The design of policies to reduce greenhouse gas emissions requires an appreciation of the distribution of the benefits and costs of policy interventions to reduce these emissions. This paper argues that a high proportion of the economic costs of taxes or tradable permits to reduce greenhouse gas emissions will be passed forward to consumers as higher product prices. As a consequence, much contemporary policy discussion and lobbying to compensate producers is exaggerated. The paper additionally argues that an understanding of the distributional consequences for first-world and third-world countries is important in designing the necessary global policy response to the global externality.

In order that the analysis can focus on the distributional effects of taxes or tradable permits, this paper takes as given many aspects of the debate about climate change and policy interventions to reduce greenhouse gas emissions.^[2] The stock of greenhouse gases is assumed to constitute an externality under current industry structures and policies, and the flow of emissions at zero private cost is a significant market failure requiring policy intervention on a global stage. The favoured form of policy intervention to correct the market failure is a system of tradable permits, but with debate about whether the permits should be auctioned, allocated to current polluters (grandfathered), or allocated on some other formula basis. The comparative economic incidence of the different options for distributing tradable greenhouse-gas permits on consumers, producers and government, and on different countries, is the focus of this paper.

The paper is in two parts. The first part presents a range of models and supporting empirical evidence to assess the distribution of the benefits and costs of market based intervention instruments to reduce greenhouse gas emissions on producers, consumers and the polluted, and the aggregate efficiency gain, either for the globe or for a particular economy. We begin with a partial equilibrium model of a competitive industry greenhouse-gas polluter, and then consider a number of partial equilibrium models where firms exercise market power. The results of these models, together with some related quantitative evidence on the economic incidence of taxes, find that most of the economic incidence of tradable permits, or of emissions taxes, to reduce greenhouse gas emissions will be on consumers. A key policy implication is to auction rather than to gift tradable permits, or to use an emissions tax, and to use much of the government revenue gain to provide lump-sum or income tax compensation to consumers.

The second part of the paper considers some of the distributional issues that challenge the reaching of any global policy agreement which includes third-world or developing countries. A simple game-theory model which uses the costs and benefits of the earlier partial equilibrium model is employed. In the absence of a global government to enforce monitoring and compliance across countries in the way that national governments can for their own citizens and resident businesses, individual countries have an incentive to free ride and to ignore the external costs of their own greenhouse gas emissions, even though a cooperative strategy to reduce global emissions would raise global welfare. If first-world countries, for whatever reasons, have decided on a strategy of reducing their own greenhouse gas emissions, it is shown that it is both welfare-improving and viable for the first-world countries to bribe third-world countries to also adopt a strategy of reducing their emissions. A final section brings together the key policy design messages.