Taxes on labor and capital income distort economic activity by depressing the overall level of employment and investment in the economy. Imposing regulations to curb emissions of CO2 in the United States is likely to further reduce the overall level of employment and investment, thereby aggravating the distortions created by taxes. These types of “spillover” effects have been termed the tax-interaction effect. Taking into account the tax-interaction effect raises the overall costs of reducing CO2 emissions, and by a potentially significant amount.
However some policy instruments would raise revenue for the government. These instruments include carbon taxes and CO2 permits that are auctioned to firms. The revenue can be used to cut other distorting taxes, such as social security taxes and corporate income taxes. Reducing these taxes increases the level of employment and investment, and thereby produces an economic gain. This gain has been termed the revenue-recycling effect. The gain from the revenue-recycling effect can offset most, but typically not all, of the added cost from the tax-interaction effect.
Other policy instruments to reduce emissions, such as tradable CO2 permits where the permits are given out free to existing firms, would not raise revenues for the government. These instruments do not produce the revenue-recycling effect to counteract the tax-interaction effect, and therefore have a higher economic cost than revenue-raising instruments. This distinction between revenue-raising and non-revenue-raising policies can affect whether a policy might produce an overall net gain for society or not. That is, for a given level of emissions reduction the environmental benefits under a revenue-raising instrument may exceed the economic costs, while under a non-revenue-raising instrument benefits may fall short of economic costs.