Recycling Carbon Tax Revenue to Maximize Welfare

July 3, 2021

By Stephie Fried, Kevin Novan and William Peterman

http://d.repec.org/n?u=RePEc:fip:fedgfe:2021-23&r=dge

This paper explores how to recycle carbon tax revenue back to households to maximize welfare. Using a general equilibrium lifecycle model calibrated to reflect the heterogeneity in the U.S. economy, we find the optimal policy uses two thirds of carbon-tax revenue to reduce the distortionary tax on capital income while the remaining one third is used to increase the progressivity of the labor-income tax. The optimal policy attains higher welfare and more equality than the lump-sum rebate approach preferred by policymakers as well as the approach originally prescribed by economists — which called exclusively for reductions in distortionary taxes.

It turns out, it is really difficult to convince people about carbon taxes. They need to see direct benefits, while indirect, general equilibrium benefits are difficult to grasp. This is one of those cases where you need to see what is “politically feasible” instead of what is “economically best” or you are stuck with the status quo. Too bad, because here we have a great paper telling us how we could do the “economically best.”