Recycling revenue can offset adverse impact of carbon tax on GDP, inequality and household income

A new ESRI study finds that a carbon tax could have some adverse impacts on GDP, inequality and household income. However, the impact is limited and could be reduced by using a well-designed revenue recycling scheme. The results come from new research using the ESRI’s newly developed environment, energy and economy (I3E) model for Ireland. 

Our research finds that an incremental increase in the carbon tax reaching €80 per tonne in 2030, as proposed by the all Government Climate Action Plan, will help reduce economy-wide emissions by approximately 15% in 2030. However, it will lead to increased prices and a small reduction in real values of gross domestic product (GDP) and household disposable income. Recycling the carbon tax revenue to decrease other taxes can reduce these impacts and result in increases in household disposable income in real terms.   

An increase in carbon tax will increase both the prices of energy and non-energy goods. Our results indicate that by 2030, an €80 carbon tax will increase energy prices by approximately 10% and the overall consumer price level (CPI) will increase by, on average, 2%.

Rural households will be more affected than urban households because they spend a greater share of their income on carbon goods, including heating fuels and transport diesel. Middle-income households face the highest price impacts in urban areas due to their high consumption of transport fuels.

When carbon tax revenues are not recycled, but used to pay off government debt, household real disposable income will decrease (by 0.3% on average by 2030). Recycling carbon tax revenues back to households can significantly reduce the regressiveness of the impacts of a higher carbon tax and increase household disposable income in real terms (by on average 0.2% in 2030).

The overall macroeconomic impacts of a carbon tax are found to be relatively small, where the annual GDP growth rate is reduced by 0.01% due to the increased carbon tax. Using carbon tax revenues to reduce other taxes, such as sales, wage or corporate tax, can reduce the macroeconomic impacts of an increased carbon tax and lead to significant increases in household income (1.2% on average in 2030) in real terms. However, doing so often results in more regressive impacts across households.

Our results show that carbon-intensive production sectors, such as transport, electricity generation and mining will be hit the hardest by a carbon tax increase, whereas low carbon-intensive sectors can benefit from a carbon tax increase as consumption shifts towards low carbon goods and services, such as the accommodation sector and other services. The transport sector faces a decrease in value added of 4% in 2030 and the accommodation sector an increase of 1%.

Increasing carbon prices will incentivise producers and households to reduce their use of carbon goods and hence reduce emissions. Our analysis shows that increasing the carbon tax will help Ireland reduce its emissions compared to the current carbon tax, but the strong projected economic growth in Ireland would mean that emissions continue to increase over time. This would mean that more initiatives are needed for Ireland to reach the EU emissions targets.

One of the ESRI report’s authors, Kelly de Bruin commented: “The economic and household-level impacts of the proposed carbon tax increase in the all government Climate Action Plan are limited and with a well-designed carbon revenue recycling scheme, it is possible to reduce impacts further and compensate those households most affected.  However, the current plan for a carbon tax would not reduce emissions enough to meet EU targets, particularly if the Irish economy continues to grow and emissions increase accordingly. Additional climate policies are needed to ensure a transition to a low-carbon economy.”