Is Broader Always Better? Preexisting Distortions, Emissions Elasticities, and the Scope of Emissions Pricing

Economists often regard a broad-based price on carbon (whether in the form of a carbon tax or cap and trade) as the most efficient policy to reduce carbon dioxide emissions. Relative to a narrower policy that omits some emissions sources, a broader policy is often favored because it can exploit more low-cost emissions reduction opportunities and cause less emissions leakage to uncovered sources. Yet narrower approaches have gained considerable political support, in part because they avoid price increases for outputs (such as gasoline) regarded as especially critical to household budgets.

Some analysts might lament any shift away from broad carbon pricing, citing potential efficiency costs. However, this paper offers theory and numerical simulations that reveal that such a shift need not involve an efficiency sacrifice.

This result stems from differences across sectors in distortions from preexisting taxes and in the elasticity of a sector’s emissions to the carbon price. Our analytical model reveals that a narrow carbon price policy that exploits these differences can be more cost-effective than a policy with a broad, economy-wide tax base.

Our numerical model of the US economy then compares quantitatively the effects of an economy-wide carbon price with those of a range of narrower policies, including a policy that applies only to the power sector, one that exempts gasoline, and one that exempts energy-intensive trade-exposed industries. We make these comparisons under a range of specifications for policy stringency and find that the ratio of the broader policy’s cost to the narrower one’s declines with the ambitiousness of the emissions reduction target and that a broader policy always becomes more cost-effective at sufficiently high stringency.