Fiscal policy and environmental degradation: Heterogeneous effects of carbon taxes and emissions trading systems

Abstract

This study compares the effectiveness of two key carbon pricing instruments, carbon taxes and emissions trading systems (ETS), in reducing environmental degradation across countries. The analysis uses a panel dataset covering 109 countries over the period 2010–2023, drawing on data from the World Bank, Our World in Data, and the Global Footprint Network. Environmental outcomes are measured using three indicators including ecological footprint, CO₂ emissions, and total greenhouse gas emissions. A two-way fixed effects model (TWFE) controls for unobserved country heterogeneity and common time shocks. An event-study approach captures dynamic treatment effects and anticipation behaviors. Results reveal significant heterogeneity in instrument effectiveness. Carbon taxes consistently deliver statistically significant and economically meaningful reductions in ecological footprint and CO₂ emissions, with effects emerging gradually and partially anticipated pre-implementation. By contrast, ETS has more limited and targeted effects: it mainly reduces total greenhouse gas emissions, while its effects on broader ecological pressure are weak or statistically insignificant. Both instruments' efficacy is heavily influenced by institutional quality where higher government effectiveness and democratic accountability amplify environmental benefits. No strong evidence supports additional gains from combining carbon tax and ETS beyond carbon tax. By highlighting the uneven performance of ETS relative to the broader effectiveness of carbon taxes, the study provides new insights for the design of green fiscal policy in both developed and emerging economies.