Editing IPCC:AR6/WGIII/Chapter-4 (section)

==== 4.4.1.8 Example: Embedding Carbon Finance in Broader Fiscal Reforms Offers a Way to Mitigate and Rethink the Social Contract ====

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In many countries, fiscal systems are currently under stress to provide resources for the implementation of development priorities, such as, for example, providing universal health coverage and other social services ( [[#Meheus--2017|Meheus and McIntyre 2017]] ) or sustainably funding pension systems in the context of aging populations ( [[#Asher,%C2%A0M.G.%20and%C2%A0A.S.%20Bali--2017|Asher and Bali 2017]] ; [[#Cruz-Martinez--2018|Cruz-Martinez 2018]] ). Overall, Baum et al. (2017) argue that low-income countries are likely not to have the fiscal space to undertake the investment entailed in reaching the SDGs. To create additional fiscal space, major options include improving tax recovery, reducing subsidies and levying additional taxes.

Mitigation offers an opportunity to create additional fiscal space, and thus to serve the objectives outlined above, by creating a new source of revenue for the government via carbon taxation or emissions permit auctioning and by reducing existing expenditures via reduction in subsidies to fossil-fuel. The 1991 tax reform in Sweden is an early example in which environmental taxation (including, but not limited to, fossil fuel taxation) was introduced as part of a package primarily aimed at lowering the marginal tax rates (more than 80% at the time), at reducing other taxes, while keeping most of the welfare state. To do so, the tax base was broadened, including through environmental and carbon taxation ( [[#Sterner--2007|Sterner 2007]] ). Once in place, the carbon tax rate was substantially ramped up over time, and its base broadened ( [[#Criqui--2019|Criqui et al. 2019]] ).

The future potential for using carbon taxation as a way to provide space for fiscal reform has been highlighted in the so-called ‘green fiscal reform’ literature ( [[#Vogt-Schilb--2019|Vogt-Schilb et al. 2019]] ). The potential is large, since only 13% of global GHG emissions were covered by carbon pricing schemes in 2019 ( [[#Watts--2019|Watts et al. 2019]] ) and since many countries price carbon negatively by subsidising fossil fuel use, thus generating effects that are the opposite of those that positive carbon prices hope to promote. In 2018, the global subsidy value amounted to USD427 billion, some 10 times the payment for carbon use ( [[#Watts--2019|Watts et al. 2019]] ). However, the size of the potential for creating fiscal space varies strongly across countries given differences in terms of current carbon prices and fuel subsidies.

The limited adoption of and political support for carbon pricing may be explained by the fact that most of the gains occur in the future and depend on actions across the globe, making them seem abstract and unpredictable, whereas the costs in the form of higher carbon prices are immediate ( [[#Karapin--2016|Karapin 2016]] ). Furthermore, the links between carbon pricing and emissions may not be clear to the public who, in addition, may not trust that the government will use budgetary savings according to stated plans. The latter may be due to various factors, including a history of limited government commitment and corruption (Withana 2016; [[#Chadwick--2017|Chadwick 2017]] ; [[#Maestre-Andrés--2019|Maestre-Andrés et al. 2019]] ).

The literature reports limited systematic evidence based on ex post analysis of the performance of carbon pricing – carbon taxes and greenhouse gas (GHG) emissions trading systems (ETSs) ( [[#Haites--2018|Haites 2018]] ). Performance assessment is complicated by the effect of other policies and exogenous factors. [[#Haites--2018|Haites (2018)]] suggests that since 2008, other policies have probably contributed more to emission reductions than carbon taxes, and most tax rates are too low to achieve mitigation objectives. Emissions under ETSs have declined, with the exception of four systems without emissions caps (ibid). Every jurisdiction with an ETS and/or carbon tax also has other policies that affect its GHG emissions.

To help policymakers overcome obstacles, research has reviewed the international experience from carbon pricing reforms. Elimination of fossil fuel subsidies, equivalent to the elimination of negative carbon prices, have been more successful when they have included complementary and transparent measures that enjoy popular support, accompanied by a strong communications component that explains the measures and stresses their benefits (Withana 2016; [[#Rentschler--2017|Rentschler and Bazilian 2017]] ; [[#Maestre-Andrés--2019|Maestre-Andrés et al. 2019]] ).

Part of the losses (and related calls for compensation or exemptions) due to carbon pricing are related to the fact that it hurts the competitiveness of sectors that face imports from countries with lower carbon prices, leading to ‘carbon leakage’ if carbon-intensive production (and related jobs) migrates from countries with relatively high carbon prices. Some research suggests that evidence that a border carbon tax (or adjustment), set on the basis of the carbon content of the import, including a downward adjustment on the basis of any carbon payments (taxes or other) already made before entry, could reduce carbon leakage while also raising additional revenue and encouraging carbon pricing in the exporting country (Withana 2016; [[#Cosbey--2019|Cosbey et al. 2019]] ).

The timing of carbon pricing reforms is also important: they are more likely to succeed if they exploit windows of opportunity provided by events that raise awareness of the costs of carbon emissions (like bouts of elevated local air pollution or reports about the role of emissions in causing global warming), as well as momentum from climate actions by other countries and international climate agreements ( [[#Karapin--2016|Karapin 2016]] ; Jakob et al.2019). It is also important to consider the level of international prices of carbon energy: when they are low, consumer resistance would be smaller since prices will remain relatively low, though the tax may become more visible when energy prices increase again. As part of ongoing efforts to accelerate mitigation, such tax hikes may be crucial to avoid a slow down in the shift to renewable energy sources (Withana 2016; [[#Rentschler--2017|Rentschler and Bazilian 2017]] ). In countries that export carbon energy, carbon taxation may run into additional resistance from producers.

There is also considerable literature providing insights on the political and social acceptability of carbon taxes, suggesting for example that political support may be boosted if the revenue is recycled to the tax payers or earmarked for areas with positive environmental effects (e.g., Bachus et al. (2019) for Belgium, and [[#Beiser-McGrath,%C2%A0L.F.%20and%C2%A0T.%20Bernauer--2019|Beiser-McGrath and Bernauer (2019)]] for Germany and the USA), as well as on the difficulties associated with political vagaries (and economic consequences thereof) associated with the introduction of such instruments ( [[#Pereira--2016|Pereira et al. 2016]] ). Similarly, ‘best practices’ have been drawn from past experience on fossil-fuel subsidy reforms ( [[#Rentschler--2017|Rentschler and Bazilian 2017]] ; [[#Sovacool--2017|Sovacool 2017]] ). Specific policies, however, depend on societal objectives, endowments, structure of production, employment, and trade, and institutional structure (including the functioning of markets and government capacity) ( [[#Kettner--2019|Kettner et al. 2019]] ). As noted in [[#4.2.6|Section 4.2.6]] , macroeconomic analysis finds that the overall economic implications of carbon pricing differ markedly depending on the way the proceeds from carbon pricing are used, and thus on the way the fiscal system is reformed, with potential for double dividend if the proceeds from the tax are used to repeal the most distortive taxes in the economy.

In the context of this section on development pathways, it is worth emphasising that potential revenues drawn from the climate mitigation component of the fiscal reform varies strongly with the context, and may not be sufficient to address the other objectives pursued. Even if the carbon price is high, the revenue it generates may be moderate as a share of GDP and eventually it will be zero if emissions are eliminated. For example, [[#Jakob--2016|Jakob et al. (2016)]] find that the carbon pricing revenues that most countries in Sub-Saharan Africa could expect to generate only would meet a small part of their infrastructure spending needs. In Sweden, the country with the highest carbon tax rate in the world, the tax has not been a significant part of total tax revenues. Moreover, emissions from sectors covered by the tax have shrunk and, as a result, the revenues from the tax, as a share of GDP, have also declined, from a peak of 0.93% in 2004, when the rate was USD109 per metric tonne of CO 2 , to 0.48% in 2018, when the rate had reached USD132 ( [[#Jonsson--2020|Jonsson et al. 2020]] ; [[#Statistics%20Sweden--2020|Statistics Sweden 2020]] ). This means that governments that want to avoid a decline in the GDP share for total tax revenues over time would have to raise the intake from other taxes. However, it is here important to note that domestic tax hikes are likely to involve trade-offs since, at the same time as the spending they fund may provide various benefits, they may also reduce the capacity of households and the private sector to consume and invest, something that may reduce growth over time and reduced resources for spending in support of human development ( [[#Lofgren--2013|Lofgren et al. 2013]] ). It is also worth emphasising that restructuring of the fiscal system amount to changes in the social contract of the society ( [[#Combet--2017|Combet and Hourcade 2017]] and 2014), and thus represents a major economic and social decision.

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