Efficient incomplete international climate agreements

We study the optimal design of a carbon tax when a group of countries seeks to maximize its net income minus its environmental costs, which depend on the sum of CO2 emissions from all countries. When both production and consumption of internationally traded fossil fuels are taxed, a particular combination of producer and consumer taxes exists which is optimal. It is also shown that with this tax the sum of the consumer tax and producer tax should be equal across all fossil fuels per unit of carbon. On the other hand, when the cooperating countries use a tax on consumption (or production) of fossil fuels as the only policy instrument, the tax per unit of carbon should in general be differentiated across fossil fuels. We close the paper by giving an empirical illustration of the theoretical analysis, assuming that the cooperating countries are those of the OECD.