International cooperation on carbon pricing

OECD working paper by Sneha Thube ’16 (Economics)

Photo by Markus Spiske on Pexels

As we are approaching the COP26 meeting to be held in Glasgow later this year, a highly anticipated milestone that is to be expected is the finalization of the rulebook for Article 6 of the Paris Agreement. Article 6 calls for ‘voluntary cooperation’ between public and private actors in carbon markets and other forms of international cooperation to meet the climate goals.

Ex-ante policy modelling assessments have shown that international cooperation on carbon pricing can result in economic and environmental gains that potentially could be used to boost the ambition of the climate targets. In our OECD working paper (jointly with Sonja Peterson, Daniel Nachtigall and Jane Ellis) we present a review of the literature on ex-ante policy modelling studies that examine the economic and environmental gains that could be realised if nations cooperate on climate action. Ex-ante modelling studies usually use Computable General Equilibrium (CGE) models or Integrated Assessment Models (IAM) to understand the socio-economic and environmental impacts of climate policies. We group the research articles into the following five types of cooperative actions that could be realised between countries – carbon price harmonization, extending the coverage of carbon pricing systems, implementing a multilateral fossil fuel subsidy reform, establishing international sectoral agreements and, mitigating carbon-leakage through strategic climate coalitions and border carbon adjustment.

The literature shows that all forms of international cooperation could potentially deliver economic and environmental benefits. Extending carbon markets to include new regions would reduce the aggregate mitigation costs but would not lead to unanimous gains for each of the participating countries and thus compensation mechanisms would be needed to incentivize participation from countries that would face costs. Sectoral agreements have a limited impact but could help in the reduction of GHG emissions though not cost-effectively. All of the studies unambiguously show that removal of fossil fuel subsidies would lead to an improvement in aggregate global welfare.

Further details about the results and individual papers can be found here:

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Sneha Thube ’16 is a researcher at the Kiel Institute for World Economy. She is an alum of the Barcelona GSE Master’s in Economics.

Within-Group Heterogeneity in a Multi-Ethnic Society

Nada es Gratis article by Miriam Artiles ’15 (Economics)

Photo by Adrian Dascal on Unsplash

Editor’s note: this article was originaly published in Spanish in the popular economics blog, Nada es Gratis, and is based on Miriam Artiles’s PhD from Universitat Pompeu Fabra. Her Job Market Paper was honorably mentioned in the third annual Nada es Gratis Job Market Paper awards.

Is ethnic diversity good or bad for economic development? When different languages, ethnicities or races coexist in the same society, there are challenges for the economy, but also opportunities. On one hand, if individuals within ethnic groups are homogeneous, and groups differ in preferences toward policies or public goods, then conflicting preferences can lead to inefficiencies in public good provision or to policy choices that may not benefit the entire society. Inter-group tensions can also result in civil conflicts or exacerbate mistrust and lack of cooperation. However, on the other hand, if ethnic groups differ in subsistence activities or skills, then complementary specializations can generate economic gains, stimulate innovation, and promote inter-group trade. Alesina and La Ferrara (2005) provide a review of this literature. While there is a general understanding that diversity brings opportunities and challenges, there is scarce evidence on which factors determine its positive or negative consequences. When is ethnic diversity good for economic development, and when is it bad?

I ask whether the effect of ethnic diversity on economic development depends on one characteristic of ethnic groups that has received little attention: the heterogeneity of individuals within ethnic groups. Underlying previous literature is the assumption that individuals within ethnic groups tend to be homogeneous. However, individuals may differ in many dimensions, including preferences, economic activities or skills, as well as cultural, genetic, and linguistic traits. I focus on having different economic specializations and skills within the same ethnic group, and I study whether ethnic groups with more heterogeneous individuals do better in multi-ethnic societies.

Consider two ethnic groups, A and B. The two groups differ in ethnicity. In turn, ethnic group A has individuals with diverse skills due to their different economic specializations, while ethnic group B is more homogeneous (individuals from ethnic group B have similar skills). The idea is that it may be easier for individuals of ethnicity A to live and to interact in a multi-ethnic society–they come from an ethnic group that is already highly heterogeneous. They will already be used to diverse environments. They will be more familiar with having to interact with heterogeneous individuals. If you come from an ethnic group that is highly heterogeneous, in terms of skills, you may be more willing to live and to interact with other ethnicities. In this case, positive interactions, mutually beneficial exchange, between ethnic groups will become more frequent.

The 16th Century resettlement of Peruvian ethnic groups

To study this, I collect new data on a natural experiment from Peru’s colonial history. I focus on highland Peru. There, Spanish colonizers resettled native populations in the 16th century. They forced together different ethnic groups in new villages, and this happened unintentionally. Importantly, in some ethnic groups, individuals had already been living in very different ecological zones of the Andes, at different altitudes, during the pre-colonial period, before the Spanish conquest. This creates within-group heterogeneity. In some cases, individuals from the same ethnic group were very different in terms of ecological specializations and skills – the types of lands and crops that they were used to cultivate. In other ethnic groups, everyone lived in the same climate zone, at the same altitude. I am asking: did the more heterogeneous ethnic groups do better once they were resettled in multi-ethnic villages?

Firstly, I use a map of the spatial distribution of ethnic groups at the time of the Spanish conquest. It allows me to compute the distance from each village to the closest ethnic frontier and use it as a source of quasi-random variation in ethnic diversity. During the pre-colonial period, individuals from the same ethnic group were distributed vertically, at different altitudes. This is the thesis of the anthropologist John Murra. He documents this vertical settlement pattern as a subsistence strategy in an environment in which differences in elevation create a variety of ecological zones and climates. At the time of the resettlement, the mountain environment of the Andes was new to Spanish colonizers – they were used to a flatter world. As a result, in villages that were created close to ethnic borders, they concentrated individuals from different ethnicities unintentionally (Pease 1978; Wachtel 1976). Secondly, I use spatial data on the distribution of ecological zones to compute a proxy for the heterogeneity of skills within each ethnic group prior to the conquest. It is important to note that ethnic groups with more heterogeneous skills may be different in other dimensions (e.g., group size, population density, etc). In the analysis, I use all the available data on the pre-colonial characteristics of ethnic groups to account for the main correlates of within-group heterogeneity.

The first result in the paper documents the direct effect of ethnic diversity, which I benchmark against previous results in the literature. I find that ethnic diversity is robustly associated with lower living standards in the long run. Specifically, I explore a variety of outcomes that capture contemporary living standards. As proxies for local economic activity, I use light intensity per capita (2000-2003) and a measure of non-subsistence agriculture from the agricultural census of 1994. For access to public infrastructure, I use data from the 1993 population census on access to public sanitation and the public network of water supply. This result is in line with the literature on the costs of ethnic diversity, though it also highlights the persistent consequences of forced diversity at the local level. When examining the effect of ethnic diversity and within-group heterogeneity, I find the following pattern:

The figure shows the average effect size of ethnic diversity as a function of within-group heterogeneity. I find a robust pattern: the more heterogeneous an ethnic group was prior to resettlement, the lower the cost of ethnic diversity. On average, where ethnic groups have more heterogeneous individuals in terms of skills, the negative effect of ethnic diversity is reduced, and ethnic diversity may even become an advantage for economic development. To understand the evolution of these long-term effects, I use data from the 1876 population census on occupations and literacy rates, showing that the documented pattern persists over time.

Why is this happening? When exploring potential channels, I find evidence consistent with cultural transmission. Individuals from more heterogeneous ethnic groups in terms of skills are more likely to interact with other ethnicities. Using data from colonial records, I find evidence suggesting cooperative behavior and more open attitudes when interacting with other ethnic groups. Overall, understanding whether individuals from more heterogeneous ethnic groups are better able to integrate in a multi-ethnic society is a relevant question, not only in an increasingly globalized world, but also in the context of forced displacements and migrations, like in the case of refugees.

References

Alesina, A., and La Ferrara, E. (2005). “Ethnic Diversity and Economic Performance.” Journal of Economic Literature, 43 (3), pp. 762-800.

Murra, J. V. (1975). Formaciones económicas y políticas del mundo andino. Instituto de Estudios Peruanos.

Pease, F. G. Y. (1978). Del Tawantinsuyu a la historia del Perú, Instituto de Estudios Peruanos.

Wachtel, N. (1976). Los vencidos: los indios del Perú frente a la conquista española (1530-1570). Alianza.

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Miriam Artiles ’15 is a PhD candidate in Economics at Universitat Pompeu Fabra and will soon start as an Assistant Professor at Pontificia Universidad Católica de Chile. She is an alum of the Barcelona GSE Master’s in Economics.

This post was edited by Ashok Manandhar ’21 (Economics).

Environmental Investment Tax Incentive Reform in Spain: a Lost Opportunity?

Nada es Gratis article by Kinga Tchórzewska ’15 (Economics)

Photo by Clayton Cardinalli on Unsplash

Editor’s note: this article was originaly published in Spanish in the popular economics blog, Nada es Gratis, and is based on Kinga Tchórzewska’s PhD from the University of Barcelona. Her Job Market Paper was honorably mentioned in the third annual Nada es Gratis Job Market Paper awards.

Firms are often reluctant to invest in green technology. As for the reason why – they point to high fixed costs and the resulting capital market failure. However, instruments that could possibly address this problem, such as environmental investment tax incentives, are not very popular among regulators – even though they may offer an interesting alternative to environmental taxation or even investment subsidies, since tax incentives are easier to implement at the administrative level. Could Environmental Investment (EI) tax incentives be successful at encouraging green investment? And how do firms react to the modifications in existing EI tax credits with respect to employment and innovation decisions? I try to tackle those questions using the EI tax credit reform in Spain.

Spanish Environmental Investment (EI) Tax Credit

Spain is a very interesting country in which to study a large-scale national tax incentive program because the EI tax credit went through some unusual transformations over the years of its existence. The specific EI tax incentive analyzed in this paper was first introduced in 1996 at 10% of the firm’s level of investment and survived in such form until 2006, when its slow phase-out was announced. The phase-out was implemented as the then government believed that the tax incentive was mostly financing end-of-pipe technologies (which do not affect the production process but purely reduce the pollution level at the end of the production line e.g. filters and sulphur scrubbers) rather than cleaner production technologies, very often required by law already. The phase-out was then successfully continued until tax credit’s complete elimination in January 2011. Unexpectedly, in March of 2011, this tax credit was re-introduced for 4 more years at the stable rate of 8% investment level. It was possibly done to mediate the effect of the financial crises on the industrial sectors. Figure 1. shows the chronology of events and the expected versus actual rates of the tax credit.

What makes this EI tax credit reform especially interesting is that it generated a lot of confusion until the very last moment and while introduced in March 2011 – it was done specifically with the intention to favor cleaner production over end-of-pipe technologies. In the analysis, I focus on industrial firms as the main beneficiaries of the program and consider the time period between 2008 and 2014. In the first part, I compare firms’ behavior before and after the change in this policy instrument using difference-in-difference analysis. This will show if the modification of the tax credit discouraged end-of-pipe technologies as well as how the policy reform affected green employment. In the second part of the analysis, by using instrumental variable approach with difference-in-difference, I examine the proportionate effect of an increase in the amount of the tax credit. I study its proportional effect on firms’ investment, employment and R&D outcomes. Thus, I perform the first quasi-experimental econometric analysis of the effectiveness of EI tax credit at encouraging adoption of green technologies directly, but also indirect green employment and green R&D effects.

Results

I find evidence that firms did in fact decrease their investment through the tax credit in the end-of-pipe technologies as a result of the policy change. This also includes the technologies specifically reducing air-pollution alone such as filters/sulphur scrubbers. We can, therefore, conclude that the modification was implemented quite successfully. That being said, there is no evidence to support the claim that this policy change led to an increase in the investment in cleaner production technologies. Unfortunately, the policy change also had a few unexpected indirect effects. It appears that firms reduced the number of green employees as well as the expenditure associated with the salaries of green employees, as can be seen in Figures 2a and 2b.

After performing the heterogeneous analyses, it is also clear that firms responded differently depending on their size – Figures 3a and 3b. More specifically, small firms seem to have benefited the most from the policy change, by considerably increasing their investment in cleaner production technologies. The opposite has happened to the large firms, who decreased their investment in the cleaner production technologies through the modified tax incentive.

By studying the proportional effect of the EI tax credit on investment outcomes it becomes apparent that Spanish environmental investment tax incentive was generally successful at inducing all types of green investment. This means that even during times of financial crises tax credit was drove firms’ green investment. However, they favored air-pollution-reducing over energy-efficient technologies, not necessarily end-of-pipe over cleaner production technologies, as per the concern of the government at the time. Additionally, I find further evidence that the increase in the amount of environmental investment tax credit results in a proportionate increase in the number of green employees and even private environmental R&D. Those indirect effects are quite hopeful, showing that a successful EI tax credit can also drive employment and create positive externalities through R&D.

Policy

This analysis provides a multitude of important implications for policy makers. Firstly, it encourages the usage of EI tax credits, which is also in agreement with previous literature, especially the work done by Ohrn (2019). However, this is in stark contrast to the decision of the Spanish government to eliminate this fiscal incentive from the Spanish Corporate Income Tax completely. This analysis supports its continuous use and perhaps even further modification, rather than a complete phase-out.

What we can learn from this green tax incentive is quite straightforward – adopting green depreciation incentives leads to increased business incentives and green employment outcomes, even during times of economic downturn. Additionally, the government can be successful at modifying the existing tax incentives, such that they discourage those technology choices that the central government considers undesirable. While the results clearly indicate that the tax credit should have been redefined even further so as to also encourage more investment in cleaner production technologies, this empirical work does not justify its complete phase-out. The fact that there is an increased investment in cleaner production technologies for smaller firms is also very important, as those are exactly the companies frequently faced with capital market failure – especially in the time of financial recession such as this one.

Of course, more research is needed to assess whether these types of incentives are the most efficient way to improve firms’ economic outcomes, and how the tax credit also affected their employees over the short- and long-run – especially after the complete elimination of the tax credit in 2015. Lastly, even given the financial burden that tax deductions and subsidies entail, they might still be economically justified in some cases. For instance, when positive externalities appear, such as increased green private R&D, which is the case here.

References

Ohrn, E. (2019). The effect of tax incentives on US manufacturing: Evidence from state accelerated depreciation policies. Journal of Public Economics, 180, 104084.

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Kinga B. Tchórzewska ’15 is a Postdoctoral Researcher at the ZEW – Leibniz Centre for European Economic Research. She is an alum of the Barcelona GSE Master’s in Economics.

This post was edited by Ashok Manandhar ’21 (Economics).