Tackling Climate Change and Productivity Gaps with Carbon Taxes in the Dominican Republic

A World Bank study analyzes the impact of a carbon tax in the Dominican Republic, finding that it could boost productivity by addressing market distortions, especially when applied to fuels. The research highlights the need for careful policy design to balance environmental goals with economic growth.

A recent Policy Research Working Paper from the World Bank, authored by economists Esteban Ferro, Davide Mare, Faruk Miguel Liriano, Fausto Patino Pena, Maria Gabriela Rodriguez Quezada, and Federica Zeni, explores the effects of a hypothetical carbon tax on productivity in the Dominican Republic. This research uses firm-level data spanning 2009 to 2018, covering over 118,000 firms, to analyze how imposing a tax on energy inputs such as electricity and fuel would impact total factor productivity (TFP). The paper suggests that carbon taxes, designed to reduce fossil fuel consumption and curb emissions, could either boost or hinder aggregate productivity, depending on pre-existing market distortions. The Dominican Republic, despite its commitment to reducing greenhouse gas emissions under the Paris Agreement, remains heavily reliant on fossil fuels, making the discussion of a carbon tax highly relevant.

The Impact of Market Distortions on Carbon Tax Effectiveness

The model developed by the authors predicts that carbon taxes have different impacts on firms based on the level of distortions in input markets, particularly energy inputs. In the Dominican Republic, like in many economies, firms face significant distortions in the energy market, including issues like electricity theft, poor infrastructure, and reliance on imported fossil fuels. These distortions mean that firms do not all face the same costs for energy consumption. More productive firms, which tend to be more efficient in their use of resources, might be less constrained by energy distortions, while less productive firms face higher barriers. The research shows that in economies where the most productive firms are less distorted, a carbon tax can lower overall productivity by increasing costs for these efficient firms. Conversely, if more productive firms are more distorted, a carbon tax can improve aggregate productivity by redistributing resources more effectively.

Fuel Taxes Offer More Impact Than Electricity Taxes

The paper’s key finding is that a carbon tax is more effective when applied to fuels rather than electricity. This is largely due to the fact that fuel consumption in the Dominican Republic produces higher carbon emissions compared to electricity, which is often generated from less carbon-intensive sources like natural gas. By targeting fuels, the carbon tax can more directly influence the behaviors of firms that rely heavily on carbon-intensive energy sources. For example, sectors such as transportation and cement manufacturing, which are some of the largest consumers of fuel, would experience the greatest reductions in emissions under a fuel-focused carbon tax. These sectors also contribute significantly to the country’s overall carbon footprint, making them prime targets for environmental taxation.

Resource Allocation and Productivity Gains

In the research, the authors use a theoretical framework to simulate the impact of two different carbon tax scenarios on productivity and emissions. They found that in most sectors, high-productivity firms tend to face greater distortions in energy consumption. This means that these firms, despite being more efficient, operate under higher energy costs due to existing market distortions. The introduction of a carbon tax helps to alleviate some of these distortions by shifting the burden of energy costs from high-productivity firms to lower-productivity ones. As a result, resources are reallocated more efficiently, leading to productivity gains across most sectors. In contrast, if the carbon tax were to be applied equally across all firms without considering these distortions, it could exacerbate inefficiencies and lower overall productivity.

Institutional Factors Affecting Carbon Tax Policies

The research also highlights the importance of considering the institutional characteristics of a country when designing environmental taxes. The Dominican Republic, as a small economy with relatively low contributions to global carbon emissions, faces different challenges than larger economies when implementing carbon pricing mechanisms. For instance, concerns about carbon leakage—the phenomenon where firms relocate their production to jurisdictions with less stringent environmental regulations—are less pronounced in the Dominican Republic due to its marginal impact on global emissions. However, other factors, such as the distributional effects of a carbon tax and its impact on competitiveness, remain important considerations for policymakers.

Balancing Environmental and Economic Goals

The authors conclude that while carbon taxes can effectively reduce emissions, their success largely depends on how they interact with pre-existing market conditions. In markets where productive firms are disproportionately affected by energy distortions, carbon taxes can help improve overall economic efficiency by reallocating resources to these firms. However, in markets where distortions are less pronounced, a carbon tax could reduce productivity by increasing costs for the most efficient firms. The study offers valuable insights for policymakers in developing countries like the Dominican Republic, where balancing environmental goals with economic growth remains a critical challenge.

In summary, this research provides a nuanced perspective on the potential effects of carbon taxes in developing economies, emphasizing the need to design these policies to account for existing market distortions carefully. By doing so, policymakers can ensure that carbon taxes not only contribute to reducing emissions but also support broader economic objectives, including improving productivity and promoting more efficient resource allocation.