This literature review explains the complexities of the distributional consequences of carbon pricing, specifically carbon taxes, based on over 20 years of economic research.
- Carbon taxes are likely not as regressive as they are often thought to be.
- Poor households can be compensated for increased prices through effective use of tax revenue.
- Incidence measures based on annual income or only use-side effects may overstate tax regressivity.
- Government programs that index to inflation may contribute to a more progressive tax.
- Tax effects in different parts of the country will be muted.
- Recycling revenue to consumers through direct rebates will be progressive and reach more households, though targeted tax swaps could have similar effects.
Economists largely agree that employing a carbon pricing mechanism—either through a cap-and-trade system or a carbon tax—is the most effective way to combat increasing greenhouse gas emissions. However, both approaches currently face political aversion, due in part to the idea that taxing carbon emissions will result in higher prices for energy and consumer goods, and would thereby hurt low-income households. In a new RFF issue brief, “Progressing to a Fair Carbon Tax: Policy Design Options and Impacts to Households,” Center Fellow Daniel Morris and Clayton Munnings argue that the regressive impacts of a carbon tax are often overstated and can be addressed by well-crafted policy. Analyzing over 20 years of economic research, the authors highlight the ways in which US carbon taxes could be made progressive, ensuring that vulnerable individuals are recompensed accordingly. Morris and Munnings note that tax revenue can be used for direct rebates or tax swaps to offset the disproportionate effects of a carbon tax on low-income households, while still helping to achieve the goal of decreasing greenhouse gas emissions in an economically effective manner. Through a rebate, the government would directly send households a portion of the revenue generated by the carbon tax. Although this approach would apply to all households, direct rebates have been found to benefit the lowest 20 percent of households to the greatest degree. With a tax swap, carbon tax revenue would be exchanged with existing distortionary taxes. According to the authors, the “swap approach would compensate households for income lost to the carbon tax by reducing income and payroll taxes, which may enhance economic efficiency, depending on the distortionary tax being offset.” They note, however, that “Increased economic efficiency may come at the detriment of equity concerns. If lawmakers are most concerned about protecting low-income households, then they need to ensure they offset the specific taxes that will benefit those households.”