How can a carbon tax benefit developing economies with informality? A CGE analysis for Côte d’Ivoire

ABSTRACT

This study investigates how a carbon tax could reduce fiscal and economic distortions as well as cut carbon emissions in developing-country economies. A computable general equilibrium model is developed to analyze the economic impacts of a hypothetical carbon tax in Côte d’Ivoire, a country in Sub-Saharan Africa with large losses of tax revenues due to informality and leakage. The model represents informal as well as formal production activities. The analysis shows that the economic impacts of a carbon tax and the levels of CO₂ reduction vary significantly among alternatives for recycling the carbon tax revenue. A carbon tax with revenues recycled to reduce the existing value-added tax would increase GDP and economic welfare. If the revenue is used to cut the existing tax on labour, the carbon tax would not only increase GDP but also induce the migration of workers from informal to formal activities. The analysis also shows that if energy producers are not excluded from carbon tax revenue recycling, the carbon emission reduction is significantly lower due to a rebound effect. A carbon tax with lump-sum transfers of revenues to households would be progressive as the revenue is equally transferred to all households, but it reduces economic output and does not help reduce informal economic activities.

Key policy insights

• A carbon tax can be beneficial to developing countries by generating fiscal co-benefits through revisions of other taxes.

• The size of the fiscal co-benefits depends on the carbon tax design.

• A carbon tax with revenue recycled to cut labour taxes incentivizes informal economic activities to move to the formal sector and to increase economic welfare.

• Using carbon tax revenues to reduce the value-added tax can reduce tax evasion and increase economic welfare.

• Unless energy producers are prevented from receiving the benefits of carbon tax revenue recycling, emission reduction is decreased due to a rebound effect.

KEYWORDS:

• Informal economy
• carbon tax
• general equilibrium modeling
• Cote d’Ivoire

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 In this study, we follow World Bank’s definition for middle – and low – income countries (Hamadeh et al., 2021). We add ‘small’ to exclude developing countries (e.g. China, India, Iran, Indonesia, South Africa and Brazil) which contribute more than one percentage of global CO₂ emissions from fossil fuel combustion in 2019 (World Bank, 2022).

2 As shown below, cutting the rate of a broad-based Value Added Tax (VAT) can have a similar effect, because such a broad-based tax on consumption that raises the real cost of living closely resembles a direct income tax.

3 Informality here refers to any economic activity that is not officially registered or licensed. Because they are thus invisible to authorities, they neither pay taxes (income taxes, general VAT, or social security contributions) nor are subject to state regulations (Fortin et al., 1997; Gibson, 2005). For more details on issues related to informality, see Peña (2013) and Maloney (2004).

4 Background information on taxes and government revenue in Cote d’Ivoire can be found in several documents, such as, KPMG (2016). For background information on existing environmental policies, AfDB (2018) and UNEP (2017) are helpful.

5 There are several studies that have attempted to incorporate informality in CGE modeling to address other topics (see e.g. Fortin et al., 1997; Stifel & Thorbecke, 2003; Gibson, 2005; Lay et al., 2006; Rada, 2009; Robilliard et al., 2008; Atuesta & Hewings, 2013; Morales et al., 2017).

6 While the ‘rebound effect’ could be defined differently in different context, we define it as the erosion or dilution of CO₂ mitigation effect of carbon tax. It occurs when fossil fuel industries also receive benefits from carbon tax revenue recycling as it could decrease the prices of fossil fuels thereby increasing their demand and associated emissions compared to the situation when fossil fuel industries do not receive carbon tax revenue benefits.

7 Other static general equilibrium models developed to analyze trade and environmental issues include Bernstein et al. (1999), and De De Melo and Tarr (1992).

8 The imperfect substitute commodities produced by formal and informal firms in each industry are aggregated into a composite commodity exported to meet foreign demand. A cost-minimization technique is used to determine the optimal structure of the composite and its index price.

9 The scenarios are designed carefully to answer specific research questions. Most existing studies have analyzed where to recycle carbon tax revenues (please see Timilsina, 2018a). Our study aims to go beyond by answering specific questions, such as how much revenues to be recycled? It examines not only where to recycle the tax revenues but also how to recycle for that purpose. It also examines whether or not fossil energy sectors and thermal power generation get benefit from recycled revenues.

10 Note, however, that emission intensive industries, such as transportation, still enjoy cutting their production tax rates using the carbon tax revenues. It means that some rebound effects still exist. One possible way to minimize the rebound effect would be not to allow all emission-intensive sectors to cut their production tax rates. However, we have not done so; otherwise there will be too many scenarios, and comparison of results will be too cumbersome.

11 Please see Timilsina (2018a) for economic impacts of carbon tax reported by a large number of existing studies published since early 90s. All carbon tax studies that consider recycling carbon tax revenues to households through a lump-sum transfer report GDP losses due to the carbon tax.

12 The reason for positive economic impacts under Scenario 3 is the increased real income of formal labor, as those workers’ income tax is cut using the carbon tax revenue. The increased income also causes increased consumption. The higher the household income would lead to a higher welfare and the higher household consumption would cause a higher GDP. Another channel that causes increased GDP under Scenario 3 is through increased net exports as explained in the case of production tax cut case.

13 Although our analysis could not include the distributional impacts of a carbon tax due to lack of data, there exists some analysis examining the distributional analysis (Brenner et al., 2007; Chepeliev et al., 2021; Ohlendorf et al., 2021; Harju et al., 2022).

14 For background information regarding CO₂ emissions by firms (formal and informal), households and the governments, please see Appendix C.

15 There are many channels through which a carbon tax reduces emissions. These are primarily pricing and substitution channels. The pricing channel works through demand reduction (higher fuel prices due to the carbon tax leads to lower demand). The substitution channel works through substitution of higher carbon intensive fuels with low or no carbon fuels. The substitution possibilities are defined by elasticity of substitution. The substitution occurs, as reflected in Figures A1 and A2, at different levels.

16 The electricity and natural gas sectors, which are the primary source of CO₂ emissions in Côte d’Ivoire, also receive carbon tax revenues to cut their production taxes. In fact, production of electricity is already subsidized in Côte d’ Ivoire, recycling carbon tax revenues to further subsidize electricity production causes carbon tax to be ineffective to reduce CO₂ emissions from this sector.

17 Such a distributional analysis has been carried out in another World Bank study of carbon tax impacts on Côte d’Ivoire, but the results are yet to be published.

Additional information

Funding

This work was supported by World Bank Group [Grant Number P163788].