How can a carbon tax be designed to benefit the poor? An investigation for Ethiopia

Abstract

Developing countries are increasingly giving attention to carbon pricing to reduce their emissions, particularly in meeting their nationally determined contribution under the Paris Climate Agreement. However, they are concerned about the potential adverse impacts, particularly the risks of higher burden on the poor as the expenditure share of low-income households is relatively higher than that of high-income households. Using a computable general equilibrium model, this study investigates under what conditions a carbon tax can increase poor households’ income in a low-income African country, Ethiopia. The study finds that a US$20/tCO₂ carbon tax would increase household income of the poorest households by 0.21 %–1.22 % if carbon tax revenue is recycled, as a cash transfer, to household income groups either equally or inversely proportional to their incomes (progressively). These scheme not only make the carbon tax progressive but also cause a higher reduction of carbon dioxide emissions (7.6 % from the baseline), thereby ensuring the alignment of equity and environmental outcomes of the carbon tax. However, these schemes are not necessarily economically efficient because they cause higher reductions of gross domestic product compared to other options considered.