Carbon taxes are notoriously unpopular, but handing back carbon tax revenue as lump-sum dividends to all citizens as climate dividends is inefficient. This column investigates three revenue recycling scenarios through a simulation model for Germany. For optimal efficiency and equity, carbon taxes must be set higher, beyond the aggregate damages from global warming, and the extra revenue used to finance a higher climate dividend. Such tax revenue recycling may be able to gain the electorate’s approval without breaking public finances.
Carbon taxes are notoriously unpopular, as can be seen from the Yellow Vests protests in France and other protests elsewhere. Lower-income groups get disproportionally hurt as price increases resulting from such taxes are typically regressive (e.g. Bento et al. 2009, Fullerton et al. 2012, Williams et al. 2015, Goulder et al. 2019, Cronin et al. 2019, Kaenzig 2023). Politicians thus hesitate to price carbon. Also, firms criticise the costs of climate policies.
One strategy to overcome popular opposition is to hand back carbon tax revenue as lump-sum dividends to all citizens. Such climate dividends favour the poor and can offset the regressive nature of carbon taxes. Austria, Canada, and Switzerland have combined carbon pricing with climate dividends (Keohane 2009).
But climate dividends are inefficient, cannot counteract a carbon tax’s negative cost to firms, and tend to shrink the income tax base and public revenue. Carbon tax revenue should thus also be used to fund income-tax cuts and compensate firms. This is more efficient but benefits higher-income groups more. Furthermore, finance ministers want to use carbon tax revenues to plug their widening budget holes.
New carbon pricing schemes are thus needed that can gain the electorate’s approval without breaking public finances. Second-best policies imply that governments do not have access to individualised poll taxes and must rely on distorting taxes, such as the labour income tax, to finance public services. In our work (van der Ploeg et al. 2024), we go further by considering a third-best carbon tax reform, which in addition is concerned with incremental tax reform in the sense that one can only use carbon tax revenue for tax reform.
We offer novel insights into how carbon taxation affects households across the income distribution and how policymakers would want to use the carbon tax instrument and the resulting revenue. We argue that one must levy carbon taxes beyond the aggregate damages from global warming to raise additional public revenue to distribute climate dividends and ensure a fair carbon tax reform.
The micro-simulation model
We investigate these issues in a micro-based simulation model for Germany. In our model, households choose to consume from key carbon-intensive consumption categories (e.g. electricity, heating, transport) and other consumption categories. We estimate a flexible disaggregated demand system using the German consumption expenditure survey. For each commodity, we generate a carbon footprint. Households also choose their labour supply depending on their after-tax consumption wage. Demands for consumption and leisure are specific to each household (e.g. marital status, household size, number of children). The government raises revenues using income and carbon taxes. It sets policy to maximise welfare (a weighted sum of the utilities of each household), allowing for inequality aversion. Income taxes paid by each household are captured by a log-linear income tax schedule. We calibrate the preferred value of the coefficient of inequality aversion (1.6) to reproduce Germany’s observed income tax schedule and use this in Table 1 below.
Firms respond to carbon taxes by mitigating emissions, which lowers factor returns, even though they pass on some of the burden to consumers via higher prices. This is the regulatory (efficiency) cost of climate policy. Carbon taxes increase prices according to their carbon intensity. They lower the real wage and employment, which represent efficiency costs. Poorer households are impacted relatively more by carbon taxes. Carbon taxes thus lower emissions at the expense of equity.
We consider three scenarios: (1) recycle carbon tax revenue as climate dividends; (2) use revenue to lower income taxes and make income taxes more progressive; and (3) use revenue for climate dividends and for adjusting the progressivity of the income tax system. In all scenarios, the carbon tax and the way it is recycled are set optimally.
Table 1 Three different recycling scenarios (relative to a no-damages and no-carbon-tax baseline)
Note: The sum of green, efficiency, and equity gains can differ from total welfare gain due to rounding.
Scenario (1): Recycling all carbon tax revenue as climate dividends
Recycling revenue as climate dividends helps to offset the regressive impact of the tax on the poor. The dividends improve equity by transferring some of the burden away from lower-income households. To illustrate this, Table 1 shows this for Germany when the social marginal damages from global warming are €100/tCO2. (In our paper, we also discuss marginal damages of €0 and €50 per tCO2.) The carbon tax is set at €77/tCO2, below marginal social damages, and each household receives a climate dividend of €341 per year. As a result, emissions fall by more than a third and employment drops by slightly more than 1%.
It is useful to contrast this with scenario (3), where all carbon revenue is optimally recycled to solely reform the income tax system with no climate dividends. While this option is better for efficiency, it is worse for equity, and emissions fall by less as the carbon tax is now only €51/tCO2. As a result, emissions only drop by about a quarter rather than a third. The inability to directly protect the poor is why carbon taxes are lower. Total welfare is much higher if the carbon taxes are set higher and all carbon tax revenue is recycled as climate dividends, as in scenario (1).
Scenario (2): Third-best optimal carbon tax reform
Even higher welfare can be achieved if the income tax system, the carbon tax, and the climate dividend are simultaneously optimised. The carbon tax revenue is thus split between providing a climate dividend and reforming the income tax system. Table 1 indicates that the carbon tax is now much higher than before, €119/tCO2, and even higher than the marginal damages of €100/tCO2. Emissions thus fall much more, by nearly half. Since demand for energy-intensive goods is not very sensitive to price changes, the carbon tax is an efficient way to raise revenue. Hence, the climate dividend is now much higher, €732 per year, albeit employment falls a little bit more and the efficiency loss is much higher (3.7%). But this loss is more than offset by the higher equity gain. Total welfare increases by the most (3.3%) among the three scenarios.
The key insight is that the third-best optimal carbon tax is set above the marginal damages from global warming, as climate dividends are an efficient way to redistribute, with all carbon tax revenue rebated as climate dividends. Figure 1 indicates that both the level of the carbon tax and total climate dividends increase if policymakers are more concerned about inequality aversion. The third-best optimal carbon tax starts at half the marginal damages if policymakers do not care about inequality but rises to 120% of marginal damages at our preferred degree of inequality aversion.
Figure 1 Effects of different degrees of inequality aversion on carbon tax and climate dividend
Note: Optimal policy packages for (1) third-best optimal, (2) carbon taxes and climate dividends, and (3) carbon taxes and income tax reform.
Figure 2 shows that for third-best carbon tax reform emissions, employment and inequality fall as policymakers become more concerned about inequality. Emissions are less than when recycling only climate dividends, except for low degrees of inequality aversion, while employment and inequality are higher, except for very high degrees of inequality aversion.
Figure 2 Effects of optimal policy packages on emissions, hours worked, and inequality
Note: For three scenarios: (1) third-best optimal, (2) carbon taxes and climate dividends, and (3) carbon taxes and income tax reform.
Summing up
To make carbon pricing acceptable to the electorate, some carbon tax revenue must be rebated as a uniform climate dividend. This helps to counter the adverse effects on the income distribution of a carbon tax. One can do even better if the climate dividends are targeted at the lowest incomes, for example, through social security payments (Tovar et al. 2021, Paoli and van der Ploeg 2021). However, one could do better for both efficiency and equity if carbon taxes are set higher, even above the sum of the marginal damages from global warming, and the extra revenue is used to finance a higher climate dividend and to reform the income tax system. This compensates for some of the regulatory (efficiency) cost of climate policy without jeopardising equity.
Our results align with those of Fried et al. (2024), who show within a general equilibrium framework that it is optimal to hand back two-thirds of carbon tax revenue to cut the distortionary tax on capital income and to use the remaining one-third to make the income tax system more progressive. This recycling scheme also attains higher welfare than handing back all the carbon tax revenue as climate dividends or handing all the revenue back as cuts in distortionary taxes.
More generally, we argue that to simultaneously achieve development and climate goals, it is important to curb inequality and make growth more inclusive (see also Wollburg et al. 2024). An important aspect that needs further consideration for the green transition is to ensure that households and corporations switch from gas-fired central heating to heat pumps and solar panels, from internal-combustion-engine vehicles to electrical vehicles, and invest in green hydrogen. To achieve this, it would be helpful to use some of the carbon tax revenues to finance – via a proportional pricing subsidy – such switching investments for the green transition (Kuhn and Schlattmann 2024). It is also important to help the poor who do not have the cash and cannot borrow to switch to green technologies.
Source : VOXeu
