On the effects of a new carbon tax in Portugal: A dynamic general equilibrium assessment

The EU has set forth an ambitious program to reduce carbon emissions. In this context, the Portuguese government has recently appointed a commission to study the issue of environmental fiscal reform. One of its most emblematic proposals is the introduction of a carbon tax. The purpose of this paper is to discuss the impact of such tax.

We focus on the issue of the multiple dividends. Clearly a carbon tax reduces emissions and thereby generates a first dividend, an environmental dividend. It would, however, negatively affect economic performance. These negative effects could conceivably be mitigated or even reversed through a revenue-neutral tax reform where the carbon tax revenues are recycled to alleviate distortions in other tax margins. A strong realization of the second dividend refers to an improvement in economic performance while a strong realization of the third dividend refers to a reduction in the public debt to GDP position in both cases compared to the pre-tax situation. Because of the terms of the policy debate in Portugal – the quest for growth and the ongoing need for fiscal consolidation – our focus is on identifying situations yielding the strong realization of these two dividends.

We use a dynamic general equilibrium model with dynamic optimization, endogenous growth, and a detailed modeling of the public sector [Pereira and Pereira (2014a, 2014b)]. Preliminary results show that using carbon tax revenues to finance reductions in the income and social security taxes and increases in investment tax credits - in particular when these changes are linked to energy efficiency activities, allows for the realization of the three dividends.

The relevance of this paper is not parochial. Climate and energy are major policy concerns in the EU and there is a growing chorus of institutional voices - IMF, OECD, World Bank - urging environmental fiscal reform. The interactions among climate policy, economic growth and the public accounts are fundamental since they correlate to the most important policy constraints faced by many economies in their pursuit of sound climate policies: the need to enact policies that promote long-term growth and fragile public budgets.

2014a. Environmental Fiscal Reform and Fiscal Consolidation: The Quest for the Third Dividend in Portugal, Public Finance Review42 (2), pp. 222-253.

2014b. On the Environmental, Economic and Budgetary Impacts of Fossil Fuel Prices: A Dynamic General Equilibrium Analysis of the Portuguese Case. Energy Economics. 42(C): 248-261.