China’s carbon emission trading and income inequality: evidence from factor substitution

As carbon pricing mechanisms gain global prominence, understanding their distributional impacts, particularly in developing economies, becomes crucial for the design of equitable climate policies. We explore the effect of carbon emission trading (CET) policy on income inequality in China through integrated theoretical and empirical analysis. We find that the CET policy significantly reduces income inequality, and this conclusion passed the robustness tests. Theoretical analysis shows that if carbon emission allowances are treated as an input factor of production, when carbon prices are relatively low, firms tend to substitute labor for carbon emission allowances, thereby increasing the labor income share (LIS). Empirical testing also confirms that the mitigation of income inequality through CET is attributable to the increase in the LIS. In addition, the equalizing effect is more pronounced in cities with higher initial income inequality and greater marketization. Government environmental expenditure and smooth labor market mobility also have positive synergistic effects. Our research provides policy insights on balancing emissions reduction with social equity.