Rethinking Climate Tools: How Green Subsidies Can Boost Global Emissions Reductions

The July 2025 working paper “Carbon Taxes and Green Subsidies in a World Economy”, authored by Matthew Kotchen and Giovanni Maggi of Yale University and FGV EPGE, and published by the National Bureau of Economic Research (NBER), offers a fresh analytical framework for thinking about climate policy in a globalized economy. Departing from conventional wisdom that ranks carbon taxes as the gold standard of climate action and views green subsidies as inferior, the authors build a theoretical case showing how both instruments, when used jointly and strategically, can improve global welfare, even in the absence of international cooperation. Their work addresses key questions facing global policymakers today: how should countries regulate carbon emissions when they trade openly, what role should international agreements play, and how does political lobbying reshape optimal policy?

Reverse Leakage: The Surprising Power of Green Subsidies

Central to the paper is the idea of “reverse leakage.” Traditionally, carbon taxes are seen as the most direct and efficient way to address climate externalities by making fossil fuels more expensive. However, in an open economy, these taxes trigger carbon leakage: emissions-intensive activities shift abroad, reducing the effectiveness of domestic action. Kotchen and Maggi reveal that green subsidies, financial incentives to boost clean energy, can counteract this. By lowering the global price of fossil fuels through competition, green subsidies decrease emissions both at home and in other countries. This reverse leakage effect makes subsidies more globally beneficial than previously thought, particularly in noncooperative settings where each country acts in its interest.

Their model shows that countries, acting alone, have a strong incentive to use both tools: reduce carbon taxes slightly while simultaneously deploying green subsidies. While this mix may seem suboptimal from a textbook perspective, the authors find it can enhance global welfare. The key caveat is that carbon tax reductions must not be too deep. So, while green subsidy “wars” might seem like a race to the bottom, they could, under the right conditions, bring mutual gains.

Two-Phase Agreements: Why ICAs May Need to Embrace Subsidies First

International climate agreements (ICAs) typically aim to harmonize carbon pricing and prevent free-riding. The authors show that a globally optimal agreement would eliminate green subsidies and raise carbon taxes to reflect the full global social cost of emissions. But in real-world politics, policies don’t change overnight. Governments face adjustment frictions, political, administrative, or social, that slow down carbon tax implementation. Here, Kotchen and Maggi offer a powerful insight: when policies must evolve gradually, ICAs might initially increase green subsidies before phasing them out as carbon taxes catch up.

This sequencing mirrors developments in actual policy. Clean energy subsidies have expanded under major legislative packages such as the U.S. Inflation Reduction Act, while carbon pricing remains politically fraught. The authors argue this isn’t just pragmatic, it may be efficient. In transitional periods, subsidies act as a bridge, delivering emissions reductions while carbon pricing infrastructure and political consensus are built. This two-phase strategy aligns with how many governments approach climate reform, especially when facing resistance from industries or voters.

Fossil Lobby vs. Green Lobby: Asymmetrical Effects on Welfare

The political economy dimension of the paper is one of its most compelling contributions. Kotchen and Maggi examine how lobbying by the fossil fuel and renewable energy sectors shapes policy outcomes. Fossil fuel lobbying, they find, predictably reduces welfare by suppressing carbon taxes and discouraging effective emissions control. More unexpectedly, green energy lobbying tends to improve welfare, at least to a point. A moderately strong green lobby pushes for higher subsidies and indirectly supports stronger carbon pricing, aligning with environmental goals. However, when green lobbying becomes too dominant, it can extract oversized subsidies that distort production and reduce efficiency, especially when paired with rising carbon taxes under an ICA.

This dynamic can even lead to the counterintuitive outcome where an ICA, designed to improve global policy, ends up reducing welfare due to intensified distortions in the green energy sector. It’s a reminder that political context matters, and even well-intentioned policies must be balanced carefully against interest group pressures.

Beyond Production Taxes: Rethinking the Climate Policy Toolkit

Finally, the paper explores the broader set of instruments available to governments, including trade and consumption-based taxes. In theory, countries with access to unconstrained trade policies might prefer import tariffs or export subsidies to influence global emissions. But in practice, trade agreements like those governed by the WTO often limit these tools. Where trade policy is constrained, countries substitute with production and consumption instruments, such as green subsidies and carbon taxes. The authors emphasize that regardless of the mix, interventions in the green sector have consistently more positive global spillovers than fossil-sector interventions.

Even when consumption-based policies are possible, their administrative complexity makes production subsidies more attractive. Green-sector instruments, whether subsidies or clean energy trade incentives, remain crucial in curbing emissions globally without causing harmful domestic trade-offs. This insight bolsters the case for keeping green subsidies in the climate arsenal, even when more targeted instruments like carbon taxes are available.

A New Lens for Climate Policy in a Connected World

Kotchen and Maggi’s work upends long-held assumptions in environmental economics. By showing that green subsidies are not just politically expedient, but economically justifiable, even desirable, in open economies, the paper provides both a theoretical and practical rationale for rethinking how countries approach climate action. It urges policymakers to recognize the importance of sequencing, flexibility, and the asymmetric impacts of political lobbying. Most importantly, it demonstrates that in the messy reality of global politics and trade, green subsidies may be doing more good than they are often credited for. As governments continue to negotiate the future of climate cooperation, this paper offers a rigorous and timely guide.