Reducing Leakage with Supply-Side Elasticities as Determinants of Optimal Carbon Taxation∗

Abstract

Consider an open economy with two polluting production inputs whose policymakers decide to implement a unilateral carbon tax on the use of the inputs. The one-sided policy introduces a leakage externality whose magnitude depends on the price responses of the polluting inputs. We show that the optimal tax on a polluting input decreases when the relative supply-price elasticity increases. The intuition is that inputs with low supplyprice elasticities experience larger price decreases in response to taxes, which incentivises the producers in the non-taxing country to use more of them. The policymaker avoids this by taxing the elastic inputs the most.

Keywords: Non-cooperative climate policy, Leakage, Pigouvian taxes, Second-best taxes, Differentiated carbon taxes, General equilibrium