Developed Markets November 03, 2021 / 03:47 pm UTC

The GDP Impact of Climate Change Mitigation

By Francesca Beausang
  • The IMF estimates that carbon emission cuts of 55% below baseline levels in 2030 would be needed to meet the Paris Agreement’s target of keeping the rise in global temperatures within 1.5 degrees Celsius relative to the pre-industrial era. Some 135 countries have committed to net zero by 2050, but even if commitments to 2030 were met, that would amount to between one- and two-thirds of the reductions needed. To stay on track, emission cuts from DM, high-income EM and low-income EM should reach 70%, 55% and 35%, respectively, or alternatively 80%, 50% and 30%. A tall order…
  • Bottom line: Beyond the climate ambitions gap, there is also a gap in policy implementation. One could hypothesize that the policy gap, especially in EM, is due to the perception that climate change mitigation policies, including environmental tax reforms, have a negative impact on GDP. Yet we show this is not the case: 1) Fiscal multipliers from environmental taxes are less negative than those from income taxes; 2) environmental taxes cause reductions in informality and tax evasion; 3) environmental taxes are especially well-suited to EM in the early stages of decarbonization, where they are the least contractionary; 4) green energy investment multipliers are higher than non-eco-friendly ones.

Figure 1: Cumulated Multipliers Associated with Green and Non-Eco-Friendly Energy Investment Spending

Source: Batini et. Al. (2021), Continuum Economics

Cutting emissions and protecting wildlife and natural resources have sometimes been portrayed as being at odds with creating jobs and fostering economic growth (see Texas Railroad Commission Chairman Wayne Christian’s article). In contrast, we take the view, in line with many senior officials from finance ministries and central banks, that:

  • Green projects deliver higher short-term returns per dollar spent and lead to increased long-term cost savings, in comparison with traditional fiscal stimulus. In particular, Batini et al. (see Figure 1) show that investments in renewable energy have larger investment multipliers (between 1.1 and 1.5) than investments in non-renewables (0.5-0.6), and public investments in renewables can support GDP objectives. In other words, every dollar spent on key carbon-neutral or carbon-sink activities can generate more than a dollar’s worth of economic activity, which is not the case for non-renewables.
  • Environmental tax reforms do not reduce GDP, and some research suggests that they even increase it. One reason noted by Schoder is that there are lower negative fiscal multipliers for carbon taxes (taxes at the point of import or extraction of fossil fuels) than for labor taxes. He looks at the impact of shifting the tax burden from personal income to carbon emission on output for a panel of 75 high- and low-income countries from 1994 to 2018. The environmental tax multiplier effects on output range from 1 on impact to 1.8 at the peak, and the personal income tax multiplier effects range from 1.4 to 2.3 (he also finds that while income taxes reduce employment, environmental taxes do not). There is a logical reason for this: With environmental taxes, the ability of the energy and production sectors to reduce carbon and energy intensities as well as the response of labor demand to an increase in energy prices drive the size of the multiplier, and the more flexible the production structure, the lower the multiplier. In contrast, there is no such flexibility in relation to personal income tax: It directly affects aggregate demand and reduces the labor input into production, resulting in more adverse GDP and employment effects. 
  • Crucially, the size of the multiplier depends on a set of conditions, in relation to the macroeconomy, energy sector, trade structure and carbon intensity. As the multiplier depends on the business cycle, Schoder finds that environmental taxes have no negative output effects when implemented during years of economic expansion or when GDP is above potential, although effects are strong during contractions. Also, environmental multipliers are negative when fuel prices are above the median, which is worth noting given the current context. Furthermore, the higher the share of commodity exports to GDP, the higher the environmental tax multiplier. Those countries trading more differentiated goods will have a lower multiplier. This is because the commodity-intensive traders are engaged in a very price-competitive environment. Finally, the higher the initial carbon intensity of GDP, the lower the environmental tax multiplier, hence those EM which are beginning decarbonization can expect lower multipliers. The main takeaway from our perspective is that especially EM in the early days of decarbonization should resort to environmental taxes over personal income taxes because they are less contractionary sources of revenue, all of the conditions mentioned above being equal.
  • Some studies, such as Hein and Black, even suggest potentially positive, albeit modest, impacts on GDP from environmental tax reforms. The reason highlighted by Hein and Black is that environmental tax reforms lead to reductions in informality and tax evasion, as carbon taxes are harder to evade than income taxes. In that sense, environmental tax reforms improve the economic efficiency of the tax system and, once again, for EM where tax revenue as a share of GDP tends to be lower than in DM, the revenue-raising potential for environmental tax reforms could be presented as its most attractive aspect. Indeed, environmental taxes can raise additional revenue at lower cost than more broad-based taxes, because marginal economic costs of tax distortions tend to be lower for environmental revenues. Countries with very high debt-to-GDP ratios could especially benefit, according to Carbone et al, assuming tax revenue serves as a down payment on deficit reduction. Finally, insofar as inefficient domestic resource mobilization constrains economic growth, environmental tax reform should unlock growth.

Figure 2: The Chinese Exception: Economic Growth Correlates with Emissions Growth

Source: Brookings, Continuum Economics

Of course, the case of China tells a different story on the relationship between green policies at large and GDP growth: It points to rapid economic ascendance associated with an equally rapid increase in emission levels, while a sharp deceleration in emissions growth in recent years correlates with China reaching a plateau in economic growth rates. China is clearly no longer an EM at the start of its decarbonization effort, the category that tends to benefit the most from environmental tax reform. In particular, while greener growth means a faster exit from polluting industries, it has asymmetric impacts across China’s regions. The country’s most developed coastal regions and leading cities have already decoupled in terms of producing lower emissions, while emissions in China’s more resource-dependent interior provinces such as Shanxi and Inner Mongolia continue to grow (see Figure 3). Green policies therefore need to avoid exacerbating intra-China inequality across regions resulting from a two-speed abatement process.

At the same time, the transition to a greener growth path offers great potential to tap into new technologies as sources of growth and job creation. But the growth rates generated by these technologies cannot compare with the rates generated during China’s early years of economic development, which were centered on a fossil-fuel intensive regime geared toward achieving GDP gains at all costs. However, comparing growth rates under the fossil fuel regime and growth rates under the sustainability paradigm is like comparing apples and oranges. The Chinese economy’s old optimization problem was the straightforward maximization of growth. Its new optimization problem is a better quality of growth, whose equation has a different, more complex solution.

Figure 3: China’s Regional Divergence in Emissions

Source: Brookings Institute, Continuum Economics

However, China’s regional divergence brings us to our final point: In general, countries must avoid creating macroeconomic imbalances as a result of green policies, including environmental tax reforms. The process of transition to net zero, like any transition, must compensate those who are left behind by the new green paradigm, whether it be regions or low-income households. And that must happen regardless of whether environmental tax reforms add to or detract from aggregate GDP in the long term.

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Analyst Certification
I, Francesca Beausang, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.