Samples from developed countries prove carbon tax will not result in catastrophic inflation

Our main finding is that carbon taxes do not lead to aggregate inflation. Both in the European and Canadian data, we do not find robust evidence that pricing carbon leads to an increase in inflation in a counterfactual scenario of a $40 per ton tax applied on 30% of an economy’s emissions. In our baseline specification for Europe, including country and year fixed effects and controlling for economic conditions, we find a cumulative response of headline inflation by 0.5 percentage points after 5 years post-tax enactment. The one standard deviation error bands always include zero. For the Canadian sample the results point to slightly deflationary responses associated with putting a price on carbon. Our findings survive to a battery of robustness checks, such as adding a broader set of controls and excluding smaller carbon taxes. Further, our results are comparable when we employ panel-vector autogressive (VAR) models, or use alternative inflation and carbon tax data.

Although we do not find evidence of carbon taxes affecting inflation, our results suggest that they change relative prices. When comparing the responses of headline, core, and energy and food inflation, we observe that inflationary pressure associated with carbon taxation is confined to the food and energy component of the consumer price index (CPI). As a result, our dynamic responses for core inflation persistently lie below those for headline inflation. This pattern is consistent with carbon taxes increasing the price of energy, but not spilling over to a broad basket of consumption goods and services.

Finally, we exploit differences in countries’ revenue recycling and monetary policy autonomy by drawing on the rich cross-section of carbon taxes in Europe. Our results suggest that countries without revenue recycling experience more inflationary effects after implementing a carbon tax. Moreover, we find that the responses of inflation are relatively smaller in countries that are not part of the Euro area and have central banks that can in principle react to carbon price shocks. While we do not formally test the role of monetary policy and revenue recycling as amplifying forces, our suggestive evidence is nonetheless in line with previous research.