Green tax reform for a just climate transition (GRETA)

Project Information

GRETA

Grant agreement ID: 101116659

DOI

10.3030/101116659

EC signature date 10 October 2023

Start date 1 January 2024

End date 31 December 2028

Funded under

• European Research Council (ERC)

Total cost

€ 1 499 743,00

EU contribution

€ 1 499 743,00

Coordinated by

HELSINGIN YLIOPISTO
Finland

Periodic Reporting for period 1 - GRETA (Green tax reform for a just climate transition (GRETA))

Reporting period: 2024-01-01 to 2026-06-30

Summary of the context and overall objectives of the project

Carbon neutrality by 2050 is an aspirational EU target that calls for a large-scale restructuring of our societies. If the most vulnerable will bear the largest cost, climate policies will contribute to the steep rise in inequality, which represents another fundamental challenge of our times. The European Energy Crisis in 2022 reminds us that energy price changes, whether caused by external shocks of government policies, have distributional impacts that call for compensation. The European Commission has acknowledged this problem, as demonstrated by the proposed Social Climate Fund. Yet, how much compensation is needed, who needs it the most and how compensation mechanisms should be designed to allocate funds to those most in need is currently poorly understood. This project will try to fill this research gap by studying the distributional impacts of carbon pricing, and how well-designed policies can counter its adverse effects.

Inequality considerations call for a new environmental economic modelling, which trades off efficiency against equity both within and across income groups. The novelty of the approach of GRETA builds on its combination of mechanism design theory and detailed individual-level data. We use mechanism design to derive the optimal green tax reform: A combination of optimal taxation and climate policies calls for a model with two-dimensional private information that is new to the literature. Building on the theory, we study the impacts of the natural experiment provided by the European Energy Crisis of 2022. Our empirical approach builds on a large individual- and firm-level administrative dataset from Finland, allowing us to measure the individuals’ exposure to climate policies through consumption, employment, and firm ownership. In addition, we will run a survey to study the attitudes towards climate-induced inequalities and link the results to the administrative data.

Work performed from the beginning of the project to the end of the period covered by the report and main results achieved so far

The manuscript "Pigouvian income taxation" develops a mechanism design approach to study externalities and redistribution. The mechanism screens individuals' social weights to strike a balance among broad distributional objectives, incentives to work, and incentives to reduce externalities. The welfare-optimal allocation can be decentralized through income taxation, defining income-dependent externality payments. Two applications use individual-level administrative data on incomes, pollution measures, and financial burdens to demonstrate how population characteristics shape the optimal policy on carbon emissions.

Progress beyond the state of the art and expected potential impact (including the socio-economic impact and the wider societal implications of the project so far)

The economists' traditional approach to steer the green transition has been to use one policy instrument for each problem: Price carbon as suggested by Pigou (1932), and address of the distributional concerns by rebates or income taxation following Mirrlees (1971). A properly set carbon price flows through the economy and corrects commodity prices and wages to equal their true social value. A common view is that any adverse distributional effects should be handled through the general income tax system. In other words, climate and tax policies are separable.

This project challenges this established way of thinking. Our premise is that the policy maker cannot know, firstly, what possibilities individuals have to reduce emissions and, secondly, what their earning possibilities are. When individuals have private information in these two dimensions, climate and tax policies are no longer separable. In contrast, they need to be designed together. This approach breaks down the classical results of Pigouvian pricing: Carbon pricing should not only consider efficiency but also account for distributional objectives. More strikingly, our approach also breaks down the optimality of uniform carbon pricing: We find that carbon prices should vary by income. These results challenge us to reconsider how climate and tax policies can be designed coordinately in Europe