Unilateral Carbon Policy with Intermediates
Abstract
I consider a two-country general equilibrium model of climate change and trade where one country (Home) imposes a carbon policy while the other (Foreign) does not. My model extends Kortum and Weisbach (2023) to incorporate intermediate goods. Intermediate goods are empirically relevant, because they account for more than 60% of the value of manufacturing output, and also highlight the distinction between direct and embodied emissions, a central concept in policy discussions. The optimal policy in my setting adds two new features (i) a tax based on carbon embodied in intermediate goods used to produce imports and (ii) a good-specific export subsidy for all exported goods. The optimal policy exploits international trade and shifts the composition of intermediates used by Foreign in order to reduce embodied emissions worldwide. I show that these findings broadly support the European Union’s latest carbon policy, the Carbon Border Adjustment Mechanism.
