A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Habla, Wolfgang; Roeder, Kerstin Working Paper The Political Economy of Mitigation and Adaptation CESifo Working Paper, No. 5729 Provided in Cooperation with: Ifo Institute – Leibniz Institute for Economic Research at the University of Munich Suggested Citation: Habla, Wolfgang; Roeder, Kerstin (2016) : The Political Economy of Mitigation and Adaptation, CESifo Working Paper, No. 5729, Center for Economic Studies and ifo Institute (CESifo), Munich This Version is available at: http://hdl.handle.net/10419/128423 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu The Political Economy of Mitigation and Adaptation Wolfgang Habla Kerstin Roeder CESIFO WORKING PAPER NO. 5729 CATEGORY 2: PUBLIC CHOICE JANUARY 2016 An electronic version of the paper may be downloaded • from the SSRN website: www.SSRN.com • from the RePEc website: www.RePEc.org • from the CESifo website: www.CESifoT -group.org/wpT ISSN 2364-1428 CESifo Working Paper No. 5729 The Political Economy of Mitigation and Adaptation Abstract In this paper, we acknowledge that the mitigation of and adaptation to climate change have differential fiscal impacts. Whereas mitigation typically raises fiscal revenues, adaptation is costly to the taxpayer and to a greater extent the more distortionary the tax system is. In an OLG model with majority voting, we analyze how the choices of mitigation and adaptation are distorted under a lump-sum and a distortionary income tax regime. We find that whenever emissions and adaptation exhibit stock characteristics, the levels of mitigation and adaptation are chosen inefficiently low in the political equilibrium under lump-sum taxation. By contrast, the political equilibrium may entail inefficiently high mitigation or inefficiently high adaptation (but not both simultaneously) if the tax system is distortionary. A calibration of our model to the German economy shows that both mitigation and adaptation can be expected to be inefficiently low in the political equilibrium. Furthermore, the standard assumption of a lump-sum tax system when analyzing mitigation and adaptation is found to underestimate the loss in utilitarian welfare relative to a distortionary tax system, although mitigation levels are generally higher under the latter regime. JEL-codes: D720, D780, H210, H230, Q580. Keywords: adaptation, mitigation, political economy, majority voting, OLG, environmental taxes. Wolfgang Habla Kerstin Roeder University of Gothenburg University of Augsburg Vasagatan 1 Universitätsstr. 16 Sweden – 40530 Gothenburg Germany – 86159 Augsburg [email protected] [email protected] January 22, 2016 We thank Kelly de Bruin, Jurate Jaraite-Kazukauski, Thomas Sterner and seminar participants at the University of Umeå for valuable comments and suggestions. Wolfgang Habla acknowledges the generous financial support from the FORMAS research program COMMONS. 1 Introduction Current climate policies consist of two options: the mitigation of greenhouse gas emissions such as CO2 and the adaptation to the adverse impacts of climate change. While the former is able to raise fiscal revenues (consider an environmental tax or the auctioning of permits under an emissions trading scheme), public adaptation (dykes against rising sea levels or transport infras- tructure that is resistant to extreme weather events) requires revenues. It has been estimated that the costs of public adaptation can be quite significant (see, e.g., Egenhofer et al., 2010; Jones et al., 2013; Israel, 2013). The fiscal dimension of climate policies has, however, been largely neglected in economic theory, with the exception of Barrage (2015), and its implications for the political feasibility of these two options will be explored in this paper. Mitigation policies have highly differential impacts on individuals with different income levels, first because they usually affect low-income individuals to a greater extent than high-income individuals (at least in developed countries, see, e.g., Bach, 2009; Poterba, 1991; Ekins et al., 2011) but also because any revenues from environmental regulation can be spent on redistribution between households. In many European countries, e.g., Germany, Sweden, the UK, Denmark or the Netherlands (see Bosquet, 2000), environmental tax revenues have been used to reduce income taxes or social security contributions, which partly offsets the regressive impacts of the tax itself. As these reductions in taxes and contributions are incurred primarily by the working population and to a much lesser degree by retired individuals, age constitutes a second important dimension along which differential impacts of climate policy can be observed. Finally, young and old individuals enjoy different benefits from mitigation policies simply because of their different time horizons. The young will – on average – benefit more (or longer) from emissions reductions than the old. The same holds true for expenditures on public adaptation that endure over time, such as sea walls and transport infrastructure. These two dimensions – different individual income levels and time horizons – have a significant impact on which policy mix of mitigation and adaptation is chosen in the political process. Specifically, we consider an Overlapping Generations (OLG) framework with two generations alive at each point in time – the young and the old. The young work, whereas the old are retired. Apart from age, agents differ in their income. They have preferences over a non-dirty (num´eraire) and a dirty consumption good such as fossil fuels, over the level of emissions (caused by dirty good consumption) and the level of adaptation investment. All agents vote on the ecotax rate that applies to consumption of the polluting good and over the level of adaptation investments. Given this multi-dimensional issue space, we invoke Shepsle’s (1979) concept of structure-induced equilibria. It separates the bi-dimensional policy space into single dimensions by assuming that institutions exist that have been assigned the unique power to determine policies related to their field of responsibility. In our model, the ministry of the environment proposes a green 1 tax rate for a given level of adaptation investment, while the ministry of finance suggests a level of adaptation investment for a given environmental tax rate. These proposals can be treated as the best responses (reaction functions) of the respective ministries and are rooted in the median voter’s preferences regarding the issue at stake. Their intersection describes the structure-induced equilibrium of the voting game. We compare the political outcome with the choices made by a utilitarian social planner and find that whether mitigation and adaptation are inefficiently low or high crucially depends on the characteristics of the underlying tax system. In particular, we consider the two most prevalent modes of financing – a distortionary income tax system and a lump-sum tax system. The standard case in the environmental economics literature is the latter because it allows one to focus on environmental externalities. Compared to that system, distortionary income taxes are borne mostly by the young generation and necessarily cause efficiency losses. The mode of financing has a twofold impact on the budget constraints of the agents in our model: first, through the recycling of ecotax revenue and, second, through the financing of adaptation. When adaptation is financed and ecotax revenue is recycled through a lump-sum tax system, both mitigation and adaptation are lower in the political equilibrium than their socially optimal levels if both policy options exhibit stock characteristics. This is because voters do not internalize the full marginal damage from the consumption of the polluting good that is imposed on future generations. If, by contrast, distortionary taxes are in place, the median voter may prefer inefficiently high mitigation given a sufficiently high income or inefficiently high adaptation given a sufficiently low income, albeit not both at the same time. The intuition underlying this result is as follows. Although, due to differences in environ- mental concerns, the social planner internalizes environmental damage to a greater extent than do individuals, high-income earners benefit more from the regressive nature of ecotaxes relative to low-income individuals. Namely, the decrease in proportional income taxes caused