Paulson Papers On Energy and Environment

Can Carbon Taxes be Good for China and the United States?
Antung Anthony Liu
April 2015

 Paulson Papers On Energy and Environment
About the Author
Antung Anthony Liu
Antung Anthony Liu is a Fellow at Resources for the Future in Washington, DC and a
Visiting Assistant Professor at the Cheung Kong Graduate School of Business in Beijing.
His research focuses on two broad areas: climate change policy and the development
process in China. Along with his work on carbon tax policy, he has studied sewage
treatment infrastructure in cities in China, transportation policy in Beijing, and Chinese
export policy. He received his PhD from the University of California, San Diego.

This essay is adapted from a working paper of the University of California, San Diego.
Cover Photo: Reuters/China Daily Information Corp

 Paulson Papers On Energy and Environment
Introduction

T

he US Environmental Protection
Agency (EPA) recently announced
a plan to reduce carbon
emissions from power plants by 30
percent by 2030. These regulations
engendered immediate controversy,
and some promptly denounced them
as an indirect tax on energy that would
be destructive to the US economy.
Underlying the
debates regarding
the regulation of
carbon through
taxes, permits,
or regulations
is premised on
a widespread
assumption that
controlling carbon
will be bad for
economic growth.
Photo: Len Matthews/Flickr

The typical argument
that carbon taxes will hurt the
economy goes something like this:
controlling carbon will raise the price
of energy. Increases in energy prices
will hurt the energy sector, costing
the country jobs and raising prices
throughout the economy. Energy
price hikes will hurt businesses and
consumers alike. In China, some deem
that the economic cost will in fact be
higher than the cost in the United
States, since China relies more on
heavy industry and has a much more
carbon-intensive energy mix.

Indeed, research by public finance
economists and environmental
economists alike have confirmed the
basic result that carbon taxes are bad
for the economy. For decades, the
academic literature has supported the
popular consensus that carbon taxes
will be bad for economic welfare,
even when the revenue from these
taxes is recycled
back into the
economy through
concomitant tax
cuts in other areas.2
This paper,
however, presents
evidence for
the opposite
conclusion. The
key finding is that
carbon taxes,
provided that the
revenue is recycled to cut taxes in
other areas,3 can be good for economic
welfare and boost economic growth.
The basic reason for this potentially
provocative result is that carbon taxes
are more efficient than other forms of
taxation and can offset inefficiencies in
the existing tax structure.
And that raises an important question
about China, which is, after all, the
world’s largest emitter of greenhouse
gases (GHGs) and has considered
various plans to contain its carbon
emissions. Shortly after the US EPA

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announced its plan, He Jiankun,
the Chairman of China’s Advisory
Committee on Climate Change, said
that China would impose a cap on
its carbon emissions starting from
2016.1 Professor He later clarified in
interviews that his comments were
made as a private citizen rather than
in his capacity as an advisor to the
Chinese government, raising questions
about the scope and depth of any
such commitment. Yet many analysts
nevertheless believe that China will act
to meaningfully control its emissions.
One way that China may do that is
through the recent idea of a national
carbon permit trading system, building
on its carbon permit pilot programs. In
China’s case, the internal debate about
promulgating these actions centers on
the implicit question of whether the
cost to the economy of pricing carbon
is worth the benefit of mitigating the
impacts of climate change.
But since China’s system, in particular,
is less efficient than that of the United
States, this paper argues that China
has potentially the most to gain from
a shift toward carbon taxes relative

to, say, an advanced economy like the
United States.
The paper begins by summarizing
how differences between carbon
taxes and other taxes can change
the policy calculus. The first section
summarizes the advantages that
carbon taxes have over other kinds of
taxes. Three reasons are offered here.
First, carbon taxes are harder to evade
than other taxes, and shifting the tax
base towards carbon taxes can reduce
tax evasion. Second, carbon taxes
fall on sources of energy and distort
market behavior less than other taxes.
Third, carbon taxes can play a role in
minimizing the informal sector.
The second section uses simple
simulations to show that these three
factors are quantitatively significant,
and how they can act in concert to
challenge the conventional belief
that restricting carbon emissions
will necessarily lead to negative
ramifications for the economy. The last
section concludes by discussing the
implications for Chinese policy of this
initial analytical finding.

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Why Are Carbon Taxes More Efficient Than Other Forms of Taxation?

E

nvironmental economists have
long studied a “double dividend”
style of tax reform, where a carbon
tax is imposed, and the revenue from
this tax is used to cut preexisting taxes.
Early research was motivated by the
possibility of two forms of benefits:
environmental benefits from the carbon
tax and economic benefits by cutting a
preexisting tax such as a labor tax.

First, carbon taxes are difficult to evade.5
Such taxes fall most heavily on energy,
in particular crude oil, electricity, and
gasoline. These energy sources must
flow through centralized points of
infrastructure such as pipelines or
the electrical grid. At these points
of infrastructure, prices are easy to
monitor and taxes are easy to collect.
In addition, the centralized nature of
these infrastructure points mean that
Unfortunately, the possibility of a
quantities bought and sold are known
double dividend
with a high level of
seemed out of
precision—virtually
Recent research has resurrected the possibility
reach when the
all government
of economic benefits from carbon taxes by
issue was examined pointing out that such taxes can be more
agencies already
more carefully.
track very closely
efficient than other forms of taxation.
One review of
how much energy
environmental tax
is produced and
research stated: “The general finding in
consumed. For these reasons, tax
the theoretical literature is that—with
evasion on energy is quite difficult, even
some qualifications—the net impact
in industrializing countries like China.
from shifting taxes off income and onto
emissions is to increase the costs of
Empirical evidence supports the idea
preexisting taxes.”4
that tax evasion on environmental
taxes is much lower than evasion on
But recent research has resurrected
other forms of tax. Sweden has for
the possibility of economic benefits
decades deployed carbon taxes and
from carbon taxes by pointing out that
environmental taxes alongside other
such taxes can be more efficient than
taxes. For each type of tax, Sweden has
other forms of taxation. The recent
measured its “tax gap,” the difference
literature has pointed out three areas
between the revenue that is actually
where carbon taxes may display such
collected and the revenue that should
comparative efficiencies: their tax
be paid if all taxes were paid honestly.
evasion properties, their ability to raise
revenue without significantly distorting
It has found that the tax gap for carbon
the behavior of market participants, and
taxes and environmental taxes is less
their impact on the informal economy.
than 1 percent, a rate far lower than

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 Paulson Papers On Energy and Environment
Table 1. Tax Gap and Evasion Rates for Various Tax Types
Tax Type
Income tax on employment
Tax on capital
Income tax on Business income
Social security
VAT
Alcohol and tobacco
Energy and environment

Tax Gap
20.4
10.9
31.9
30.2
35.3
3.3
0.5

Taxes Collected
405.0
22.7
92.0
425.0
253.0
11.0
66.7

Tax Evasion
4.8%
32.4%
25.7%
6.6%
12.2%
23.0%
0.7%

Notes: Tax figures are in billions of kronor; all amounts are for 2005.
Source: Liu (2013)

taxes such as the sales tax or personal
income tax (see Table 1). Even the valueadded tax, a revenue stream purported
to have a low rate of evasion, has an
evasion rate of 12 percent.
As a result, a tax system that leans more
heavily on carbon taxes and less on
other kinds of tax revenue will yield less
overall tax evasion. Since tax evasion
generates real costs—such as lawyers
and accountants who are hired to find
loopholes—a system with lower tax
evasion will be more efficient than one
with higher tax evasion.
Second, carbon taxes raise revenue
with less distortion than other types
of taxes.6 Consider the types of taxes
that are currently the main drivers of
revenue in both the United States and
China. In the United States, the personal
income tax, the social security tax, and
the sales tax are most important to the
revenue base. For each of these, higher
tax rates lead to tradeoffs in terms of

lower incentives to work and less
consumer spending. These “tax
distortions” are deemed a necessary
evil to raising government revenues. In
China, by contrast, the main sources of
taxation—the value added tax (VAT),
the personal income tax, and the
corporate income tax—can act as similar
disincentives to work and spend.
Now consider the carbon tax. A large
portion of the carbon tax falls on energy,
which in turn is imposed on producers
of energy at oil wells and natural gas
fields. Many of these producers earn
profit by licensing and pumping these
natural resources. A carbon tax would
reduce these profits, but it would
have considerably less impact on the
decision to produce or not produce than
comparable taxes on labor, sales, or
profits.
As a result, an economy that leans
more heavily on carbon taxes will
have lower amounts of production

Can Carbon Taxes be Good for China and the United States?
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 Paulson Papers On Energy and Environment
decision distortion than an economy
that excludes them. Minimizing these
distortions improves welfare and
benefits the economy.

manufacturing, and power, are almost
impossible to produce in the informal
economy. So a carbon tax increase has
little effect on the informal sector.

Third, carbon taxes can work to reduce
the scope and impact of the informal
economy.7 The informal economy is
defined as the portion of the economy
that escapes taxes and regulations,
and it plays a major role in every
country. The United States has one of
the smallest informal sectors in the
world, representing just 8 percent of
GDP; in China, the informal economy is
estimated at 16 percent of GDP.8

By contrast, a tax cut on services creates
a new incentive for participants in
the informal economy to re-join the
formal sector. Some firms operating at
the fringes of the formal and informal
economies may join the formal sector,
boosting the overall tax base of the
economy.9

Shrinking the informal sector can also
have salutary effects on the wider
economy. For
Carbon
taxes
can
potentially
be
more
effective
To understand
example, a tax
in
China
than
in
the
United
States
because
the
how carbon taxes
cut on a labor
former’s existing tax system is relatively less
can affect the
tax like the social
efficient
across
these
important
dimensions.
informal economy,
security tax in
first consider the
the United States
would reduce the cost of operating
composition of the informal economy.
In the United States, services such as
in the formal sector for painters,
nannies, and gardeners. Some small
home care and domestic help constitute
a large portion of the informal
businesses in these groups may decide
sector; so do informal finance and
that the disadvantages of remaining
informal construction. In China, these
in the informal sector—such as being
services also play a large role, joined
unable to scale activity while remaining
by elements such as informal retail
invisible—are now too great; they may
and light manufacturing. Each of the
register as businesses and pay taxes. If
some of these choose to join the formal
constituent parts of the informal sector
is comparatively labor intensive and
economy for the first time, the burden
does not require much energy.
on other taxpayers will decrease,
boosting the economy overall.
A carbon tax, when coupled with
concomitant cuts on other forms of
Revenue from a carbon tax in China
taxation, will shift the tax burden off of
might be directed to cut taxes like the
these labor-intensive goods and onto
business tax, which functions as a tax
energy-intensive ones. The most energyon sales that is targeted at the services
intensive goods, such as cars, heavy
sector. China, with its larger informal

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 Paulson Papers On Energy and Environment
economy, has even more potential for
growth from streamlining its tax system.
Some operators in the Chinese informal
sector—financial services, construction,
and other informal services—might
respond to this incentive to enter
the formal sector, representing an
enormous source of potential growth in
the economy.
In summary, this section has illustrated
how a carbon tax has unique
characteristics that distinguish it
from other types of taxation. When
an economy relies more heavily on a
carbon tax, it could well result in less

tax evasion, less tax distortion, and a
smaller informal economy.
But one important conclusion is that
each of these factors tends to be more
important in China than in the United
States. That is because China has a
higher rate of tax evasion, depends
more heavily on energy production, and
has a much larger informal sector. As
a result, carbon taxes can potentially
be more effective in China than in the
United States because the former’s
existing tax system is relatively less
efficient across these important
dimensions.

Can Carbon Taxes be Good for China and the United States?
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 Paulson Papers On Energy and Environment
Can Carbon Taxes Be Good for the Chinese and US Economies?

M

erely highlighting that carbon
taxes have some beneficial
properties is useful but does
not prove that carbon taxes can be good
for the economy. Each factor separately
reduces the economic cost of carbon
taxes, but how do they cumulatively
affect the economy?
What follows are simple simulations
that quantitatively estimate how the size
of the cumulative effect of these three
factors on the economy.10 These first
simulate the United States, then China.
The key result is presented in the graph
below (see Figure 1).

Each point on the x-axis of this graph is
a separate simulation, and each point
on this graph is the percentage by which
carbon emissions are reduced. The
y-axis is the impact of the policy change
in welfare, expressed as a percentage
of the country’s GDP. This change in
welfare is certainly a low estimate, since
it does not include improvements to the
environment from emissions reductions.
Let us focus first on the thin dashed red
line and the thin blue line. These are the
results of the simulations when none of
the three factors from the previous

Figure 1. Effect of All Factors Combined on the Cost of Carbon Emissions Cuts

Source: Carson et al. (2014)

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 Paulson Papers On Energy and Environment
section is considered. The lines confirm
the prior contention in three ways.
First, every point on these lines is
below the x-axis, so that every cut in
carbon emissions through a carbon tax
is harmful to the economy. Second, the
lines sweep exponentially downward,
suggesting that the cost of large cuts in
emissions is exponentially larger than
the cost of small cuts. Third, the thin
blue line is below the thin dash red
line, showing that carbon cuts in China
are more expensive than those in the
United States.
Now consider the other pair of thick
dashed red lines and the thick solid blue
line. These are the same simulations,
except that three factors outlined in
the section above are included. The
incorporation of the three factors
markedly shifts the result.
In fact, the central finding of this
paper is that for emission cuts below
13 percent, both lines lie above the
x-axis. It indicates that the three factors
discussed above can actually act as a
corrective presence in the economy,
reducing the inefficiencies caused by tax
evasion, distortionary behavior, and the
informal sector. The economy will see
improvements by shifting the tax base
toward a carbon tax.

The second major result is that the thick
solid blue line is above the thick red line
for emission cuts below 12 percent. This
suggests that the welfare gain in China,
up to a point, will be even greater than
similar gains in the United States for
policy relevant cuts in carbon emissions.
As explained above, because China has
higher levels of all three factors—tax
evasion, reliance on non-distortionary
energy sources, and informal sector
size—a carbon tax could improve the
Chinese economy more significantly
than the American one.
In summary, simple simulations of the
impact of the three key factors show
that they are quantitatively significant.
They appear large enough to offset
the entire cost of a carbon tax for
carbon emission cuts below 12 percent.
Moreover, the results offer evidence
contradicting the prevailing view of
the economic cost of a carbon tax,
particularly for China since it stands to
gain more from taxing carbon than the
United States would at this point.
For large emissions reductions, the
costs of a carbon tax are still large and
positive. Despite the three factors
presented here, the tradeoff between
economic efficiency and environmental
quality remains significant when
contemplating the very large reductions
in carbon emissions called for in many
international forums.

Can Carbon Taxes be Good for China and the United States?
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 Paulson Papers On Energy and Environment
Conclusions and Areas for Future Research

T

he possibility that imposing a
has tended to be high. This paper
carbon tax could simultaneously
contributes to this debate by arguing
reduce emissions and enhance
that the cumulative economic gains
economic growth could dramatically
from a carbon tax policy will, in fact,
alter the dynamics of what is both
outweigh the economic losses.
optimal and possible in terms of a global
climate agreement. While most analysts
New evidence is presented here for
think that the best way to decrease
policymakers weighing the effects of
such a tax on the broader economy
GHG emissions is carefully coordinated
and how to balance carbon emissions
country-by-country unilateral action,
reductions while not sacrificing
these results, albeit preliminary,
suggest that countries might benefit
economic growth. Such a finding is all
economically even if they made
the more surprising because developing
unilateral cuts in their carbon emissions
countries, which have historically been
most opposed to
through revenuecutting emissions,
neutral carbon
Developing countries, which have historically
taxes.
been most opposed to cutting emissions, stand stand to gain more
from revenueto gain more from revenue-neutral carbon
neutral carbon
These results
taxes.
come with some
taxes. This is the
important caveats,
case in China.
however. Implementation of a carbon
There are many factors that were not
tax matters enormously, and each
directly considered in this analysis
country’s tax code incorporates unique
that could further enhance the case
complexities that could influence this
for carbon taxes. For example, taxes
result. More fine-tuned and detailed
models are necessary to study these
on carbon tend to reduce emissions
of other forms of closely-related
issues further. Prior studies that
pollutants, like particulate matter and
have reproduced these factors in
full economic models have generally
sulfur dioxide. Reductions in pollution
can have broad effects, ranging from
affirmed their quantitative importance.
reduced property damage to improved
Further, a carbon tax will invariably
worker health and productivity. These
generate in each country winners
“co-benefits” are particularly important
who support the tax and losers who
in developing countries like China (see
oppose it. Since many of the losers
Paulson Institute paper on climate and
are concentrated in a few industries,
air pollution co-control). Some studies
political opposition to carbon tax reform
have linked carbon taxes to energy

Can Carbon Taxes be Good for China and the United States?
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 Paulson Papers On Energy and Environment
efficiency, showing how higher prices
can induce technological change. Again,
analysis suggests that these factors tend
to strengthen the benefits of a carbon
tax for the economy.
This paper has contributed some
additional arguments for the potential
imposition of carbon taxes. For instance,
policymakers who consider elements
such as tax evasion when raising
government revenue or revising their
tax code should consider a carbon
tax because it is difficult to avoid.
Meanwhile, even those attempting
to minimize the impact of taxes on
their economy may also want to

consider a carbon tax as a way to gain
revenue while limiting other economic
distortions. Finally, governments
combatting the thorny problem of the
informal sector may also consider a
carbon tax as a simple way to lighten the
burden on those who might otherwise
choose to enter the informal economy.
Separately considered, each of these
arguments is important. Collectively,
however, they suggest that a carbon
tax can actually benefit the economies
of countries that implement them. And
this seems especially to be the case for
China.

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Endnotes  
Chen, Kathy and Reklev, Stian, “China Plan to Cap Emissions Seen Turning Point in Climate
Talks,” Reuters, June 3, 2014, http://uk.reuters.com/article/2014/06/03/china-climatechangeidUKL3N0OK1VH20140603.

1

2

See for example Goulder (1995) and Bovenberg and Goulder (2002).

An equivalent argument is to say that, when revenue must be raised, it should be raised through a
carbon tax rather than through another tax.

3

Parry, I. W., J. Norregaard, and D. Heine, 2012. “Environmental Tax Reform: Principles from Theory
and Practice,” Annual Review Resource Economics, 29(3): S64-S77.

4

Liu, A. A., 2013. “Tax Evasion and Optimal Environmental Taxes,” Journal of Environmental Economics
and Management, 66(3): 656-670.
5

Bento, A. and M. Jacobsen. 2007. “Ricardian Rents and Economic Policy: The Double-Dividend
Hypothesis,” Journal of Environmental Economics and Management 53(1): 17-31.

6

Bento, A., M. Jacobsen, and A. Liu. 2014. “Environmental Policy in The Presence of An Informal
Sector,” Working paper, University of California, San Diego.

7

Schneider, F., 2005. “Shadow Economies of 145 Countries all over the World: What Do We Really
Know?” Center for Research in Economies, Management, and the Arts Working Paper No. 2005-13.

8

Gorodnichenko et al. (2009) show that tax evasion responds sharply to tax rates. Peter (2009) shows
that the size of the informal sector responds to the top marginal tax rate.

9

Carson, R., M. Jacobsen, and A. Liu, 2014. “Comparing the Cost of a Carbon Tax in China and the
United States,” Working paper, University of California, San Diego.
10

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