# **1 Introduction**

In 2015, in correspondence of the Paris Agreement, the Government of the Dominican Republic (DR) submitted its Nationally Determined Contribution (NDC) to the United Nations Framework Convention on Climate Change.<sup>1</sup> In its NDC, the Dominican Republic has pledged to reduce its greenhouse gas (GHG) emissions by 27% by 2030, relative to the levels recorded in 2010. Despite the effort to meet this commitment,<sup>2</sup> the DR is still an economy which relies heavily on fossil-fuel sources.<sup>3</sup> In similar contexts, countries have considered large-scale regulatory interventions, such as the introduction of a carbon tax.<sup>4</sup> The regulation would provide a strong price incentive for firms to reduce consumption of fossil-fuels and switch to lower carbon alternatives. While contributing to reducing emissions, the introduction of a carbon tax would also affect energy costs, which indicates that it would also have an impact on the allocation of factor inputs across firms.

In this paper, we analyze the impact of a hypothetical carbon tax on aggregate total factor productivity (TFP) through the resource allocation channel. We begin by developing a model in which a carbon tax affects firms’ consumption of energy inputs. In this model, the carbon tax is levied on firms’ total emissions from the use of electricity and fuel in the production process. Consequently, the introduction of this tax alters the cost of energy inputs, thereby changing firms’ demand for all factor inputs, modifying their emission intensities, and affecting aggregate TFP through resource reallocation.<sup>5</sup> Utilizing data from all formal firms in the Dominican Republic between 2009 and 2018, we calibrate the model at the sector level and quantify changes in firm-level emission intensities and aggregate sector TFP under two carbon tax scenarios. Our findings indicate that a carbon tax is more effective when levied on fuels rather than electricity. Additionally, this tax is likely to positively impact aggregate sector TFP for most industries by reducing distortions for high-productivity firms relative to low-productivity ones, thereby reallocating resources from the latter to the former within these sectors. Overall, the study highlights the importance of considering existing input market distortions when analyzing the introduction of environmental taxes.

> 1The Paris Agreement, adopted by 196 Parties in Paris in December 2015, is a legally binding international treaty that aims to limit global warning. It entered into force on November 4, 2016.

> 2Among other initiatives, in 2021 the DR signed a landmark agreement with the World Bank to subsidize reduction of emissions through preventing deforestation.

> 3The GHG footprint of the DR comes from the production and consumption of energy (from fossil-fuels for heating or lighting, for industrial processes, and transport) and partly from the agriculture sector (enteric fermentation and manure left on pasture). Aggregate information can be found on the International Energy Agency (IEA) website, while information at the economic sector level is reported in Sections 2 and 3.

> 4For the case of the DR, see for example the 2018 Collaborative Instruments for Ambitious Climate Action (CI-ACA) Dominican Republic or the 2020 carbon pricing instrument road map. A carbon tax entails imposing a levy on every unit of pollution emitted.

> 5A firm’s emission intensity is defined as the emissions produced by its consumption of an energy input per unit of output revenue.

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