Costs of compliance with the Kyoto Protocol: a developing country perspective

Ž .Energy Economics 24 2002 21�39

Costs of compliance with the KyotoProtocol: a developing country perspective

Roy Boyda,�, Marıa E. Ibarraranb´ áDepartment of Economics, Ohio Uni�ersity, Room 211, Haning Hall, Athens, OH 45701, USA

bUni�ersidad de las Americas, Puebla, Mexico´

Abstract

Mexico is currently the 15th largest emitter in the world of greenhouse gases and by farthe largest source of such emissions in Latin America. Thus, from a strategic standpoint,Mexico’s decision to abide or not by carbon emission restrictions in the future is a matter ofrelative significance. Mexico has found itself under intense pressure to join with the world’sindustrialized economies and develop a plan for limiting its use of carbon-based energysources in the future. Such a plan would, of course, entail economic costs and couldsignificantly limit future growth, investment, and consumer welfare. A carbon tax mayreduce the growth rate of carbon emissions as well as impose constraints on sector-relatedand overall economic growth. Nonetheless, it has a progressive effect on welfare levels in all

Ž .simulations, meaning that it benefits or harms less the groups with lower income levels. Onthe other hand, a Double Dividend is very unlikely to result from this policy. Only undersignificantly high rates of technological change in the Mexican economy, namely of 5�6%,can a reduction in the rate of growth of carbon emissions and an increase in welfare beattained for all income groups simultaneously. At the same time, high rates of technologicalchange increase production and therefore emissions. Overall, there are strong benefits fromthe application of this policy in that it reduces the growth rate of carbon emissions. Thisexercise is a first approach to the application of an ample environmental tax to a developingcountry and results show that a favorable outcome may be expected. However, estimatingthe costs of practical policies to make investment in energy-saving technological changeattractive to producers has yet to be addressed. � 2002 Elsevier Science B.V. All rightsreserved.

Keywords: Carbon tax; Kyoto Protocol; CGE model; Developing country

� Corresponding author.Ž .E-mail address: [email protected] R. Boyd .

0140-9883�02�$ - see front matter � 2002 Elsevier Science B.V. All rights reserved.Ž .PII: S 0 1 4 0 - 9 8 8 3 0 1 0 0 0 8 0 - 9

( )R. Boyd, M.E. Ibarraran � Energy Economics 24 2002 21�39´22

1. Introduction

Serious thought on the effect of carbon emissions on the Earth’s climate hasfigured as one of the main recent environmental concerns. The internationalcommunity has responded by making attempts to curb increases in the level of CO2in the atmosphere. Initially, the attention was on the industrialized economieswhich are responsible for the vast majority of existing CO emissions. However,2since the meeting held in Kyoto in 1998, there has been increasing pressure on theworld’s largest and fastest growing developing economies to reduce carbon emis-sions.

Mexico is currently the 15th largest emitter in the world of greenhouse gases andby far the largest source of such emissions in Latin America. Thus, from a strategicstandpoint, Mexico’s decision to abide or not by carbon emission restrictions in thefuture is a matter of relative significance. It comes as no surprise then that Mexicohas found itself under intense pressure to join with the world’s industrializedeconomies and develop a plan for limiting its use of carbon-based energy sources inthe future. Such a plan would, of course, entail economic costs and could signifi-cantly limit future growth, investment, and consumer welfare. To date, however,there has been no unified treatment of exactly what these costs and impacts wouldbe.

Thus, the objective of this paper is to provide a comprehensive analysis ofcompliance with restrictions of carbon emissions on the Mexican economy and tosee if a tax on carbon would yield a so-called Double Di�idend. To do this we

Ž .employ a dynamic computable general equilibrium CGE model of the Mexicaneconomy. Such a model is well suited to this particular task since it divides theaggregate economy of Mexico into a number of production sectors and consumergroups, each of which stands to be differentially impacted by such a policy. Inaddition to this, the model itself is dynamic. This allows us to enact a policy thatbecomes increasingly restrictive over time in line with the type of policies that havebeen proposed.

Our analysis here will proceed as follows. After discussing Mexico’s present levelof emissions and energy use in Section 2, we will present the dynamic CGE modelused in our policy simulations in Section 3. In Section 4 we will discuss the resultsof our model’s simulations as well as the implications of those results for energyand environmental policy in Mexico. Finally, in Section 5 we will give the mainconclusions to be drawn from our analysis.

2. Background: emissions

In the last 20 years, Mexico evolved from a closed, inward-oriented economy, toone of the most open economies of the world as can be inferred from the low tariffrates that now apply to international trade. Initially, industrialization led thisprocess through import substitution relying heavily on state intervention in bothproduction and investment, protection of domestic industry through high tariffs on

( )R. Boyd, M.E. Ibarraran � Energy Economics 24 2002 21�39´ 23

imports, and subsidies on the main factors of production such as energy andcapital. Subsidized energy prices contributed directly to industrialization, as well asto the increase in energy intensity in the Mexican economy, as opposed to mostindustrialized countries. Increase in energy use is one of the direct causes ofemission of greenhouse gases.1

Mexico is the only Latin American country on the list of the 15 largest emittercountries. Thermal energy production and consumption in Mexico account foralmost half of the emissions of the entire Latin American region. Latin America ingeneral, and Mexico specifically, has responded to climate change by signing and

Žratifying the United Nations Framework Convention on Climate Change UN-.FCCC , and now carries out the National Greenhouse Inventory, responding to the

UNFCCC requirements.

2.1. Energy use

Oil is very important to the Mexican economy. Indeed, throughout this pastcentury the petroleum sector has played a central role in both the economic andpolitical development of the country. In the early 1900s large deposits of oil werediscovered off Mexico’s Gulf Coast. Angered at foreign control of their naturalresources, the Mexican Government nationalized all oil production in 1939, andsince that time the government has depended on oil revenue for much of itsoperating budget. It has also fostered policies whereby consumption of oil issubsidized.

Since the 1970s industrialization has increased the demand for oil and electricity.Although a large part of oil production was exported, domestic consumption alsoincreased. Between 1970 and 1990, energy pricing policies led to an annual implicit

Ž .subsidy for energy products petroleum fuels, gas and electricity of between $8 and$13 billion dollars, or 4�7% of GDP, from 1980 to 1985. Subsidies to energy usehave been a common practice in Mexico and this was particularly true during theyears of high world oil prices, revenue from oil exports were high, between 1976and 1985. Low energy prices encouraged industrial development from the 1960s tothe 1980s. However, these low prices did not encourage efficient technologies.

The two main consumers of energy are the industrial and the transportationsectors. At the same time, energy use is the main source of air pollution andgreenhouse gas emissions. In Mexico, according to the Emissions Inventory carried

Ž .out by the Instituto Nacional de Ecologıa INE, 1996a,b,c , in 1990 almost 84% of´final energy and 62% of electricity came from fossil fuels. Between 1987 and 1993,

1 Ž . Ž . Ž .Greenhouse gases are carbon dioxide CO , methane CH , nitrous oxides N O , tropospheric2 4 2Ž . Ž .ozone O , and chlorofluorocarbons CFCs . They trap the heat from the sun that is radiated back to3

space by the Earth. This phenomenon is what allows life to exist at all on this planet, since it works as ablanket that protects the Earth from losing the energy it gets from the sun. However, accumulation ofthese gases over a short period of time may also generate an increase in the average temperature of theEarth’s atmosphere, through the global warming effect. According to the International Panel on

Ž .Climate Change 1995 , CO is believed to contribute to more than 80% of the total warming potential.2


carbon dioxide emissions per capita fell by 7.1%, from 3.75 to 3.48 tons, whereascarbon dioxide intensity, defined as emissions per unit of GDP, fell by 6.1%.

In 1990, of the greenhouse gas emissions, 96% were carbon dioxide emissions,1% was methane, and the other 3% was distributed between the other gases. Oftotal carbon dioxide emissions, 41% of emissions were directly related to theindustrial sector, 21% to transportation, 31% to change in land use, and 5% toresidential and commercial uses.

2.2. Carbon taxes

Mexico has been involved in the negotiations that took place in Rio de JaneiroŽ . Ž . Ž . Ž . Ž .1992 , Berlin 1995 , Geneva 1996 , Kyoto 1998 , Buenos Aires 1999 , and The

Ž .Hague 2000 . Mexico is a non-Annex I country and its commitments are to carryout a greenhouse emissions inventory periodically, as well as vulnerability andmitigation studies. However, Mexico’s actions to curtail emissions will be highlyvalued at a global level, especially by the Annex I countries that consider thatmitigation of global warming should be a joint international effort.

Any meaningful reduction in carbon emissions by Mexico, however, must involvea substantial and sustained increase in fossil fuel prices. The first step in imple-menting such a policy would be to eliminate any existing subsidies on gas and fossilfuels. This in itself may be the initial attempt towards full cost pricing in the sensethat at least the production costs will be covered. Unsubsidized prices, however,will still not reflect any further externalities.

Imposing carbon taxes may be a second step once subsidies to energy use havebeen eliminated. Carbon is not the only greenhouse gas. However, carbon is theeasiest to track because there is a direct relation among each fossil fuel burned andthe carbon it generates and because carbon emissions from fossil fuels are verydifficult to eliminate. Depending on the price elasticity of fossil fuel demand,carbon taxes may lead to a curtailment of energy consumption, and therefore to areduction in air pollution and emissions of greenhouse gases. Thus, even thoughglobal warming is an uncertain phenomenon in terms of its timing and magnitude,there may be a case for the adoption of a carbon tax as a win�win opportunitybased on its revenue potential, efficiency and distributional implications, andimpacts on externalities.

2.3. Pre�ious studies

Ž .Shah and Larsen 1992 used a partial equilibrium model to calculate therevenue potential of taxation to greenhouse gases generated by the combustion offossil fuels. They estimated that in 1987 a US $10�ton carbon tax in Mexico wouldhave eliminated approximately 943 kg�capita of carbon emissions exclusively fromfossil fuel combustion. The revenue potential of such a domestic carbon tax wouldhave been US $772 million, representing 0.55% of GDP. Government revenues toGDP were 17.41%, and thus the tax would account for 3.16% of total governmentrevenues. Revenues from such a carbon tax would be enough to cover 4.1% of the


government’s deficit at that time. In terms of distributional impacts, they concludethat the regressive effect of carbon taxes may be overstated. And in the case ofregressive effects, targeted subsidies can still be used as well as alternativemeasures.

2.4. The double di�idend

Policy makers argue that environmental taxes such as a carbon tax induce twoeffects: they enhance environmental quality and they raise revenues for thegovernment. These revenues can be used to reduce other taxes that distorteconomic decisions and reduce welfare. Thus, if the environmental tax is intro-duced in a revenue-neutral fashion, i.e. reducing other tax rates so that the overalltax revenues remain constant, it can improve environmental quality at a negative or

Ž .zero gross cost Goulder, 1995a . Gross costs refer only to variations in economicŽ .welfare consumption plus leisure due to the cutback in the rates of distortionary

taxes, not to welfare gains from changes in environmental quality that may resultfrom these new taxes. Thus, the first dividend is the enhancement of environmentalquality; the second dividend is the improvement of economic welfare. The firstdividend is quite straightforward: an environmental tax will discourage environ-mentally damaging activities. However, the relative size of this dividend is uncer-tain, since if deals with the valuation of non-market values. Nevertheless, we willassume that it has a positive value. Therefore, the definition, magnitude, and sign

Ž .of the second dividend are most relevant. Goulder 1995b proposes severaldefinitions for the second dividend, namely weak, intermediate, and strong forms.He states that for the strong form of the second dividend, ‘the revenue-neutralsubstitution of the environmental tax for typical or representative distortionarytaxes involves a zero or negative gross cost’.

Here, we assume that taxes on capital and labor are ‘typical or representativedistortionary taxes’. Thus, one of our principle objectives in this paper is to test if

Žthe introduction of an environmental tax a tax on the carbon content of fossil. Žfuels in a revenue-neutral fashion i.e. using these revenues to reduce the tax rates

.on capital and labor , can generate a strong second dividend for the Mexicaneconomy. If so, and given the assumption of the existence of a first dividend madeabove, we can conclude that this particular type of environmental taxation yields aDouble Dividend for Mexico and is a win�win opportunity.

3. The dynamic CGE model

Important efforts have gone into evaluating the effect of alternative taxationpolicies. Tax policy models accommodate several taxes simultaneously, providingnumerical estimates of efficiency and distribution effects. These models allow theappraisal of an overall tax reform, such as the one proposed here.

The use of equilibrium analysis to calculate the impact of various tax policiesŽ .dates back to the early work of Harberger 1962, 1964 . Such analyses, however,


were generally limited to two or three sectors until the advent of the moreŽ .complicated computable general equilibrium CGE models in the early 1970s.

Ž .Cornerstone works related to taxation models include Shoven and Whalley 1972 ,Ž . Ž . Ž . Ž .Whalley 1975 , Shoven 1976 , Ballentine and Thirsk 1979 , Keller 1980 , Piggot

Ž . Ž . Ž . Ž .1980 , Slemrod 1983 , Serra-Puche 1984 , Piggot and Whalley 1985 , and BallardŽ .et al. 1985 . The taxes that have been analyzed through these models include

Ž .income, corporate earnings, property, sales and value added , and social security.ŽBoth efficiency and distribution impacts are presented in these studies for main

.features of the above models, see Shoven and Whalley, 1992 .Analytical treatment of aggregate economic growth has its origin in the work of

Ž . Ž . Ž .early theorists such as Ramsey 1928 , Solow 1956 , and Koopmans 1965 .Nonetheless, due to their heavy computational requirements, true dynamic exten-sions of computable general equilibrium models are a fairly recent development. In

Ž .the past few years, authors such as Summers and Goulder 1989 , Jorgenson andŽ . Ž .Wilcoxen 1990 , and Rutherford et al. 1997 , have used dynamic CGE models to

explore policy issues using a single consuming agent.New models have been developed to address the issue of carbon taxes to prevent

global warming. A comparison of many of these models is found in GoulderŽ .1995b . They all estimate the economic impact of imposing a tax on carbon

Žemissions. Most of these models have been applied to the United States Shackel-.ton et al., 1992; Goulder, 1995a,b; Jorgensen and Wilcoxen, 1995 and other

industrialized nations. However, there are also some applications to India, Indone-Ž .sia, and Pakistan Shah and Larsen, 1992 . Other important studies on this topic

Ž . Ž .may be found in Nordhaus 1993 , Bovenberg and van der Ploeg 1994 , BovenbergŽ . Ž .. Ž .and Mooji 1992, 1994 , Poterba 1991, 1993 , and Manne and Rutherford 1994 .Ž .Boyd et al. 1995 have also developed a model to analyze the net benefit of energy

taxation as a policy instrument to reduce CO emissions in the US.2Some researchers have studied the impact of environmental taxes in Mexico

through the use of computable general equilibrium models. The results of two ofŽ . Ž .these studies, namely Romero 1994 and Fernandez 1997 are described to´

visualize what the expected results will be in the case of this environmental taxreform.

Romero found that under a 20% ad valorem carbon tax scenario, total emissionsdecrease 13%. The effect on the consumer price index is very small: it increases0.3%. For the year 2001 GDP is only 0.6% lower than under a no-tax scenario. Thesectors most harmed by this tax in the long run are oil, mining, construction, andchemicals. The overall effect on wages depends on the proportion of workersemployed in each sector. The tax proposed is not revenue-neutral.

Ž .Fernandez 1997 introduces an environmental tax to the manufacturing sectoránd evaluates the policy outcome with and without revenue neutrality. The base-line case considers a maximum tax of 5% to the most polluting of the manufactur-ing industries, that is, basic petrochemical products. The remaining tax rates aredefined depending on the pollution intensity of each sector relative to the heaviestpolluter. Results indicate that the introduction of an environmental tax to manu-


facturing reduces pollution significantly, decreases output of the heavily pollutingsectors, and reallocates resources from the private to the public sector.

Our model here is disaggregated into nine producing sectors, seven final demandŽ . 2goods, four household income categories, a foreign sector, and the government.

The economic variables determined by the model are investment, capital accumu-lation, and production by each sector, household consumption by sector, importsand exports, and relative prices, all calculated for every year for a 20-year period.The model is calibrated to a 1994 data set.

3.1. Production

The production portion of the model is built upon information from a balanceddata set that is flexible as regards the substitution between the primary factor

Ž . 3inputs capital and labor . Technologies are represented by production functions,which exhibit constant elasticities of substitution. Technological progress is takenas exogenous to the model.4

Production in each sector for every time period is represented as a constantŽ .elasticity of substitution CES value added function of capital and labor inputs,

where the elasticity of substitution can vary between zero and infinity.5 Hence,

Ž .��1Ž��1.� � Ž��1.� � Ž .V � � � L � � K 1t t L t K t

where V is value added at time t, is the elasticity of substitution between capitaltand labor that is estimated econometrically for the different sectors, � is antefficiency parameter that shifts the whole production function. L is labor at timett, K is capital at time t, and the � values are the share parameters defined so thatt

� ,� � 0 andL K

� � � � 1L K

In each time period producers maximize profits in a competitive market environ-ment. Output and input prices are treated as parameters. Profit maximization,

2 The producing sectors are agriculture, coal mining, oil and natural gas, manufacturing, chemicalsand plastics, refining, food processing, and services. The consumption sectors are gasoline consumption,housing and appliances, consumer services, automobile consumption, energy consumption, transporta-tion services, and food consumption.

3 The input�output table used is an updated version of the 1990 table. The update was performedwith information provided be SEMARNAP.

4 Ž .For endogenous technological change, see Romer 1990 . Another good reference is Butter et al.Ž .1995 .

5 Substitution elasticities between capital and labor for agriculture and manufacturing were derivedŽ .from case studies Heuter, 1997 and Skuta, 1997, respectively ; price elasticities of imports were derived

Ž .from various recent reports done on Mexico since NAFTA Wylie, 1995 ; the elasticities for petroleumŽwere US estimates since no appropriate Mexican estimates were found, except for gasoline SEMAR-

.NAP, 1995 .


based on the described production technology, yields output supply and factordemands for each production sector and factor market in the model.

The equilibrium in the labor market is endogenous. Demand of labor is de-termined by the firms as a result of their profit maximization process. Sixty hoursper week is the limit of time that can be either supplied as labor or can be enjoyed

Žas leisure. This leisure�labor choice is made by individuals in this case by the.income groups depending on the marginal tax rate on income. The higher this

marginal tax rate, the less labor supplied and the more leisure consumed. Popula-tion grows at rate G, the exogenous rate of population growth.

3.2. Consumption

On the demand side, the model reflects the behavior of domestic consumers andŽ .foreigners who can also invest , as well as the government. Domestic consumers

are grouped according to income and a demand equation is specified for eachgroup. Each group has a different consumption bundle depending on its income.All four groups are endowed with labor and capital, which they sell to finance thepurchase of domestic or foreign goods and services, save, or pay taxes to thegovernment. For each household c, total utility is modeled by

�tŽ . Ž . Ž .U � Ý U X ,R � 1 � � t � 1, . . . ,n 2c t c ,t c ,t c ,t

where U is household utility over all n time periods, U is the utility derived fromc c ,tŽthe present period consumption of goods and services, X a seven-dimensionalc ,t

. 6vector and leisure R , and where � is the rate of time preference. Each U isc ,t cŽ .taken to be a nested CES utility function defined over all consumer goods as well

as all time periods.7 The value of household utility is given by the addition of thevalue of consumption plus the value of leisure, which is equal to the number ofhours devoted to leisure times the net wage per hour worked; the latter represents

Ž .the price of leisure foregone wages . Each consumer’s expenditure constraint canbe written as

Ž Ž . Ž ..Ý TG � TF � P � L � r � K �St c ,t c ,t L ,t c ,t t c ,t

ŽŽ . Ž . Ž .. Ž .� Ý INV �S � P � X � P � R 3t t c ,t I ,t c ,t L ,t c ,t

where endowments are given on the left-hand side of the equation and expendi-tures are placed on the right hand side. TG and TF represent the transfer toc ,t c ,t

6 To rule out the possibility of a Ponzi game it is assumed that the credit market puts a limit on theamount of consumer borrowing. This is specified by the constraint that the present value of the assetsowned by the consumer must be non-negative.

7 For the purpose of this analysis, all consumers have a constant intertemporal elasticity of substitu-Ž .tion CIES utility function, and use values for this elasticity which are consistent with the empirical

literature.


the consumer from the government and the foreign agents, P is the price ofL ,tlabor and r is the rental rate of capital. K is the level of capital stock in period t,tS is the share of total capital owned by consumer c, INV is the total investmentc ,t tin time period t, and P is the vector of prices for consumer goods. Thus, transfersI,tto consumers from the government and the foreign sector plus income from laborand capital earnings are used for savings, consumption of goods and services, andconsumption of leisure.

Ž .Maximizing the nested utility function 2 with respect to the expenditureŽ .constraint 3 simultaneously determines the consumption level of the seven

consumer goods and services, the amount of labor supply, and the consumers levelof saving and investment in each of the periods.

3.3. Go�ernment

Ž .The government sector is treated as a separate agent Ballard et al., 1985 . Thegovernment agent is modeled with an expenditure function similar to the house-

Ž .hold expenditure functions i.e. based on a CES utility function . Revenues derivedfrom all taxes and tariffs are spent according to an expenditure function. Thegovernment also redistributes income through subsidies and transfer payments.

Taxes in the model are expressed ad valorem and include personal income taxes,labor taxes, capital taxes, property taxes, revenue taxes, value added taxes, salestaxes, and import tariffs. When applicable, taxation is based on marginal tax rates.To capture the incentive effect of the tax system, the highest marginal rate is leviedon the relevant revenue base. Since this procedure results in over taxation, thedifference between the revenue generated by the highest marginal tax rate and theaverage tax rate is rebated to consumers as a lump-sum transfer.

3.4. Trade

International trade within the model is handled by means of a foreign agent.Output in each of the producing sectors is exported to the foreign agent inexchange for foreign-produced imports. Price-dependent import supply schedulesare derived from elasticity estimates found in the literature. Following ArmingtonŽ .1969 we assume that foreign and domestic goods are imperfect substitutes. Thebalance of trade relationship is given by

Ž .P �IM � P �EX � ÝTF t � 1, . . . ,n 4m ,t j ,t j ,t j ,t c ,t

Ž .where IM is a nine-dimensional vector representing the quantity of each of thej ,tproducer goods imported, P is the vector of imported goods prices, EX is them ,t j,tvector of producer goods exported, and P is the vector of producer goods prices.j ,tThus, for each time period, the value of total imports is equal to the total value ofexports plus foreign transfers. Since these transfers are used to finance domesticinvestment this relation provides the closure rule, namely, that investment is


equated to domestic savings minus net exports. This, of course, includes balancedtrade as a special case.8

3.5. Labor growth and capital formation

Growth within our dynamic CGE model is brought about by the changes overtime in both the labor force and the capital stock. In keeping with the theoretical

Ž .underpinning of the Ramsey model 1928 , we model the changes in the populationas exogenous and constant over time period considered. More formally, the growthin the labor over time is given by

Ž . Ž .L � L 1 � � 5t�1 t

where � is the labor growth rate over time. In the absence of any perturbation theRamsey model predicts that the economy will grow at the labor growth rate in thesteady state.

Capital growth rate is modeled in accordance with capital theory and is repre-sented by a system of three equations. For each time period t we have

Ž .P � P t � 1, . . . ,T 6A ,t k t�1

Ž .where P is the weighted aggregate price of consumption, and P is nextA ,t k t�1year’s price of capital. This says that the opportunity cost of acquiring a unit ofcapital next year is a unit of consumption in the present period. We also have

Ž . Ž .P � 1 � r � � P t � 1, . . . ,T 7k t t k t�1

meaning that the price of capital in this period must be equal to the presentperiod’s rental value of capital plus next periods price of capital. Finally, we have

Ž . Ž .K � K 1 � � � INV t � 1, . . . ,T 8t�1 t t

where � stands for the rate of depreciation and INV stands for gross investment.This states that the capital stock in the next period must be equal to this year’s

Ž . Ž .capital stock plus net investment. Taken together, Eqs. 6 � 8 insure that economicgrowth will be consistent with profit maximizing behavior on the part of investors.

3.6. Terminal conditions

One potential drawback of a computable model such as ours is that it can onlybe solved for a finite number of periods. Consequently, a few adjustments arenecessary to design a model which when solved over a finite horizon approximatesinfinite horizon choices. We divide the problem into two distinct sub-problems, one

8 Capital flows are the remainder of the exports minus imports, or net exports, term since the deficitin the current account must be made up for by the capital account. Mexican investment abroad is notconsidered since in 1994 Mexico was a net importer.


defined over the finite period from t � 0 to t � T and the second the infiniteperiod from t � T � 1 to T � �. Hence, the first problem is

tT 1Ž . Ž .Max U X ,R 9Ý c ,t c ,t c ,tž /1 � �t�0

T T

Ž .P X � P � L � P K S � P K S 10Ý ÝAt ct Lt ct k 0 c ,0 C t k ,T�1 c ,T�1 CT�1t�0 t�0

Ž .L � L � R for all t � 0,1, . . . T 10ac ,t c ,t c ,t

and the second problem is

t� 1Ž . Ž .Max U X ,R subject to 11Ý ct c ,t c ,tž /1 � �t�T�1

� �

Ž .P X � P L � P K S 12Ý ÝA ,t c ,t L ,t c ,t K ,T�1 c ,T�1 c ,t�1t�T�1 t�T�1

Ž .L � L � R for all t � T � 1, . . . � 12ac ,t c ,t c ,t

where � is the rate of time preferences, r and K refer to the rental value ofo c ,ocapital and quantity of capital before the terminal period, r and K refer toT�1 c ,T�1these variables after the terminal period, and L is total labor plus leisure forc ,teach agent in the t th time period.

We then need to specify an equation or specific value for K . At first glancec ,T�1it might seem best to impose the long-run steady state level, but then the modelhorizon would have to be sufficiently long to eliminate terminal effects. As analternative, we include the level of post-terminal capital as a variable and add aconstraint on investment growth in the final period.

Ž .INV �INV � Y �Y 13T T�1 T T�1

where Y gives GDP at time T. This constraint imposes balanced growth in theTfinal period, but does not require that the model achieve steady-state growth. Thisapproach alleviates the need to determine a specific target capital stock or aspecific terminal period growth rate.

4. Results: carbon taxes

Energy taxes are meant to reduce the amount of energy used in the economy,


and therefore promote energy savings and a cleaner environment. The type ofŽtaxes that energy is subject to vary widely among countries Weizsacker and

.Jesinghaus, 1992 . We consider an ad valorem tax on the carbon content of fossilŽ .fuels. This tax can be expected to have three outcomes: 1 substitution of cleaner

Ž .fuels for dirtier ones; 2 energy efficiency through both technological change andŽ . Ž .input substitution capital and labor for energy ; and 3 lower emissions of

greenhouse gases and other pollutants.The demand for fossil fuels in both intermediate and final use can be met by any

of the fuels that are substitutes for that purpose, i.e. coal, natural gas or petroleum.Our focus is on substitution between these three general categories given thatwithin each category the fuels have approximately the same carbon content. Takingnatural gas as the numairare, we indexed the carbon content of other fuels to thatof natural gas, so the relative carbon content for coal is 1.6 and for oil is 1.3.9 Thetax is set as a proportion of the final price of the fossil fuel, and as a function ofthe carbon content of the fuel. The carbon tax rates suggested here for Mexico are

Ž . Ž .middle ground between those suggested by Romero 1994 , and Fernandez 1997 ,´that is, they vary between 5 and 20% of the price of fuels. Taxes were introducedthroughout three periods. The final tax rates for each fuel were then 10% for

Ž .gasoline, 5% for household energy use mainly natural and LPG , 20% for coal,and 10% for oil.10

A tax on fossil fuel use is expected to reduce, on the consumption side,disposable income, given that the price of fossil fuels and other goods and servicesthat contain them will increase. On the production side, it will affect profits since itwill increase input costs. Decreasing labor and capital taxes is a way to offset theimpact of the carbon tax and achieve revenue neutrality. In this exercise tax ratesof capital and labor will be reduced by the same proportion.

4.1. Simulations

There are two research questions to be answered. First, what are the effects of aŽ . Ž .carbon tax on a the growth rate of carbon emissions; b economic welfare levels;

Ž . Ž .c energy use; and d energy prices? Second, under what conditions is there aŽ .Double Dividend as defined by Goulder, 1995a ?

To answer these questions we run the dynamic CGE model discussed aboveunder a variety of assumptions. Initially we run the model in benchmark. Next, we

9 ŽThe carbon content for natural gas is 15.75 metric tons of carbon per million BTU Energy.Information Administration, 1994 .

10 The different rates of technological change vary among the producing sectors depending on theŽ .relative share of fuel they use Romero, 1994 . This assumption considers that the more the sector relies

on the use of fuels as a share of its total inputs, the higher the technological change it will aim for andeventually achieve. This need not be so and results would not vary significantly. However, if thisassumption is allowed for, higher degrees of technological change will then be in the coal, petroleum,and natural gas sectors. An intermediate rate of change will take place in the chemicals and the refiningsectors, and finally the lowest but still positive rates will be those of the service sector. The other sectorsare assumed not to have any technological change.


project these activities forward over the time span of the model at a constant‘steady state’ growth rate of 1.3% per year. We then alter our model by assumingthe implementation of carbon taxes, and measure the changes that subsequentlyoccur in production, consumer welfare, government revenues, carbon emissions,and the value of the capital stock.

All told we introduce three carbon tax scenarios to compare with our benchmarkcase. Scenarios vary according to the rate of technological change assumed.Scenario 1 assumes an average rate of technological change of 1.5% as estimatedby the OECD for industrialized countries. Scenario 3 then assumes a 2% rate oftechnological change. This is because Mexico is a developing country and can takeadvantage of higher returns to capital according to the convergence hypothesisŽ . 11see, for example Barro and Sala-I-Martin, 1995 .

Within each of these three scenarios we evaluate two cases dealing with the useof revenue from the carbon tax. In case 1 we assume that there is no revenueneutrality. Hence, the government keeps spending the revenues from the carbontax in the same way and maintaining the same proportions of its past expenditure,i.e. the same shares as before go to public expenditure and as transfers toconsumers. In case 2 we assume revenue neutrality. To compensate the increase inrevenues due to the carbon tax, the tax rates on capital and on labor are bothreduced in the same proportion so as to maintain total tax revenues at the samelevel as in the benchmark case. The welfare, emissions and revenue results for all

Ž .runs are given in Tables 1 and 2. Total welfare i.e. total consumption plus leisurefor each agent is treated as an index which is equal to one in the benchmark case.

Ž .We turn first to case 1 in the first i.e. no exogenous technological changescenario. There, we find that introducing the carbon tax reduces welfare levels forall income groups. Such welfare reduction is lowest for the lower income groupsand higher for the higher income levels. Revenues from the carbon tax increasepublic income 2.5% with respect to a no-tax scenario. The final value of the capitalstock falls by 0.7%. The growth rate of carbon emissions is 17 percentage pointslower than in the Benchmark case. Therefore the rate of growth of carbonemissions not only falls, but future growth of carbon emissions will start from amuch lower level. In case 2, capital and labor taxes have to be cut down by 9% toachieve revenue neutrality. This has a positive but very low effect on the welfarelevel of group 1. Group 2 is not affected and groups 3 and 4 are slightly worse off,but less than in case 1. The final value of the capital stock grows slightly becausethe reduction in taxes allows for moderate savings and investment. Finally, the

11 The different rates of technological change vary among the producing sectors depending on theŽ .relative share of fuel they use Romero, 1994 . This assumption considers that the more the sector relies

on the use of fuels as a share of its total inputs, the higher the technological change it will aim for andeventually achieve. This need not be so and results would not vary significantly. However, if thisassumption is allowed for, higher degrees of technological change will then be in the coal, petroleum,and natural gas sectors. An intermediate rate of change will take place in the chemicals and the refiningsectors, and finally the lowest but still positive rates will be those of the service sector. The other sectorsare assumed not to have any technological change.


Table 1Results

Benchmark Scenario 1 Scenario 2 Scenario 3case Case 1 Case 2 Case 1 Case 2 Case 1 Case 2

aWelfare levelGroup 1 1.000 0.996 1.001 0.999 1.004 1.000 1.006Group 2 1.000 0.995 1.000 0.998 1.004 0.999 1.005Group 3 1.000 0.994 0.998 0.996 1.000 0.997 1.001Group 4 1.000 0.992 0.995 0.994 0.996 0.994 0.997

bPublic revenues � 2.5% 0.0% 3.3% 0.0% 3.5% 0.0%bValue of final capital stock � �0.7% 0.14% �0.2% 1.2% 0.0% 1.5%cValue of final capital stock 29.0% 12.0% 14.6% 15.6% 17.7% 16.0% 18.3%

a Discounted index of welfare level.b Ž .Growth rate with respect to the Benchmark Case 20-year period .cGrowth rate of carbon emissions for the 20-year period.

growth rate of carbon emissions is 14 percentage points lower than in theBenchmark case. This rate is slightly higher that in case 1 because revenueneutrality reduces production costs and technology change encourages additionalproduction. Additionally, a reduction of taxes on labor increases disposable incomethat in turn increases demand for final consumption goods and services.

Scenario 2 assumes rates of technological change similar to those of the OECDcountries. The main result is that these rates of technological change are notenough to compensate the effect of the carbon tax if no revenue neutrality takesplace, as happens in case 1. Tax revenues increase 3.3% because technologicalchange will partly lead to higher production in spite of the carbon tax. Finally thevalue of the final capital stock drops marginally and the growth rate of carbonemissions is 13 percentage points lower that in the Benchmark case. Under case 2,in order to achieve revenue neutrality tax rates on capital and labor were cut backby 13%, increasing the welfare level of groups 1 and 2. The final value of capital

Table 2Ž .Growth rate of energy-related goods and sectors percent lower than in benchmark case

Short run Long run

Lower bound Upper bound Lower bound Upper bound

Final consumption goodsGasoline use �20.8 �18.4 �27.4 �24.5Household energy �5.9 �4.3 �9.4 �6.2CommoditiesCoal �21.0 �17.8 �27.6 �23.9Joint sector �6.1 �3.6 �10.0 �5.2

The short run is defined as period 4 and the long run as period 14. The lower bound is given byScenario 1, case 1, whereas the upper bound is Scenario 3, case 2.


stock increases by 1.2% and the rate of growth of carbon emissions is lower thanbenchmark by 11 percentage points.

Scenario 3 assumes the highest rate of technological change; it is slightly higherthan that of industrialized nations, yet conservatively low. Under case 1, still mostof the group’s welfare level is reduced. Public revenues from the carbon taxincrease 3.5% with respect to the Benchmark case and the value of the capitalstock remains constant. The rate of growth of carbon emissions is 13 percentagepoints lower than in the Benchmark case. Under case 2, welfare levels increase for

Ž .all groups but for group 4 by cutting tax rates on capital and labor by 14%. Thefinal value of the capital stock increases by 1.5%. Carbon emissions also grow at alower rate than the Benchmark case by almost 11 percentage points.

Analyses of further simulations considering higher rates of technological changewere made. Results indicate that under the assumption of no revenue neutralityonly a 6% rate of technological change can increase welfare given a carbon tax. Fora revenue-neutral tax policy to produce an increase in welfare for all income levelsjointly, at least a 5% technological change rate has to be attained.

However, to mitigate negative impacts on welfare levels, higher rates of techno-logical change have to be assumed. This brings about an increase in output andthus emissions rise at a higher rate. Therefore, there is no double dividend fromthis policy, because a positive welfare impact cannot be attained without increasingthe rate of growth of carbon emissions. On the other hand, the growth rate ofemissions even under high rates of technological change is in fact lower than in theBenchmark case, leading to a partial benefit from this carbon tax.

4.2. Energy

Consumption of energy-related final consumption goods, such as gasoline andenergy for household use, and the production of the energy sectors, coal, oil andnatural gas fuel both for the lower and upper bound scenarios were compared toresults of the Benchmark case. The fall is lower in the case where technologicalchange and revenue recycling takes place, but even in that case the fall issubstantial.

Growth of gasoline consumption in the short run under Scenario 1 is lower thanthe Benchmark case by a range of 18�21%. The same holds for the long run. Forthe case of household energy use, the reduction in its consumption growth rate inthe short run is between is between 4 and 6%. A similar range holds for the longrun. On the production side, coal is 24�28% lower than in the Benchmark case. Asfor the joint sector, production is between 5 and 10% lower than in the Benchmarkcase both in the short run and in the long run.

The difference between the lower and the upper bound scenarios is lower in theshort run than in the long run. This is because the short run case do not take intoconsideration any technological change for the upper bound scenario since, byassumption, technological progress does not take place until period 5 and the shortrun is defined as period 4.


4.3. Prices

The most important results of our model in terms of prices are the change in theprices related to the energy sector, i.e. to the taxed fuels. Results are obtained bycomparing the average price of fossil fuels of the lower and upper bound scenarioswith the values of the Benchmark case in the short and in the long run. Includingthe tax on fossil fuels the price of gasoline is approximately 25% higher than in theBenchmark case in both time periods. The price of household energy increases by5% in both cases. As for energy output of the producing sector, the price of coal isthe one that has the highest increase with respect to the Benchmark case, i.e. 39%in the short run and 30% in the long run. This is due to the relatively high taximposed on coal. The price of oil increases approximately 8% in the short run and6% in the long run, and that of natural gas grows by less than 5% in both timeperiods.

4.4. Effect on output

The growth rate of output of coal and the joint sector, that produces oil andnatural gas, falls due to the tax. The most affected sector is coal, which in the lowerbound scenario grows less than 0.1%, whereas in the upper bound case growsalmost 0.3% per year, still one percentage point lower than in the Benchmark case.The joint sector is not so profoundly affected as coal. The carbon tax rate imposedon oil and especially on natural gas is much lower. The growth rate of the jointsector drops from 1.3% in the Benchmark case to almost 1% in the lower boundcase and by only 0.1% in the upper bound scenario. Thus, both technologicalchange and revenue neutrality play a significant role towards growth.

4.5. Consumption

In the Benchmark case, the index for final consumption goods grows at the samerate in all cases, namely 1.3% per year. This situation changes in the upper andlower bound scenarios analyzed with respect to the Benchmark case. For the caseof demand of final consumption goods, the average annual growth rate for eachparticular good in the lower bound scenario does not vary from the Benchmarkcase, except for gasoline and household energy use. The upper bound scenarioyields slightly higher results than the lower bound scenario in both time periodsand higher results for all goods except gasoline when compared to the Benchmarkcase. Consumption of final demand goods grows in the upper case scenario becauseof the introduction of technological change. At the same time a cut in taxes onboth capital and labor as a way to compensate for the tax on fuels increasesdisposable income and this increases consumption. Because of the tax, consump-tion of gasoline and household energy use grows at a much slower pace than therest of the sectors, but it still has a positive growth rate.


5. Conclusions

A carbon tax may reduce the growth rate of carbon emissions. However, thispolicy imposes constraints on sector-related and overall economic growth.Nonetheless, it has a progressive effect on welfare levels in all simulations,

Ž .meaning that it benefits or harms less the groups with lower income levels. Therationale behind this is that lower income groups spend a larger share of theirincome on energy, but at the same time the highest rates of technological changetake place in the energy sectors. Technological change shifts the productionfunction and the marginal costs curves, and reduces the relative price of the goodsprovided by the energy sector.

On the other hand, a Double Dividend is very unlikely to result from this policy.Only under significantly high rates of technological change in the Mexican economy,namely of 5�6%, can a reduction in the rate of growth of carbon emissions and anincrease in welfare be attained for all income groups simultaneously. At the sametime, high rates of technological change increase production and therefore emis-sions.

The political economy behind this tax proposal indicates that a revenue-neutralreform is unlikely to be strongly supported by the Finance Ministry. This is becausedirect taxes on capital and labor are substituted by taxes on the carbon content offossil fuels, indirect taxes that are easier to evade. Another possible reason for notintroducing these taxes is that the taxable base can go down as energy-efficienttechnologies are adopted. This may reduce tax revenues significantly and imposesevere constraints on the budget of the public sector. Furthermore, there aredistributional issues to be considered as the relative position of the producers ofdifferent sectors changes. Energy-saving technological change is the only way toescape from the tax. However, this has a cost that the producers have to cover.Thus, lobbying against this policy is most likely to take place.

Overall, there are strong benefits from the application of this policy in that itreduces the growth rate of carbon emissions. This exercise is a first approach to theapplication of an ample environmental tax to a developing country and resultsshow that a favorable outcome may be expected. However, estimating the costs ofpractical policies to make investment in energy-saving technological change attrac-tive to producers has yet to be addressed.

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Further reading

Banco de Mexico, 1995. The Mexican Economy. Banco de Mexico, Mexico.´ ´ ´Ž .International Monetary Fund IMF , 1995. International Financial Statistics, IMF, Washington DC.

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