that reforms based on CO2 taxation stimulate GDP when tax revenues are used to promote private or public investment and employment when used to finance reductions in personal income taxation or firms' social security contributions. More generally, reforms allow for reductions in the costs of climate policy, a weaker realization of the second dividend. In addition, several reforms lead to reductions in public debt, the realization of a third dividend. When political constraints on reducing public spending are considered, however, this third dividend only materializes when revenues finance public investment or reductions in the firms' social security contributions. Overall, our results suggest that low growth and high public debt need not be regarded as hindrances for environmental fiscal reform but can actually be seen as catalysts. Keywords: : Carbon Tax, Environmental Fiscal Reform, Economic Growth, Budgetary Consolidation, Dynamic General Equilibrium, Endogenous Growth. JEL Classifications: D58, H54, H63, O44, Q48, Q54.

Alfredo Marvão Pereira Department of Economics, The College of William and Mary, Williamsburg, USA PO Box 8795, Williamsburg, VA 23187 [email protected] Rui M. Pereira Dept. of Economics University of the Algarve Faro, Portugal [email protected]

1.

Introduction Environmental tax reform has gained momentum as an important part of a package of

policy instruments for reducing greenhouse gas emissions in a cost-effective manner (OECD, 2004). These policies replace revenue from existing taxes with revenue from taxes on pollution. The presence of distortions in the tax system gives rise to the potential for simultaneous improvements in environmental outcomes and economic performance called a double dividend [see, for example, Goulder (1995a, 1995b), Parry (1997), Goulder et al. (1999), Parry and Bento (2000), Goulder et al. (2008), and Fullerton and Kim (2008)]. The key factors determining the existence of a double dividend are the magnitude of existing inefficiencies and the extent to which reform shifts taxes from more efficient to less efficient factors, making potential efficiency gains dependent on the structure of the tax system [see, for example, Bovenberg and Goulder (1995)]. This has lead to the analysis of environmental tax reform for economies and public sectors with different structures [see, for example, Shackleton et al. (1993), Farmer and Steininger (1999), Takeda (2007), Verde and Tol (2008) and Conefrey et al. (2008)]. Recently, the focus of the literature has expanded from simple environmental tax reform to more general environmental fiscal reform by considering the influence of tax deductible spending, partial corporate income tax integration, and public debt financing [see, for example, Parry and Bento (2000), Metcalf (2005), and Conferey et al. (2008)]. This paper continues this line of research by studying environmental fiscal reforms that include the traditional tax policies but also include tax expenditure, renewable energy and public expenditure policies, policies not previously examined in the literature. This more comprehensive analysis of revenue recycling options is especially pertinent and timely. Indeed, programs, including those in the EU, the Regional Greenhouse Gas Initiative and the Western Climate Initiative, now advocate the use of ( )

*

This paper is part of a project sponsored by the Fundação de Ciência e Tecnologia do Ministério de Ciência e Tecnologia, Lisbon, Portugal. Reference: PTDC/ECO/72065/2006. ( **) Corresponding author.

CO2 permit revenue to support the deployment of renewable energies, job training and social transfers, among others options [see, for example, WCI (2008), EU (2009), and RGGI (2011)]. In a different vein, and more importantly from the standpoint of this paper, we have witnessed a generalized growing concern over mounting public debt in recent years and the need to promote fiscal sustainability. CO2 taxes and auctioned emissions permits have emerged as potentially important instruments for increasing public revenues [see, for example, Metcalf and Weisbach (2008), Galston and MacGuineas (2010), Metcalf (2010) and Nordhaus (2010)]. In this context, this paper expands the traditional focus of the literature on the double dividend to the quest for a third dividend, fiscal sustainability. We define this third dividend as a reduction in the public debt to GDP ratio resulting from revenue neutral environmental fiscal reform. This is a very strong definition in that it excludes the direct use of CO2 tax revenue to pay down public debt and instead focuses on second order tax revenue and spending effects. Generally, analyses of the public debt implications of environmental fiscal reforms focus on using CO2 tax revenue to finance the purchase of financial assets, paying down debt [see, for example, Shackelton (1993), Conferey et al. (2008), and Farmer and Steininger (1999)]. The links between climate policy, the economy and the public budget are fundamental since they directly correlate to some of the most important policy constraints faced by many countries in their pursuit of sound climate policies: the need to enact policies that promote longterm growth and fragile public budgets. These policy constraints are particularly relevant for the less developed energy-importing economies in the EU, such as Greece, Ireland, and Portugal, for example. As EU structural transfers have shifted towards new member states, these countries have been forced to rely on domestic public policies to promote real convergence to EU standards of living. This poses a challenge since growing public spending and, more recently,

1

falling tax revenues and countercyclical policies have contributed to a fast increasing public debt and a sharp need for budgetary consolidation. In this context of low growth and high public debts, and even more so in light of the austerity policies to be implemented in the foreseeable future in these countries under the auspices of the IMF and the EU, it is easy to dismiss environmental efforts as untimely. The key objective in this paper is to determine whether or not environmental fiscal reform can actually interact positively with the other policy concerns, and – ultimately, whether the current economic and fiscal difficulties should be regarded as a hindrance or as a catalyst for enacting climate policies. This is in line with the recent foremost recommendations of the OECD (2011). In this paper we address these issues in the context of a dynamic general equilibrium model of the Portuguese economy. This model incorporates fully dynamic optimization behavior, endogenous growth, and a detailed modeling of the public sector activities, both tax revenues and consumption and investment spending. Previous versions of this model have been used to evaluate the impact of tax policy [see Pereira and Rodrigues (2002, 2004)], social security reform [see Pereira and Rodrigues (2007)] and, more recently, energy and environmental policy [see Pereira and Pereira (2011a, 2011b)]. 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, for example, Goulder and Bovenberg (1995), Goulder et al (1999), Parry and Williams (1999), Babiker et al (2003) and Goulder and Parry (2008)]. On the other hand, it incorporates many of the insights of

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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)]. The key distinguishing feature of this model in the applied climate policy literature is its focus on endogenous growth and the associated treatment of public sector optimization behavior [see Conrad (1999) and Bergman (2005) for literature surveys]. Productivity enhancing public sector investment in public capital 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 [Greiner (2005) and Gupta and Barman (2009)]. The remainder of this paper is organized as follows. Section 2 provides a brief model description together with a discussion of several implementation issues. Section 3 presents marginal abatement cost curves and discusses the economic and budgetary impact of environmental fiscal reform. Section 4, considers in great detail a variety of environmental fiscal reform policies consistent with achieving the 20/20 emission goals for Portugal. Finally, section 5 provides a summary of the simulation results and concluding remarks.

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

3

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, , is produced with a CES technology, as in (Eq. 1), linking value added, , and aggregate primary energy demand, _ . Value added is produced with a Cobb-Douglas

technology (Eq. 2), exhibiting constant returns to scale in the reproducible inputs – effective labor, , private capital, , and public capital, . Only the demand for labor, , and the private capital stock are directly controlled by the firm, meaning that if public investment is absent then decreasing returns set in. Public infrastructure and the economy-wide stock of

knowledge, , are publicly financed and are positive externalities. The capital and labor shares

are and , respectively, and = 1 − − is a public capital externality parameter. is a size parameter. Private capital accumulation is characterized by (Eq. 3) where physical capital

depreciates at a rate . Gross investment, , is dynamic in nature with its optimal trajectory 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

4

Figure 1: Overview of the Production Structure Production CES

Capital

Value Added

Energy

CD

CES Labor

Crude Oil

Non Transportation Fuels CD

CES - Constant Elasticity of Substitution CD - Cobb Douglas

Coal

Natural Gas

Wind

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, , (Eq. 4), represents the after-tax position when revenues

from sales are netted of wage payments and investment spending. After-tax net revenues reflect the presence of a private investment and wind energy investment tax credit at an effective rate of and , respectively, taxes on corporate profits at a rate of , and Social Security contributions paid by the firms on gross salaries, , at an effective rate of

.

Buildings make up a fraction, 0 < #1 − $ % < 1, of total private investment expenditure.

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 &'(, . The corporate income tax base is calculated as net of total labor costs, 5

#1 +

% ,

and net of fiscal depreciation allowances over past and present capital

investments, + . A straight-line fiscal depreciation method over ,- periods is used and investment is assumed to grow at the same rate at which output grows. Under these assumptions, depreciation allowances simplify to + , with + is obtained by computing the difference of two 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 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

is the shadow price of private capital, which evolves according to (Eq. 8). function, where ./0

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 The energy sector is an integral component of the firms' optimization decisions.

Aggregate primary energy demand is produced with CES technology (Eq. 9) in which crude oil,

1234567 , and non-transportation fuels, 8 are substitutable at a lower rate reflective of the

dominance of petroleum products in transportation energy demand and the dominance of coal, natural gas and, to a lesser extent, wind energy, in electric power and industry. Nontransportation 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 (Eq. 16) where the physical capital, wind

turbines, depreciate at a rate of . Gross investment in wind energy infrastructure, 9 , is dynamic in nature and is subject to adjustment costs as private capital.

6

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 levels given in (Eq. 13), yielding (Eq. 12). Finally, the variational condition for optimal wind energy investment is given in (Eq. 17) and the equation of motion for the shadow price of wind energy is given in (Eq. 18). 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 natural gas, and 98.0% from coal, oxidizes to form CO2. Together, the quantity of fuel consumed, its carbon factor, oxidation rate, and the ratio of the molecular weight of CO2 to carbon are used to compute the amount of CO2 emitted from fossil fuel combustion activities in a manner consistent with the Intergovernmental Panel for Climate Change (2006) reference approach. These considerations suggest a linear relationship between CO2 emissions and fossil fuel combustion activities. Computation of CO2 emissions from fossil fuel combustion is given in (Eq. 19). 2.3

The Households An overlapping-generations specification was adopted in which the planning horizon is

finite but in a non-deterministic fashion. A large number of identical agents are faced each period

with a probability of survival, :. The assumption that γ is constant over time and across agecohorts yields a perpetual youth specification in which all agents face a life expectancy of

0

0;
? AB + #1 − :>? % _ AB C @

@

= >?, # %EF G E

(1)

0;EF;EG

H,/0 = #1 − I %H, + H, − JI

(2)

K H,

H,

(3)

= − =1 + LMMN C # % − H, − O, − #1 − $ %>?, H, − PQ, − NR = − =1 + LMMN C # % − +H, − +S, − PQ, C + RN, H, + RN, S, + = T1 − #1 + U%;VW(X Y⁄,-T1 − #1 + U%;0 Y

(5)

0D @AB ;0

:&' =:>? AB + #1 − :>? %_ AB C @

@

[\ = #1 + @

%

(6)

1 %;0 #1 = − ^1 + #1 − $ %&', − + − _#2J ./0 + 1/0 % 2J . = #1 − %

(4)

(7)

./0 K + `1 − + J a b c 1 + 1/0

(8)

The Energy Sector 0D @d

_ = (, =:( 1234 567 d + #1 − :( % 8 d C @

@

(9)

PQ, = PLQ, + =PNef Q gRh, + 4i6jj6kl_mnopk1gRh N?eqgr C 1234 567

(10)

r

PLQ, = s=PL,R, + 4i6jj6kl_mnopk1L N?eqgr CR,

(11)

Rt0

=PL,R, + 4i6jj6kl_mnopk1L N?eqgr C L,u R, − =PL,u, + 4i6jj6kl_mnopk1L N?eqgr C L,R u, = 0

(

0D 0D ;0 _ ;0 @ @ @ @ @ =:>? AB + #1 − :>? %_ AB C @AB #1 − :( % (, =:( 1234 567 d + #1 − :( % 8 d C @d 8 d − PLQ, = 0

0D 0D ;0 _ ;0 #1 − :&' % =:>? @ AB + #1 − :>? %_@AB C @AB :( (, =:( 1234 567@d + #1 − :( % 8@d C @d 1234 567@d − PNef Q gRh, = 0 1234 567

8 = (K, =vNL 9C

EwG

r

x R,y,z Rt0

E

9/0 = #1 − eI %9 + S, − JeI

(13) (14) (15)

K S, 9

(16)

S, 1 %;0 = − =1 + #1 − $ %>?, − + NR − RNe C#2JeI ./0 #1 + 1/0 % 9 2JeI . =

(12)

(17)

{| ./0 S, K = #1 − NR % + b ~ }#1 − eI % + JeI a {9 9 #1 + 1% 9

(18)

V

n1kli6jj6klj = s 4i6jj6kl _mnopk1L R, + 4i6jj6kl_mnopk1gRh 1234 567

(19)

L

8

Table 1 (con't): The Dynamic General Equilibrium Model - The Model Structure The Household Sector ?, =

;0 ;0 s : `o?/,/ + ℓ?/,/ c −1 ∞

(20)

t

s : T1 + #1 − e %1/> Y;> =1 + &', C?/>,/> = 8?, ∞

(21)

t

8?, ≡ ?, + ?, + -

:

?, = s a b a=1 − HR C #1 − SMMN %/ = − ℓ?/,/ C / + 89/ + 9/ − 8/ b 1 + #1 − e %1/

(22)

∞

t

(23)

H L ?, = =1 + #1 − e %1;0 C-,;0 + #1 − %;0 − =1 + 1;0 C,;0 + =1 − HR C #1 − SMMN %;0 = − ℓ?;0,;0 C ;0 + 89;0 + 9;0 − 8;0 − #1 + >? %?;0,;0

(24)

#1 + >? % ℓ = #1 − SMMN %=1 − HR C #1 − 9 %

(26)

#1 + >? % = T1 − #1 + #1 − e %1;0 %;0 : Y# + #-, − , % + - %

The Public Sector

HfqhRN = sT= ℓ C H

0;

Y #1 + #1 − e %1XW %;

(27)

-,/0 = #1 + 1XW %-, + =1 + >?,N C + =1 + >?,R C + =1 + >?,R C + 89 − 8 8 = -8 + 8 + 8 + + + 958 + 8 K /0 = =1 − I C + − JI K

/0 = #1 − I % + − JI

XW ./0 .XW XW = #1 + #1 − e %1/0 % #1 + #1 − e %1XW % ℓH XW ./0 = #1 − +N % a b #1 + #1 − e %1XW % I XW −./0 = ./0 a2JI b . =

. =

(28) (29) (30) (31) (32) (33) (34)

XW ./0 { ./0 K # #1 − NR % + NR % + b ~ XW }=1 − I C + JI a { #1 + #1 − e %1XW % #1 + #1 − e %1/0 %

XW I −./0 = ./0 a2JI

(25)

I

b

(35) (36)

XW I ./0 { ./0 K #1 − %#1 + NR %LMMN + SMMN C % + b ~ XW =HR =1 − LMMN C − XW }#1 − I + JI a #1 %1 #1 %1 {

#1 + − e % #1 + − e /0 %

(37)

Market Equilibrium

#1 − 9 % =

(38)

r

= s PL,R, R, + PNef Q gRh, 1234 567 + + H, + S, + + + − Rt0

,/0 = =1 + 1 C, + − 9 L

(39) (40)

= -, − ,

(41)

9

The household, aged n at time p, chooses consumption and leisure streams that maximize intertemporal utility, (Eq. 20), subject to the consolidated budget constraint, (Eq. 21). The objective function is lifetime expected utility subjectively discounted at the rate of .

Preferences, 2?/>,/> , are additively separable in consumption and leisure, and take on the CES form where is a size parameter and is the constant elasticity of substitution. The effective

subjective discount factor is : meaning that a lower probability of survival reduces the effective discount factor making the household relatively more impatient. The budget constraint, (Eq. 21), reflects the fact that consumption is subject to a value-

added tax rate of &', and states that the households’ expenditure stream discounted at the

after-tax market real interest rate, 1 + #1 − e %1/> , cannot exceed total wealth at p, 8?, . The

loan rate at which households borrow and lend among themselves is 1⁄: times greater than the

after-tax interest rate reflecting the probability of survival.

For the household of age n at p , total wealth, 8?, (Eq. 22), is age-specific and is

composed of human wealth, ?, , net financial worth, ?, , and the present value of the firm,

- . Human wealth (Eq. 23), represents the present discounted value of the household’s future

labor income stream net of personal income taxes, X , and workers’ social security contributions, O

.

Labor's reward per efficiency unit is .

The household’s wage income is determined by its endogenous decision of how much

labor to supply, = − ℓ , out of a total time endowment of , and by the stock of

knowledge or human capital, , that is augmented by public investment on education. Labor earnings are discounted at a higher rate reflecting the probability of survival. A household’s income is augmented by net interest payments received on public

debt, -, , profits distributed by corporations, , international transfers, 9 , and public 10

transfers, 89 . On the spending side, debts to foreigners are serviced, taxes are paid and consumption expenditures are made. Income net of spending adds to net financial wealth (Eq. 24). Under the assumption of no bequests, households are born without any financial wealth. In general, total wealth is age-specific due to age-specific labor supplies and consumption streams. Assuming a constant real interest rate, the marginal propensity to consume out of total wealth is age-independent and aggregation over age cohorts is greatly simplified. Aggregate consumption demand is given by (Eq. 25) and an age-independent coefficient enables us to write the aggregate demand for leisure, (Eq. 26), as a function of aggregate consumption. 2.4

The Public Sector

The equation of motion for public debt, -, , (Eq. 28), reflects the fact that the excess of

government expenditures over tax revenues has to be financed by increases in public indebtedness. Total tax revenues, 8 , (Eq. 29) include personal income taxes, -8 , corporate income taxes, 8 , value added taxes, 8 , social security taxes levied on firms and workers

8 and 8 . All of these taxes are levied on endogenously defined tax bases. Residual taxes are modeled as lump sum, 8 , and are assumed to grow at an exogenous rate.

The public sector pays interest on public debt at a rate of 1XW and transfers funds to

households 89 in the form of pensions, unemployment subsidies, and social transfers, which

grow at an exogenous rate. In addition, it engages in public consumption activities, , and public investment activities in both public capital and human capital, and .

Public investments are determined optimally, respond to economic incentives, and

constitute an engine of endogenous growth. The accumulations of and are subject to

depreciation rates, and , and to adjustment costs that are a fraction of the respective

investment levels. The adjustment cost functions are strictly convex and quadratic.

11

Figure 2: Overview of the Public Sector Personal Income Tax

Wages Dividends Interest Income Depreciations Allowances

Corporate Income Tax

Interest Payments on Public Debt

Renewable Energy Investment Tax Credit

Public Consumption

Public Investment

Expenditure

Revenue

Social Security Contributions

Workers Employers Private Consumption

Human Capital Investment Value Added Tax Pensions Unemployment

Investment Tax Credit

Public Consumption Private Investment

Social Transfers

Carbon Tax

Social Action

Human Capital Investment Public Investment

Public sector decisions consist in choosing the trajectories for , , and that maximize social welfare, (Eq. 27), defined as the net present value of the future stream of utility derived from public consumption, parametric on household private consumption-leisure decisions. The optimal choice is subject to three constraints, the equations of motion of the stock of public debt, (Eq. 28), the stock of public capital, (Eq. 30), and the stock of human capital, (Eq. XW , ./0 , and ./0 , the shadow prices of the public 31). The optimal trajectories depend on ./0

debt, public capital, and human capital stocks, respectively. The relevant discount rate is XW 1 + #1 − e %1/0 because this is the financing rate for the public sector. Optimal conditions are

(Eq. 32) for public debt, (Eq. 33) for public consumption, (Eq. 34-35) for public investment, and (Eq. 36-37) for investment in human capital. 12

2.5

The Foreign Sector

The equation of motion for foreign financing, , , (Eq. 40), provides a stylized

description of the balance of payments. Domestic production, , and imports are absorbed by

domestic expenditure and exports. Net imports, − , (Eq. 39), are financed through foreign

transfers, 9 , and foreign borrowing. Foreign transfers grow at an exogenous rate. In turn, the domestic economy is assumed to be a small, open economy. This means that it can obtain the desired level of foreign financing at a rate, 1W , which is determined in the international financial markets. This is the prevailing rate for all domestic agents. 2.6

The Intertemporal Market Equilibrium The intertemporal path for the economy is described by the behavioral equations, by the

equations of motion of the stock and shadow price variables, and by the market equilibrium conditions (Eq. 38-41). The labor-market clearing condition is given by (Eq. 38) where a structural unemployment rate of 9 is exogenously considered. The product market equalizes demand and supply for goods and services. Given the open nature of the economy, part of the demand is satisfied through the recourse to foreign production, hence (Eq. 39) and (Eq. 40). Finally, the financial market equilibrium, (Eq. 41), reflects the fact that private capital formation and public indebtedness are financed by household savings and foreign financing. We define the steady-state growth path as an intertemporal equilibrium trajectory in

which all the flow and stock variables grow at the same rate, U, while market prices and shadow

prices are constant. There are three types of restrictions imposed by the existence of a steadystate. First, it determines the value of critical production parameters, like adjustment costs and depreciation rates given the initial capital stocks. These stocks, in turn, are determined by assuming that the observed levels of investment of the respective type are such that the ratios of

13

capital to GDP do not change in the steady state. Second, the need for constant public debt and foreign debt to GDP ratios implies that the steady-state public account deficit and the current account deficit are a fraction U of the respective stocks of debt. Finally, the exogenous variables, such as public transfers or international transfers, have to grow at the steady-state growth rate. 2.7

Dataset, Parameter Specification, and Calibration The model is implemented numerically using detailed data and parameters sets. The

dataset is reported in Table 2 and reflects the GDP and stock variable values in 2008; public debt and foreign debt reflect the most recent available data. The decomposition of the aggregate variables follows the average for the period 1990–2008. This period was chosen to reflect the most recent available information and to cover several business cycles, thereby reflecting the long-term nature of the model. In turn, the baseline energy and environmental accounts are presented in Table 3. The baseline primary demand for crude oil grows to 658.8 PJ, coal demand to 169.1 PJ and demand for natural gas to 158.0 PJ in 2020. These lead to a baseline projection for emissions of 71.9 Mt CO2 in 2020. Parameter values are reported in Table 4 and are specified in different ways. Whenever possible, parameter values are taken from the available data sources or the literature. This is the case, for example, of the population growth rate, the probability of survival, the share of private consumption in private spending, the output scale parameter, and the different effective tax rates. In turn, consistent with the conditions for the existence of a steady-state, the exogenous variables, as mentioned above, were set to grow at the observed long-term steady-state growth rate. These parameters play no direct role in the model calibration.

14

Table 2: The Dynamic General Equilibrium Model - The Basic Data Set Domestic spending data (% of )

U _ H, S, Primary energy demand (GJ as a % of ) 8 1234567 g?h, V?fe?h ?M, Energy prices (€per GJ)

Pef Q Rh, PL,g?h, PL,V?fe?h ?M, Foreign account data (% of ) 1W , 9 , , Public sector data (% of )

8 -8 8 8 8N 8 8N 8R 8R 0, K, n1kl 8n 8 89 1XW -, , -,

GDP (billion Euros) Long term growth rate (%) Value added Primary energy consumption expenditure Private consumption Private investment Private wind investment Public consumption Public capital investment Public investment in education

166.228 1.763 85.393 2.557 62.343 20.312 0.064 12.285 3.329 7.025

Primary fossil energy spending Non transportation fuels Fossil fuels (excluding crude oil) Quantity of crude oil imports Quantity of coal imports Quantity natural gas imports

2.472 0.584 0.160 0.321 0.082 0.077

Import price of crude oil Import price of coal Import price of natural gas

6.140 1.890 4.450

Trade deficit Interest payments of foreign debt Unilateral transfers Current account deficit Foreign debt Total tax revenue Personal income tax revenue Corporate income tax revenue Value added tax revenue on private consumption expenditure on private investment expenditure on public consumption expenditure on public capital investment expenditure on public investment in human capital Social security tax revenues employers contributions workers contributions Carbon tax Lump sum tax revenue Social transfers Interest payments of public debt Public deficit Public debt

15

5.358 2.933 8.855 1.908 108.200 39.366 5.392 3.094 12.050 9.351 1.739 0.521 0.333 0.100 11.700 5.600 6.100 0.000 7.130 15.915 2.326 1.513 85.800

Table 2 (con't): The Dynamic General Equilibrium Model - The Basic Data Set Population and employment data (% of ) -5- 9 Private Wealth (% of )

Prices

Population (in thousands) Active population Unemployment rate

-

10.608 5.614 5.979

Human wealth Financial wealth Present value of the firm Distributed profits

.XW .I .eI I . .I Capital stocks (% of )

2827.507 -22.400 1695.452 17.603

Wage rate Shadow price of public debt Shadow price of private capital Shadow price of wind energy capital Shadow price of public capital Shadow price of human capital

9

Private capital Wind energy capital stock Public capital stock Human capital stock

0.034 -0.969 1.288 1.288 1.211 8.450 273.587 1.381 97.250 218.913

Table 3: Baseline Energy and Environmental Accounts Primary Energy Demand (PJ)

Crude Oil Coal Natural Gas Wind Energy

2010 553 142 133 22

2020 659 169 158 27

2030 785 201 188 32

2040 934 240 224 38

2050 1,113 286 267 45

CO2 Emissions from Fossil Fuel Combustion Activities (Mt CO2)

Crude Oil Coal Natural Gas Total

2010 40.2 12.8 7.4 60.4

2020 47.8 15.3 8.8 71.9

2030 57.0 18.2 10.5 85.6

16

2040 67.8 21.6 12.5 102.0

2050 80.8 25.8 14.9 121.5

Table 4: The Dynamic General Equilibrium Model – The Structural Parameters Household parameters

: UXX P0 Production parameters

X

&' ef Q

( vNL

Emissions factor

g?h

?M :&' :( I JI I JI ¡R ⁄R

Discount rate Probability of survival Population growth rate Elasticity of substitution Leisure share parameter

0.001 0.987 0.000 1.000 0.358

Labor share in value added aggregate Capital share in value added aggregate Public capital share in value added aggregate Elasticity of substitution between value added and energy Elasticity of substitution between oil and other energy wind energy share in non-transportation fuels fossil energy share in non-transportation fuels Wind energy price:quantity capacity utilization factor coal share in non-transportation fuels natural gas share in non-transportation fuels CES scaling share between value added and energy CES scaling share between oil and other energy Depreciation rate - Private capital Adjustment costs coefficient - Private capital Depreciation rate - Wind energy capital Adjustment costs coefficient - Wind energy capital Exogenous rate of technological progress

0.520 0.290 0.190 0.400 0.400 0.146 0.854 0.062 0.313 0.687 1.000 0.580 0.043 1.473 0.021 2.359

Emissions factor for oil (tCO2 per TJ) 4i6jj6kl_mnopk1gRh 4i6jj6kl_mnopk1Ng?h Emissions factor for oil (tCO2 per TJ) 4i6jj6kl_mnopk1?M Emissions factor for oil (tCO2 per TJ) Public sector parameters - tax parameters HR e NR ,+ $ RN, RN, &', >?, >?,N >?,R >?,R LMMN SMMN

Effective personal income tax rate Effective personal income tax rate on distributed profits Effective personal income tax rate on interest income Effective corporate income tax rate Time for fiscal depreciation of investment Depreciation allowances for tax purposes Fraction of private investment that is tax exempt Investment tax credit rate - Private capital Investment tax credit rate - Wind energy capital Value added tax rate on consumption Value added tax rate on investment Value added tax rate on public consumption Value added tax rate on public capital investment Value added tax rate for public investment in human capital Firms' social security contribution rate Workers social security contribution rate

17

72.600 90.193 55.820 0.091 0.112 0.200 0.116 16.000 0.735 0.680 0.005 0.005 0.176 0.094 0.044 0.111 0.014 0.144 0.157

Table 4 (con't): The Dynamic General Equilibrium Model – The Structural Parameters Public sector parameters - outlays parameters

1 − + I JI I JI Real interest rates

1, 1 W , 1 XW

Public consumption share Public infrastructure depreciation rate Adjustment cost coefficient Human capital depreciation rate Adjustment cost coefficient Interest rate

0.182 0.010 3.246 0.000 13.993 2.711

All the other parameters are obtained by calibration; i.e., in a way that the trends of the economy for the period 1990–2008 are extrapolated as the steady-state trajectory. These calibration parameters assume two different roles. In some cases, they are chosen freely in that they are not implied by the state-state restrictions. This is the case, for example, of the discount rate, the inter-temporal elasticity of substitution, the elasticities of substitution, the shares for labor and capital in production, and the public capital externality. Although free, these parameters have to be carefully chosen since their values affect the value of the remaining calibration parameters. Accordingly, they were chosen either using central values or using available data as guidance. The remaining calibration parameters are obtained using the steadystate restrictions as discussed above.

3.

Environmental Fiscal Reform

3.1

Simulation Design Our simulation experiments are designed to identify the impact of environmental fiscal

reform on indicators for the three dividends: CO2 emissions, economic performance, and the public sector account. The different revenue recycling policies are grouped according to the basic mechanism for cost containment involved, as opposed to public sector accounting conventions:

18

policies that stimulate demand, namely, value added tax replacement and public consumption financing; employment oriented policies, including personal income tax replacement, firms' social security contribution replacement, and human capital investment financing; and, policies that encourage investment in physical capital, including private capital and wind energy capital investment tax credits and public capital financing. This analysis provides a consistent methodological framework and a natural way of ranking policy alternatives. The CO2 tax works primarily through two mechanisms. First, it increases energy expenditure and reduces the firms' net cash flow, household income and domestic demand. Second, by affecting relative prices, it drives changes to the firms' input structure that affect the marginal productivity of factor inputs. These scale and substitution effects are central in defining the impact of CO2 taxes. Each of the environmental fiscal reforms counteracts, to varying degrees, these negative scale and substitution effects either by stimulating demand, encouraging employment or by promoting capital accumulation. Furthermore, we will distinguish between the reforms' potential for reducing the costs of achieving an emissions target, a weak form of the double dividend, and the potential for actually stimulating economic activity, a stronger form of the double dividend. The environmental fiscal reforms under consideration are designed to be revenue neutral. By construction, the CO2 tax revenue is directly offset by increased spending or decreased tax receipts. The policies, however, are not deficit neutral. Thus, the net effect of the reform on the public sector account, and the realization of a third dividend, depends on optimal public sector spending decisions, second order tax revenue effects and tax interactions which can increase distortions in a second best setting.

19

3.2

Marginal Abatement Cost Curves We begin by constructing marginal abatement cost curves to evaluate the effects of

environmental fiscal reform. These are presented in Figures 3, 4 and 5 for 2020, a common benchmark year for climate policy analysis. Each figure has three panels, corresponding to each of the three dividends: the top panel presents the marginal abatement cost curves in terms of the effectiveness of CO2 taxation in reducing emissions; the middle panel presents the corresponding impact on GDP; finally, the bottom panel measures the corresponding impact on public debt. Naturally, all policies lead to favorable environmental outcomes, the first dividend. The wind energy investment tax credit financing policy yields the largest reduction in emissions. Next, the demand oriented policies, i.e. the public consumption and value added tax recycling policies, result in slightly smaller emissions reductions than the lump sum case. Public investment in education, the personal income tax and firms' social security contributions recycling policies provide another band for emissions reductions of roughly the same magnitude, reflecting their shared focus on employment. Finally, the public capital investment and the private investment tax credit policies generate the smallest reduction in emissions. Environmental fiscal reform always reduces the costs of climate policy relative to the lump sum recycling policy, a realization of the weak form of the double dividend. Generally, the improvements in economic performance relative to the lump sum recycling policy are weakest for the demand driven policies, followed by the employment oriented policies and the policies promoting physical capital accumulation. In fact, we observe a realization of the strong double dividend for the policies that encourage private and public capital formation. Interestingly, incentives for wind energy reduce climate policy costs by more than the demand driven policies, the only change to the policy rankings from an environmental to an economic perspective.

20

Figure 3: Marginal Abatement Costs for CO2 Emissions in 2020: Demand Policies 19,500

Emissions Reduction (kt CO2)

18,000

CO2 Emissions

16,500 15,000 13,500 12,000 10,500

Lump Sum Transfer

9,000

Value Added Tax

7,500

Public Consumption

6,000 4,500 3,000 1,500 GDP Impact (% deviation from baseline)

0.00 GDP 0.50 0.00 -0.50 -1.00 -1.50

Public Debt Impact (% deviation from baseline)

-2.00 -2.50 Public Debt 7.50 3.75 0.00 -3.75 -7.50

CO2 Tax (Euros per tCO2)

21

Figure 4: Marginal Abatement Costs for CO2 Emissions in 2020: Employment Policies 19,500


18,000

CO2 Emissions

16,500 15,000 13,500 12,000 10,500

Lump Sum Transfer

9,000

Personal Income Tax Social Security Contributions

7,500

Human Capital Inv.

6,000 4,500 3,000

GDP Impact (% deviation from baseline)

1,500 0.00

GDP

0.50 0.00 -0.50 -1.00 -1.50


-2.00 -2.50

Public Debt

7.50 3.75 0.00 -3.75 -7.50


22

Figure 5: Marginal Abatement Costs for CO2 Emissions in 2020: Investment Policies 19,500


18,000

CO2 Emissions

16,500 15,000 13,500 12,000 10,500 9,000 7,500 Lump Sum Transfer

6,000

Investment Tax Credit

4,500

Wind Energy Investment Tax Credit 3,000

Public Capital Inv.

1,500 GDP Impact (% deviation from baseline)

0.00 GDP

0.50 0.00 -0.50 -1.00 -1.50


-2.00 -2.50 Public Debt 25.00 12.50 0.00 -12.50 -25.00


23

From the discussion above, it is clear there is a trade-off between the environmental effectiveness and the economic costs of the environmental fiscal reforms. The economic stimulus resulting from reductions in the policies' costs increases energy demand, generating a small rebound in emissions and reducing the policies' effectiveness. This effect is largest for the private investment tax credit and public investment financing policies due to their positive economic impact but remain relatively modest. For a tax of €15.00 per tCO2 the rebound in emissions is equal to 7.7% of the reduction in the lump sum recycling policy for the private investment tax credit financing policy, 3.9% for the personal income tax replacement, 3.2% for the firms' social security contributions replacement, and 1.7% for the value added tax replacement policy. Only the wind energy investment tax credit financing policy yields a reduction in policy costs while increasing its efficacy, allowing for a 11.7% larger reduction in emissions. The marginal abatement costs curves also present the potential for a third dividend from environmental fiscal reform. A reduction in the public debt to GDP ratio can be achieved through two mechanisms, optimal reductions in public spending or positive second order tax effects due to expanding tax bases following the realization of the second dividend. Each of the reforms yields smaller public debt reductions than the lump sum recycling policy. The most beneficial policies are those that stimulate employment. The value added tax replacement policy and the public consumption financing policy differ more substantially here than with respect to their environmental and economic impacts, with a larger impact on public debt for the public consumption policy. This arises from the simulation design because the public sector is free to increase public consumption, relative to the lump sum case, in the value added tax replacement policy. Generally, however, financing public expenditure increases public debt. Finally, both the private investment tax credit and public investment financing policies increase public debt.

24

4.

On the Effects of Achieving Existing 2020 Climate Policy Objectives We now examine the energy sector, economic and budgetary impacts of compliance with

the emissions target set out in EU Decision 406/2009/EC, limiting emissions in Portugal in 2020 to a 1.0% increase above 2005 levels. Table 5 presents the energy and environmental impacts while Tables 6-11 present the economic and budgetary impacts. 4.1

On the Energy Sector and Environmental Impacts By normalizing the policies by their emissions target, the emissions reductions are the

same and the energy sector impacts are very similar across policies. Accordingly, we only discuss the case of the lump sum recycling policy. From the marginal abatement curves, we find that a tax of €16.50 per tCO2 achieves the 2020 emission target. This CO2 tax is effective in reducing emissions by 9.1 Mt CO2 or 12.7%, which is consistent with a reduction in the emissions intensity of the economy to 0.3061 tCO2 per thousand Euros GDP and a reduction in per capita emissions to 5.9 tCO2. This is achieved by shifting primary energy demand away from fossil fuels, from carbon intensive fossil fuels and substitution away from energy inputs all together. Indeed, primary energy demand falls by 8.4% while overall primary demand for fossil fuels falls by 11.5%. This results from the increase in the price of fossil fuels relative to renewable energy due to the CO2 tax. In addition, the tax changes the relative price of fossil fuels to reflect their carbon content. As a consequence, we observe a 34.3% reduction in coal demand coupled with a 23.3% increase in investment in wind energy. Oil and gas demand fall by 7.6% and 3.0%, respectively.

25

Table 5: The Energy Sector and Environmental Impact of 2020 Emissions Limits: Environmental Fiscal Reform with Lump Sum Recycling (Percentage points deviations from steady state baseline)

Energy Fossil Energy Crude Oil Coal Natural Gas Private Investment in Wind Energy Wind Energy Infrastructure

2010 Energy

2020

2030

2040

2050

-8.97 -10.90 -7.22 -33.62 -1.96 30.64 2.45

-8.40 -11.46 -7.61 -34.34 -3.03 23.29 8.94

-8.16 -11.79 -7.86 -34.73 -3.61 19.19 12.40

-8.09 -12.00 -8.04 -34.96 -3.94 17.12 14.02

-8.11 -12.15 -8.18 -35.11 -4.16 16.19 14.76

53.02 -12.17 24.51

62.75 -12.72 47.37

74.46 -13.04 74.87

88.48 -13.25 107.77

105.19 -13.40 147.02

4.99

5.91

7.01

8.33

9.90

0.3080

0.3061

0.3050

0.3042

0.3037

Environmental Carbon Dioxide Emissions (kt CO2) Deviations from Baseline Increase over 1990 levels Per Capita Emissions (kt CO2 per person) Emissions Intensity of the Economy (kt CO2 per 1000 Euros GDP)

4.2

On the Effects of the Lump Sum Recycling Policy Although the lump sum recycling policy works to boost household income and, therefore,

stimulate demand, we discuss this scenario separately because it provides a basic reference point for our analysis of the remaining policies. CO2 taxation increases energy costs, which affects the firms' net cash flow, employment and investment demand, as well as household wealth. The negative effect on the firms' net cash flow limits input demand. Employment falls by 0.4%, less than the 0.4 pp drop in private investment, which corresponds to a 1.9% drop below its baseline steady state trajectory. Both reductions, however, are substantially smaller than the 11.5% drop in primary demand for fossil fuels. This is consistent with an overall reduction in factor input levels coupled with a shift in input demand in favor of capital and especially labor. This same pattern also develops for public sector investment decisions, with similar effects on production.

26

Table 6: The Economic Impact of 2020 Emissions Limits: Demand-Driven Policies (Percentage points of GDP relative to steady state)

2010 2020 Lump Sum Recycling -0.05 -0.03 Growth Rate -0.39 -0.92 GDP -0.25 -0.28 Consumption -0.39 -0.44 Investment 0.02 0.02 Wind Energy Investment -0.61 -3.22 Private Capital 0.03 0.15 Wind Energy Capital -1.38 -8.27 Foreign Debt -0.16 -0.35 Employment (percentage deviation from baseline) -0.18 -0.02 Wage (percentage deviation from baseline) Value Added Tax Replacement -0.04 -0.03 Growth Rate -0.25 -0.67 GDP -0.06 -0.07 Consumption -0.32 -0.36 Investment 0.02 0.02 Wind Energy Investment -0.50 -2.63 Private Capital 0.03 0.16 Wind Energy Capital -0.50 -5.39 Foreign Debt 0.11 -0.03 Employment (percentage deviation from baseline) 0.04 0.16 Wage (percentage deviation from baseline) Public Consumption Financing -0.04 -0.03 Growth Rate -0.26 -0.67 GDP -0.51 -0.60 Consumption -0.32 -0.36 Investment 0.02 0.02 Wind Energy Investment -0.50 -2.64 Private Capital 0.03 0.16 Wind Energy Capital -1.05 -6.16 Foreign Debt 0.11 -0.04 Employment (percentage deviation from baseline) -0.42 -0.30 Wage (percentage deviation from baseline)

2030

2040

2050

-0.02 -1.44 -0.31 -0.53 0.02 -5.47 0.25 -12.67 -0.47 0.09

-0.02 -2.01 -0.35 -0.65 0.02 -7.72 0.34 -15.47 -0.56 0.18

-0.01 -2.67 -0.39 -0.81 0.02 -10.22 0.42 -17.08 -0.64 0.25

-0.02 -1.06 -0.08 -0.42 0.02 -4.43 0.26 -8.37 -0.12 0.23

-0.01 -1.49 -0.10 -0.52 0.02 -6.21 0.36 -10.18 -0.18 0.29

-0.01 -1.97 -0.11 -0.64 0.02 -8.16 0.45 -11.18 -0.23 0.34

-0.02 -1.07 -0.72 -0.42 0.02 -4.45 0.26 -9.32 -0.13 -0.22

-0.01 -1.50 -0.85 -0.52 0.02 -6.24 0.36 -11.27 -0.19 -0.16

-0.01 -1.99 -1.01 -0.64 0.02 -8.21 0.45 -12.37 -0.24 -0.11

Given the reductions in factor demand, it is no surprise that CO2 taxation has a negative impact on GDP. The reduced net cash flow has a direct impact on household income, driving down private consumption. This initiates an important dynamic feedback between income, consumption and production. Overall, private consumption falls by 0.3 pp. Ultimately, the net effect of this process is a 0.9 pp reduction in GDP. Thus, the strong form of the double dividend does not materialize for the lump sum recycling policy.

27

Table 7: The Budgetary Impact of 2020 Emissions Limits: Demand-Drive Policies (Percentage points of GDP relative to steady state)

2010 Lump Sum Recycling -0.16 Public Debt -0.47 Total Expenditure -0.36 Public Consumption -0.08 Public Investment -0.03 Human Capital Investment -0.13 Public Capital -0.01 Human Capital 0.30 Total Tax Revenue -0.02 Personal Income Tax 0.00 Corporate Income Tax -0.10 Value Added Tax -0.05 Firms' Social Security Contributions -0.05 Workers' Social Security Contributions 0.52 Carbon Tax Value Added Tax Replacement 0.27 Public Debt -0.35 Total Expenditure -0.26 Public Consumption -0.07 Public Investment -0.03 Human Capital Investment -0.11 Public Capital -0.01 Human Capital -0.16 Total tax revenue -0.02 Personal Income Tax 0.00 Corporate Income Tax -0.59 Value Added Tax -0.04 Firms' Social Security Contributions -0.04 Workers' Social Security Contributions 0.54 Carbon Tax Public Consumption Financing -0.19 Public Debt 0.07 Total Expenditure 0.17 Public Consumption -0.07 Public Investment -0.03 Human Capital Inv. -0.11 Public Capital -0.01 Human Capital 0.32 Total Tax Revenue -0.02 Personal Income Tax 0.00 Corporate Income Tax -0.12 Value Added Tax -0.04 Firms' Social Security Contributions -0.04 Workers' Social Security Contributions 0.54 Carbon Tax

28

2020

2030

2040

2050

-2.03 -0.55 -0.41 -0.10 -0.04 -0.81 -0.05 0.21 -0.08 -0.03 -0.12 -0.08 -0.09 0.62

-3.20 -0.64 -0.47 -0.11 -0.05 -1.57 -0.12 0.16 -0.13 -0.06 -0.14 -0.12 -0.13 0.73

-3.90 -0.75 -0.55 -0.14 -0.06 -2.41 -0.21 0.10 -0.18 -0.08 -0.16 -0.16 -0.18 0.87

-4.25 -0.89 -0.64 -0.17 -0.08 -3.40 -0.33 0.05 -0.24 -0.11 -0.19 -0.21 -0.23 1.03

-1.13 -0.41 -0.30 -0.08 -0.03 -0.66 -0.04 -0.30 -0.06 -0.03 -0.70 -0.07 -0.08 0.64

-1.98 -0.48 -0.35 -0.09 -0.04 -1.26 -0.09 -0.43 -0.10 -0.05 -0.83 -0.10 -0.11 0.75

-2.48 -0.56 -0.40 -0.11 -0.05 -1.93 -0.16 -0.58 -0.14 -0.06 -0.99 -0.13 -0.14 0.90

-2.72 -0.67 -0.48 -0.13 -0.06 -2.70 -0.26 -0.74 -0.19 -0.09 -1.18 -0.17 -0.19 1.07

-1.87 0.10 0.21 -0.08 -0.03 -0.66 -0.04 0.26 -0.06 -0.03 -0.14 -0.07 -0.08 0.64

-2.96 0.13 0.27 -0.09 -0.04 -1.27 -0.09 0.23 -0.11 -0.05 -0.16 -0.10 -0.11 0.75

-3.67 0.17 0.33 -0.11 -0.05 -1.94 -0.17 0.21 -0.15 -0.07 -0.19 -0.13 -0.14 0.90

-4.09 0.21 0.40 -0.13 -0.06 -2.72 -0.26 0.19 -0.20 -0.09 -0.23 -0.17 -0.19 1.07

On the positive side, this policy yields a 2.0 pp reduction in public debt to 83.1% of GDP, allowing for the realization of a third dividend. Spending reductions due to the greater opportunity cost of public funds are the driving forces behind this effect. Overall, public expenditure falls 0.6 pp, or 2.0%, led by reductions in public consumption of 0.4 pp and public capital investment of 0.1 pp. Public spending falls in a manner consistent with a shift in the input mix towards employment through public investment in education. Overall, the drop in productivity-enhancing public investment activities compounds the negative effects of CO2 taxation on private inputs and economic activity as discussed above. In turn, there is a contraction of the tax bases due to lower incomes coupled with reductions in product and factor demand. This is, however, largely offset by the additional revenue from the CO2 tax resulting in a net increase in tax revenues of 0.2 pp. Social security contributions and personal income tax revenues decline by the largest relative magnitude, 1.2%, while value added tax revenues fall by the largest absolute amount, 0.1 pp. 4.3

On the Effects of Demand-Driven Recycling Policies We consider now the two remaining demand driven reforms. Here, CO2 tax revenue is

used to stimulate private and public consumption activities by offsetting value added tax revenues and by financing public consumption directly. Both policies require a tax of €17.00 per tCO2 to achieve the emissions target. The resulting CO2 tax revenues can finance either a 5.5% reduction in the value added tax rate or a 4.5% increase in public consumption relative to the lump sum recycling policy. Both demand policies yield a small improvement in economic performance over the lump sum recycling policy, yielding a weak double dividend. In both cases, GDP falls by 0.7 pp while employment remains virtually unchanged in 2020 and falls by 0.2% in 2050. This small

29

improvement in GDP and, relatively greater improvement, in employment outcomes reflects the small distortions associated with indirect taxation. In turn, both demand policies allow for a third dividend as a result of optimal reductions in public spending. Both policies, however, yield smaller reductions in public debt than the lump sum recycling policy. Because the government is free to increase public consumption levels in the value added tax replacement policy, this policy leads to smaller public debt gains than the public consumption financing. The principal distinction between the value added tax replacement policy and the public consumption financing policies lies in their impact on private and public consumption behavior. Naturally, the value added tax replacement policy stimulates increased private consumption; the public consumption financing policy encourages increased public consumption. 4.4

On the Effects of Employment-Driven Recycling Policies We now turn our attention to the employment driven reforms, the personal income tax

replacement, firms' social security contributions replacement and human capital investment financing policies. These allow us to evaluate labor responses to reductions in the tax burden on households and firms as well as responses to financing for labor productivity enhancing public sector investment in education. These policies require a tax of €17.50 per tCO2 to ensure compliance with climate policy objectives. CO2 tax revenues finance a 18.0% reduction in the personal income tax rate, a 9.4% reduction in the employers' social security contribution rate or a 7.7% increase in public investment in education. Overall, employment driven policies generate larger improvements in economic performance and larger reductions in the costs of climate policy than do the demand driven policies. These policies yield a 0.3 pp drop in GDP for the personal income tax replacement

30

Table 8: The Economic Impact of 2020 Emissions Limits: Employment-Driven Policies (Percentage points of GDP relative to steady state)

2010 2020 2030 Personal Income Tax Replacement -0.03 -0.02 -0.02 Growth Rate -0.03 -0.34 -0.67 GDP 0.00 0.01 0.03 Consumption -0.23 -0.27 -0.34 Investment 0.02 0.02 0.02 Wind Energy Investment -0.35 -1.92 -3.40 Private Capital 0.03 0.17 0.28 Wind Energy Capital -1.31 -6.59 -10.32 Foreign Debt 0.58 0.45 0.35 Employment (percentage deviation from baseline) -0.94 -0.80 -0.68 Wage (percentage deviation from baseline) Firms' Social Security Contributions Replacement -0.04 -0.02 -0.02 Growth Rate -0.10 -0.45 -0.81 GDP -0.17 -0.20 -0.22 Consumption -0.26 -0.30 -0.37 Investment 0.02 0.02 0.02 Wind Energy Investment -0.40 -2.18 -3.77 Private Capital 0.03 0.17 0.27 Wind Energy Capital -1.22 -6.40 -9.90 Foreign Debt 0.42 0.29 0.19 Employment (percentage deviation from baseline) 0.42 0.56 0.66 Wage (percentage deviation from baseline) Human Capital Financing -0.02 0.00 0.01 Growth Rate -0.36 -0.55 -0.58 GDP -0.25 -0.29 -0.34 Consumption -0.29 -0.24 -0.19 Investment 0.02 0.02 0.02 Wind Energy Investment -0.47 -2.13 -2.93 Private Capital 0.03 0.17 0.28 Wind Energy Capital 0.40 1.67 4.05 Foreign Debt -0.15 -0.20 -0.18 Employment (percentage deviation from baseline) -0.27 -0.42 -0.62 Wage (percentage deviation from baseline)

2040

2050

-0.02 -1.06 0.06 -0.44 0.02 -4.99 0.37 -12.89 0.27 -0.57

-0.01 -1.53 0.09 -0.57 0.02 -6.86 0.47 -14.47 0.20 -0.47

-0.01 -1.21 -0.25 -0.47 0.02 -5.43 0.37 -12.22 0.12 0.75

-0.01 -1.68 -0.28 -0.60 0.02 -7.34 0.47 -13.61 0.05 0.84

0.02 -0.48 -0.39 -0.14 0.02 -3.17 0.39 6.40 -0.12 -0.84

0.02 -0.25 -0.46 -0.08 0.02 -2.97 0.49 8.14 -0.05 -1.07

policy, 0.5 pp for the firms' social security contributions replacement policy and a 0.6 pp for the human capital investment financing policy. The personal income tax and firms' social security contributions replacement policies result in a strong double dividend with respect to employment that is, an improvement in environmental performance together with employment gains, while the human capital investment financing does not. Employment increases by 0.5% in the personal income tax replacement policy and by 0.3% in the firms' social security contributions replacement policy while it falls by 0.2% in the human capital financing policy. 31

Table 9: The Budgetary Impact of 2020 Emissions Limits: Employment-Driven Policies (Percentage points of GDP relative to steady state)

2010 2020 2030 Personal Income Tax Replacement -0.35 -1.77 -2.73 Public Debt -0.28 -0.33 -0.38 Total Expenditure -0.14 -0.15 -0.17 Public Consumption -0.05 -0.06 -0.08 Public Investment -0.09 -0.11 -0.14 Human Capital Investment -0.08 -0.51 -1.01 Public Capital -0.02 -0.15 -0.33 Human Capital -0.10 -0.20 -0.31 Total Tax Revenue -0.56 -0.70 -0.86 Personal Income Tax 0.00 -0.02 -0.03 Corporate Income Tax -0.03 -0.04 -0.04 Value Added Tax -0.03 -0.05 -0.08 Firms' Social Security Contributions -0.03 -0.05 -0.08 Workers' Social Security Contributions 0.55 0.65 0.78 Carbon Tax Firms' Social Security Contributions Replacement -0.28 -1.72 -2.66 Public Debt -0.15 -0.17 -0.20 Total Expenditure -0.03 -0.02 -0.01 Public Consumption -0.06 -0.07 -0.08 Public Investment -0.07 -0.09 -0.11 Human Capital Investment -0.09 -0.56 -1.10 Public Capital -0.02 -0.11 -0.25 Human Capital 0.04 -0.04 -0.13 Total Tax Revenue 0.03 -0.01 -0.04 Personal Income Tax 0.00 -0.02 -0.04 Corporate Income Tax -0.06 -0.07 -0.08 Value Added Tax -0.51 -0.63 -0.76 Firms' Social Security Contributions 0.04 0.03 0.02 Workers' Social Security Contributions 0.55 0.65 0.78 Carbon Tax Human Capital Financing 0.43 1.21 2.14 Public Debt 0.39 0.48 0.59 Total Expenditure -0.08 -0.09 -0.11 Public Consumption -0.05 -0.04 -0.03 Public Investment 0.51 0.61 0.72 Human Capital Investment -0.07 -0.41 -0.65 Public Capital 0.09 0.59 1.28 Human Capital 0.34 0.37 0.46 Total Tax Revenue -0.03 -0.05 -0.05 Personal Income Tax -0.01 -0.03 -0.04 Corporate Income Tax -0.07 -0.07 -0.07 Value Added Tax -0.05 -0.06 -0.07 Firms' Social Security Contributions -0.05 -0.07 -0.08 Workers' Social Security Contributions 0.55 0.65 0.78 Carbon Tax

32

2040

2050

-3.35 -0.46 -0.19 -0.10 -0.17 -1.60 -0.58 -0.44 -1.04 -0.05 -0.05 -0.11 -0.12 0.92

-3.69 -0.54 -0.21 -0.12 -0.21 -2.31 -0.90 -0.59 -1.26 -0.07 -0.06 -0.14 -0.16 1.10

-3.25 -0.24 -0.01 -0.10 -0.13 -1.72 -0.43 -0.22 -0.07 -0.05 -0.10 -0.92 0.00 0.92

-3.56 -0.28 0.00 -0.12 -0.16 -2.46 -0.68 -0.32 -0.10 -0.07 -0.12 -1.11 -0.02 1.10

2.96 0.71 -0.13 -0.02 0.86 -0.80 2.20 0.61 -0.05 -0.05 -0.08 -0.07 -0.08 0.93

3.50 0.85 -0.16 -0.01 1.02 -0.84 3.41 0.82 -0.03 -0.04 -0.08 -0.06 -0.07 1.10

The main difference between the personal income tax replacement policy and the remaining two employment policies is their impact on wages. The firms' social security contribution replacement policy represents a labor demand shock which, leads to a 0.6% increase in wages. In contrast, the increase in labor supply for the personal income tax replacement policy represents a labor supply shock which, leads to a 0.8% drop in wages. This leads to larger employment and private consumption gains in the personal income tax replacement policy. In addition, both the personal income tax replacement and the firms' social security replacement policies allow for a third dividend while the human capital investment financing policy does not. Public debt falls by 1.8 pp in the personal income tax replacement policy and by 1.7 pp in the firms' social security contribution replacement policy and increases by 1.2 pp in the human capital investment financing policy. The impact of these policies on employment and wages, by affecting private consumption decisions, leads to differences in public sector expenditure patterns. Public expenditure falls by less in the social security contributions replacement policy due primarily to smaller reductions in public consumption but also due to smaller reductions in public investment in education. The similarities in public debt effects between the two tax policies results from greater levels of revenues, particularly employees' social security contributions in the firms' social security contributions replacement policy. Naturally, the human capital investment financing policy yields larger levels of public expenditure. 4.5

On the Effects of Investment-Driven Recycling Policies Finally, we consider the cases using CO2 tax revenues to finance physical capital

investment incentives, namely a private capital and wind energy infrastructure investment tax credit, and public capital investment. Climate objectives can be achieved with a CO2 tax of

33

Table 10: The Economic Impact of 2020 Emissions Limits: Investment-Driven policies (Percentage points of GDP relative to steady state)

2010 2020 2030 Private Investment Tax Credit Financing 0.08 0.04 0.02 Growth Rate -0.30 0.31 0.75 GDP 0.03 0.04 0.05 Consumption 0.90 0.92 1.02 Investment 0.02 0.02 0.02 Wind Energy Investment 1.39 7.06 11.38 Private Capital 0.03 0.18 0.31 Wind Energy Capital 2.58 9.88 13.35 Foreign Debt -0.35 -0.09 0.04 Employment (percentage deviation from baseline) -0.22 -0.39 -0.48 Wage (percentage deviation from baseline) Wind Energy Investment Tax Credit Financing -0.03 -0.01 0.00 Growth Rate -0.26 -0.50 -0.69 GDP -0.31 -0.37 -0.44 Consumption -0.25 -0.23 -0.24 Investment 0.33 0.53 0.65 Wind Energy Investment -0.39 -1.86 -2.86 Private Capital 0.20 1.94 5.13 Wind Energy Capital -0.55 -2.89 -3.65 Foreign Debt -0.02 -0.08 -0.10 Employment (percentage deviation from baseline) -0.28 -0.21 -0.17 Wage (percentage deviation from baseline) Public Capital Financing 0.08 0.09 0.08 Growth Rate -0.54 0.26 1.38 GDP 0.49 0.59 0.71 Consumption -0.10 0.22 0.50 Investment 0.02 0.02 0.02 Wind Energy Investment -0.21 0.25 2.58 Private Capital 0.03 0.19 0.32 Wind Energy Capital 4.25 20.95 33.91 Foreign Debt -0.82 -0.47 -0.12 Employment (percentage deviation from baseline) 0.16 -0.14 -0.42 Wage (percentage deviation from baseline)

2040

2050

0.01 1.14 0.07 1.18 0.02 15.24 0.43 14.98 0.10 -0.52

0.01 1.53 0.09 1.40 0.03 19.19 0.55 15.67 0.14 -0.55

0.00 -0.87 -0.52 -0.27 0.77 -3.70 9.18 -3.96 -0.10 -0.14

0.00 -1.08 -0.61 -0.32 0.91 -4.57 13.79 -4.14 -0.11 -0.11

0.07 2.76 0.86 0.80 0.03 6.14 0.46 42.72 0.19 -0.66

0.05 4.40 1.04 1.13 0.03 10.72 0.60 47.71 0.44 -0.87

€14.50 per tCO2 when tax revenues are used to finance a wind energy investment tax credit. In contrast, both the private investment tax credit policy and the public investment policy require a tax of €18.50 per tCO2. The resulting tax revenues could be used to finance a 188 times larger wind energy investment tax credit or a 5.9 times larger private investment tax credit financing or a 20% increase in public investment. The private investment tax credit policy stimulates a 0.9 pp increase in private investment, boosting GDP by 0.3 pp by 2020 and 1.5 pp by 2050. In turn, the public investment 34

Table 11: The Budgetary Impact of 2020 Emissions Limits: Investment-Driven policies (Percentage points of GDP relative to steady state)

2010 2020 Private Investment Tax Credit Financing 0.80 2.50 Public Debt 0.09 0.11 Total Expenditure 0.09 0.09 Public Consumption 0.00 0.02 Public Investment 0.01 0.01 Human Capital Investment -0.01 0.05 Public Capital 0.00 0.01 Human Capital -0.20 -0.03 Total Tax Revenue -0.09 -0.02 Personal Income Tax -0.70 -0.78 Corporate Income Tax 0.10 0.10 Value Added Tax -0.04 -0.01 Firms' Social Security Contributions -0.05 -0.01 Workers' Social Security Contributions 0.58 0.69 Carbon Tax Wind Energy Investment Tax Credit Financing 0.08 -0.36 Public Debt -0.25 -0.29 Total Expenditure -0.19 -0.22 Public Consumption -0.05 -0.05 Public Investment -0.01 -0.02 Human Capital Investment -0.07 -0.42 Public Capital 0.00 -0.02 Human Capital -0.18 -0.27 Total Tax Revenue 0.00 -0.04 Personal Income Tax -0.50 -0.61 Corporate Income Tax -0.06 -0.05 Value Added Tax -0.04 -0.05 Firms' Social Security Contributions -0.04 -0.06 Workers' Social Security Contributions 0.46 0.54 Carbon Tax Public Capital Investment Financing 1.88 8.06 Public Debt 1.21 1.43 Total Expenditure 0.69 0.80 Public Consumption 0.48 0.58 Public Investment 0.04 0.05 Human Capital Investment 0.74 4.73 Public Capital 0.01 0.06 Human Capital 0.52 0.88 Total Tax Revenue -0.05 0.02 Personal Income Tax -0.04 -0.03 Corporate Income Tax 0.16 0.23 Value Added Tax -0.06 -0.01 Firms' Social Security Contributions -0.06 -0.01 Workers' Social Security Contributions 0.58 0.69 Carbon Tax

35

2030

2040

2050

3.35 0.13 0.10 0.03 0.01 0.21 0.03 0.09 0.03 -0.90 0.11 0.01 0.01 0.83

3.77 0.16 0.11 0.04 0.02 0.44 0.05 0.18 0.06 -1.06 0.13 0.03 0.03 0.98

3.95 0.19 0.13 0.05 0.02 0.74 0.07 0.27 0.09 -1.26 0.16 0.05 0.05 1.17

-0.51 -0.33 -0.26 -0.05 -0.02 -0.77 -0.05 -0.35 -0.06 -0.73 -0.06 -0.06 -0.07 0.63

-0.57 -0.39 -0.31 -0.05 -0.03 -1.11 -0.09 -0.42 -0.08 -0.86 -0.06 -0.08 -0.09 0.75

-0.59 -0.46 -0.37 -0.06 -0.03 -1.49 -0.13 -0.50 -0.10 -1.02 -0.08 -0.09 -0.10 0.89

12.56 1.69 0.93 0.70 0.06 9.30 0.13 1.35 0.12 0.00 0.29 0.05 0.06 0.83

15.48 1.99 1.07 0.84 0.08 14.57 0.23 1.93 0.24 0.04 0.37 0.13 0.15 0.99

17.03 2.35 1.25 1.01 0.09 20.66 0.37 2.61 0.38 0.10 0.46 0.23 0.25 1.19

financing policy crowds in private investment by 0.2 pp and yields a 0.3 pp expansion in economic activity in 2020 and 4.4 pp in 2050. Accordingly, both policies yield a strong double dividend. In addition, over the long term both policies lead to an increase in employment level. Employment increases by 0.1%, in 2050, in the private investment tax credit financing policy and by 0.4% for the public capital financing policy. These employment gains, however, occur only after somewhat substantial short term losses in employment, particularly for the public capital financing policy. The case of the wind energy investment tax credit policy differs in that it only yields a double dividend in its weak form. The relative merits of the private capital investment tax credit and public investment financing policies depends primarily on the marginal products of each type of capital investment, its depreciation rate and adjustment costs. In both policies, the marginal increase in investment financing is equal to the CO2 tax revenue. As a result, the public investment policy is subject to greater adjustment costs due to the relatively smaller stock. Over the long term, however, the lower depreciation rate and slightly larger marginal product provide a substantial contribution towards economic growth. Similarly, the impact of the wind energy financing policy is subject to substantial adjustment costs and is sensitive to its lower marginal product than that for either private capital or public capital. Of the three policies, only the wind energy investment tax credit financing yields, albeit only very marginally, a third dividend, reducing public debt by 0.4 pp. The public investment financing policy increases public debt by 8.1 pp while the private investment tax credit financing policy increases public debt by 2.5 pp. The increases in public debt result in the former from substantial increases in public consumption and public investment while in the later they are the

36

outcome of more modest public consumption increases together with weaker revenue growth, particularly over the short term as firms employ less labor. 4.6

On the Relevance of Endogenous Public Sector Spending Decisions In the previous sections, we considered optimal adjustments to public sector spending

decisions, often in the form of reductions in public spending, which thereby lead to favorable budgetary outcomes. It is well understood, however, that political realities may not allow for such spending reductions. Here we explore the implications of maintaining pre-reform public consumption and public investment levels on both the economic and budgetary impact of the reforms. Table 12 presents simulation results which highlight the role of public sector spending decisions on the realization of a second and third dividend, respectively. Exogenous public consumption decisions affect both the magnitude and the nature of the second dividend, particularly with respect to employment. This is most notable for the public consumption financing policy and the wind energy investment tax credit financing policy in which a strong employment dividend materializes in the presence of an exogenous public consumption trajectory. The connection between employment and consumption is clearly derived from the households' optimization problem. Public consumption financing in particular plays affects private consumption and labor supply decisions directly. Exogenous public sector investment decisions affect the magnitude of the second dividend without affecting the potential for the realization of a strong second dividend. At a design level, exogenous public sector investment decisions increase the reference trajectory for public investment in human capital and public capital relative to the central scenario. As a result, the human capital and public capital investment financing policies permit substantially larger levels of investment with positive economic growth effects. In this context, the human capital investment financing policy yields marginal long term GDP gains and a strong form of the 37

Table 12: On the Impact of Public Spending Decisions on the Second Dividend (Percentage points of GDP relative to steady state)

Central 2020

2050

Exogenous Public Consumption 2020 2050

Exogenous Public Investment 2020 2050

Second Dividend - GDP Effects Lump Sum Recycling Value Added Tax Replacement Public Consumption Financing

-0.92 -0.67 -0.67

-2.67 -1.97 -1.99

Personal Income Tax Replacement Firms' Social Security Contributions Replacement Human Capital Investment Financing

-0.34 -0.45 -0.55

-1.53 -1.68 -0.25

Private Investment Tax Credit Financing Wind Energy Investment Tax Credit Financing Public Capital Investment Financing

0.31 -0.50 0.26

1.53 -1.08 4.40

Demand Policies -0.81 -2.28 -0.57 -1.63 -0.55 -1.56 Employment Policies -0.30 -1.38 -0.45 -1.68 -0.51 -0.14 Investment Policies 0.28 1.44 -0.43 -0.82 0.04 3.68

-0.79 -0.56 -0.57

-1.66 -1.17 -1.21

-0.23 -0.33 -0.45

-0.60 -0.77 0.04

0.31 -0.42 0.42

1.30 -0.62 5.36

Second Dividend - Employment Effects Lump Sum Recycling Value Added Tax Replacement Public Consumption Financing

-0.35 -0.03 -0.04

-0.64 -0.23 -0.24


0.45 0.29 -0.20

0.20 0.05 -0.05


-0.09 -0.08 -0.47

0.14 -0.11 0.44

Demand Policies -0.21 -0.41 0.08 -0.05 0.11 0.01 Employment Policies 0.49 0.28 0.29 0.05 -0.16 0.01 Investment Policies -0.12 0.09 0.00 0.03 -0.75 -0.01

-0.43 -0.09 -0.11

-0.54 -0.15 -0.18

0.38 0.22 -0.20

0.30 0.15 -0.02

-0.06 -0.10 -0.53

0.12 -0.06 0.53

Third Dividend - Public Debt Effects Lump Sum Recycling Value Added Tax Replacement Public Consumption Financing

-2.02 -1.13 -1.86

-4.25 -2.72 -4.09


-1.76 -1.71 1.20

-3.69 -3.56 3.50


2.50 -0.36 8.04

3.95 -0.59 17.03

38

Demand Policies 2.30 11.03 1.94 8.17 2.57 11.58 Employment Policies -0.16 1.68 -1.44 -3.03 2.11 6.79 Investment Policies 1.53 0.85 1.91 7.57 0.02 -10.78

-0.53 0.08 -1.19

-1.15 -0.22 -3.35

-0.53 -0.46 1.83

-0.97 -0.86 4.49

2.30 0.38 9.52

3.30 0.81 19.83

Table 13: The Realization of the Second and Third Dividend - A Summary Central

Exogenous Public Consumption Public GDP Labor Debt Demand Policies

Exogenous Public Investment Public GDP Labor Debt

GDP

Labor

Public Debt

Lump Sum Recycling

R

R

Yes

R

R

No

R

R

Yes

Value Added Tax Replacement

W

W

Yes

W

W

No

W

W

Yes

Public Consumption Financing

W

W

Yes

W

S

No

W

W

Yes

Employment Policies Personal Income Tax Replacement

W

S

Yes

W

S

No

W

S

Yes

Firms' Social Security Contributions Replacement

W

S

Yes

W

S

Yes

W

S

Yes

Human Capital Investment Financing

W

W

Yes

W

W

No

W

S

No

Investment Policies Private Investment Tax Credit Financing

S

S

No

S

S

No

S

S

No

Wind Energy Investment Tax Credit Financing

W

W

Yes

W

S

No

W

W

No

Public Capital Investment Financing

S

S

No

S

S

Yes

S

S

No

Note: R – Reference, S – Strong, W - Weak

double dividend. Generally, however, the exogenous public investment levels serve to dampen the effects of the policies. Exogenous public consumption decisions imply that, in most cases, optimal reductions in public consumption do not materialize. This effectively eliminates the gains in fiscal consolidation in all but the firms' social security contributions option. In contrast, lower levels of 39

public consumption in the public investment financing policy allow for a third dividend where it did not exist before. In general, it is clear that responsive and responsible optimal public consumption decisions are critical for the third dividend to materialize. In turn, with exogenous public investment trajectories, which eliminate the mechanisms of endogenous growth, any meaningful public debt gains are neutralized in all but the public consumption financing policy. Although under personal income tax replacement and the firms' social security contributions replacement a third dividend can still be identified, it is rather small and certainly substantially smaller than under our central assumption. The firms' social security contributions recycling option generates positive tax revenue effects as a result of the increase in wages and employment levels. This leads to an increase in workers social security contributions and positive second order tax revenue effects. Although this is positive it reflects social security accounts more than the general government balance. In practice, this is one of the more robust policies in terms of producing the three dividends. For the public capital investment financing policy, expanding tax bases contribute to positive second order tax revenue effects. Thus, if public consumption activities do not expand, this policy can lead to emissions reductions, increased employment and GDP growth and fiscal consolidation. The same effect does not materialize for the private investment tax credit policy due to the fact that the substitution of private capital for labor inputs is more pronounced, leading to losses short term losses in personal income tax revenue and social security contributions.

5.

Summary and Concluding Remarks This paper examines the extent to which environmental fiscal reform, considering a

variety of CO2 tax revenue recycling options, can be designed to produce the three dividends:

40

lower emissions, lower climate policy costs and fiscal consolidation. All policy options under consideration achieve, by design, the first dividend, i.e., a reduction in CO2 emissions consistent with the 2020 climate policy target. Under the lump sum reference recycling option this requires a tax of €16.50 per tCO2. Most of the remaining policy options require taxes between €17.00 and €18.50. The need for slightly higher tax rates vis-à-vis the lump sum case reflects the existence of small rebounds in emission under these policies. These figures are in line with the current value of forward contracts for 2020 emission permits in the Inter Continental Exchange reflective of expected revenue levels for permit auctions in phase III of the EU-ETS. Wind energy investment tax credits are often used to boost the environmental effectiveness of climate policy programs. From our analysis of the marginal abatement cost curves, we see that financing these credits with CO2 tax revenue does indeed generates the largest emissions reduction. As a practical policy point, this means that these credits require a lower equilibrium tax for meeting climate policy objectives, specifically of €14.50 per tCO2. In the context of auctions for the emissions trading system, this means lower equilibrium prices or, if the use of the revenue is not disclosed prior to auction, a weaker secondary market. Simulation results show that environmental fiscal reform can stimulate economic performance through private and public investment financing policies - an increase in GDP of 1.1 pp and 4.4 pp, respectively - and generate employment gains through reductions in the personal income tax rate and firms' social security contributions - of 0.2% and 0.1% respectively, In this case, we observe a strong realization of the second dividend. Generally, however, all reforms considered reduce climate policy costs compared to the reference lump sum recycling option and thereby allow for the realization of a weak double dividend. Policies that promote

41

investment activities generate the largest reduction in policy costs followed by those that affect employment and those that affect final demand. These results contribute to the mounting evidence that environmental fiscal reforms that encourage private capital formation provide greater economic gains than those that encourage final demand [see, for example, Shackleton et al. (1996), Bovenberg and Goulder, (1995), Farmer and Steininger (1999), and Takeda (2007)]. These gains typically stem from the greater distortions associated with capital taxation in existing tax systems. A novel feature of our analysis, however, is that we show that recycling policies that promote public investment can also lead to very strong gains. In addition, we find significant differences between industry subsidies that stimulate employment and investment. Employment policies tend to have a smaller long term impact than the investment policies, which indeed yield a strong double dividend. The employment policies can, however, provide a short term cost mitigation strategy for overcoming adjustment costs associated with capital investment. Simulation results suggest that the third dividend, a reduction in public debt, occurs under several of the revenues recycling options under consideration. They also show that this is mostly due to optimal reductions in public expenditure associated with the increasing opportunity cost of public funds. Generally, analyses of the public debt implications of environmental fiscal reforms focus on using CO2 tax revenue to finance the purchase of financial assets, paying down debt, and find that the costs of these policies exceed those of other revenue recycling options [see, for example, Shackelton (1993), Conferey et al. (2008), and Farmer and Steininger (1999)]. Indeed, given that our recycling policies are revenue neutral, by design their impact on public debt is completely determined by second order tax revenue effects and public sector spending decisions. In this vein, when we consider political constraints that would prevent such optimal

42

reductions in public spending, only in the firms' social security contributions and the public investment recycling options do we observe the third dividend. This highlights the critical importance of flexible and responsible spending decision in achieving budgetary consolidation in a framework of environmental fiscal reform. To conclude, it should be highlighted that although the analysis and results in this paper are directly relevant for policy making in Portugal, their interest and applicability is far from parochial. Concerns over economic growth and fiscal sustainability are at the forefront of policy discussion in many countries. Against this backdrop environmental policies are regarded with concern if not outright dismissed as untimely. Our results, however, make it clear that it is possible to design environmental fiscal policies that achieve the emission goals while at the same time promoting economic performance and fiscal consolidation. This implies that, the current economic and fiscal woes do not have to be viewed as a hindrance to the implementation of environmental policies but can actually be regarded as a catalyst for such policies. Well designed environmental fiscal reforms, can provide for all three dividends, a reduction in emissions, economic and employment stimulus, and fiscal consolidation.

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