Most of the final or economic incidence of a system of emission taxes or tradable permits to reduce greenhouse gas emissions will be on consumers, and not producers. This follows from the high elasticity of long-run supply of most products intensive in carbon, and it is supported by studies of the incidence of indirect taxes and the experience of the GST tax reform package of 2000. If we allow for the exercise of firm market power, even more than 100 per cent of the tax or permit price could be passed forward.

The passing forward of most to all of the cost of carbon taxes or tradable permits to consumers as higher prices has at least two key messages for the design of a tradable-permits scheme. First, gifting the permits to producers, including under grandfathering principles, represents a redistribution of national income. A status-quo equity system would auction the permits or turn to a tax on emissions systems, and then return the initial government revenue gains to consumers. Second, because of the consumer price increase and associated increase in the cost of living, there is a compelling case for using the government revenues gained to compensate households via cuts in income taxes and increases in social security payments in an aggregate revenue-neutral package to minimise the prospects of compensating increases in wages and an impetus to inflation.^[11] This form of compensation would not alter the necessary change in relative prices against carbon-intensive products.

A complete picture of the distributional effects of a tradable emissions or emissions tax scheme to reduce greenhouse gas emissions requires a general equilibrium model assessment. These policy interventions change relative prices. While the production and consumption of carbon-intensive products facing higher relative consumer prices decline, other products facing lower relative consumer prices expand and in the process create new investment and employment opportunities.

In the global context there are incentives for individual countries to free ride and not to invest in policy actions to reduce greenhouse emissions and achieve a cooperative global social optimum. Third-world countries argue, with considerable merit, that they should bear less of the cost burden of reducing global greenhouse gas emissions than first-world countries and, in particular, they object to a system of grandfathered allocations of tradable permits of the form proposed under the Kyoto Protocol. Clearly, global cooperation from the developing countries requires innovative options on an equitable distribution of global permits.

Interestingly, the paper shows that if first-world countries choose to invest in policies to reduce their greenhouse emissions and the third-world countries decline to participate, there is a sizeable win-win opportunity for the first-world countries to subsidise or bribe the third-world countries to join a cooperative global welfare-maximising agreement.