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 supply-price 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.