Blog Post

Recycling Revenue from a Carbon Tax

A national tax on carbon dioxide (CO2) emissions is a cost-effective and efficient tool to achieve environmentally beneficial emissions reductions that will generate billions of dollars per year in revenue for the US government. These carbon revenues can serve a range of purposes. They can pay for energy efficiency investments; they can finance cuts in current distortionary taxes, payments to negatively affected stakeholders, or dividend checks to all households; or they can help reduce the federal deficit.

We examine the impacts of alternative revenue recycling options in our recent paper, in which we compare lump-sum rebates (dividend checks), cuts in personal and/or corporate income taxes, and a tradable exemption option for carbon-intensive industries. Using the Goulder-Hafstead E3 model of the US economy, which offers a detailed representation of domestic energy supply and demand alongside a detailed tax system, we show that using carbon tax revenue to finance marginal tax rate cuts can significantly lower the cost of the carbon tax relative to lump-sum rebates.

Overall, personal income tax cuts reduce GDP costs by 42 percent relative to lump-sum rebates while corporate income tax cuts offer a 58 percent cost reduction relative to lump-sum rebates. Tradable exemptions are able to reduce a carbon tax’s negative impact on profits for the carbon-intensive industries that receive the exemptions; however, exemptions reduce the revenue that can be used to finance tax cuts and therefore they are a less cost-effective method than using all of the carbon revenue to reduce distortionary taxes.

Carbon-intensive industries such as coal mining, coal-fired electricity generation, and petroleum refining potentially suffer significant profit losses when revenues are recycled through personal income tax cuts. The losses to carbon-intensive industries are considerably smaller when the revenues are devoted to corporate income tax cuts. When tradable exemptions are offered to these industries, however, their losses are reduced even further; in fact, a well-designed allocation of exemptions could completely eliminate profit losses in the most vulnerable industries.

We estimate that a carbon tax that starts at $10 per ton and increases by 5 percent each year has the potential to generate $690 billion in gross revenue in the first 10 years of the policy. The net revenue—the amount that can be devoted to cuts in distortionary taxes—will be considerably lower because of declines in the tax revenue generated by other taxes and increases in nominal government spending induced by increases in the price level. Despite these offsets, a carbon tax generates significant revenue that can be used to contribute to meaningful general tax reform while reducing harmful CO2 emissions.