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Optimal Environmental Taxation with Capital Mobility

18 Apr 2017


Climate policy exemptions for energy intensive sectors are often justified with distributional concerns. One concern is that households employed in energy intensive sectors might be affected disproportionally due to (international) capital mobility. By assuming that workers cannot move freely between sectors we can reproduce this concern: uniform climate policy causes more inequality between the sectors when capital is mobile than when it is not. We find, however, that affected households can be relieved more effectively with sector specific labor taxes than with sector-specific climate policy. The reason for this finding is that households benefit more directly from sector-specific labor tax cuts than from climate policy exemptions. Keeping climate policy uniform across sectors has the added benefit of creating incentives for long-term decarbonization. In addition, we find that the differential effect of capital mobility depends on the government's degree of inequality aversion: Redistribution is more expensive when capital is mobile.

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