Distribution of the Cost of a Carbon Tax
While the aggregate effects of a carbon tax are important, they are certainly not all that matters. The distribution of those effects is also important because of both equity and political considerations. This subsection considers how the costs of a carbon tax are distributed across income groups and across states and regions of the United States. Note that this section focuses only on the distribution of the costs of the tax (and distributional effects of potential uses of the carbon tax revenue). It does not consider the distribution of the environmental benefits from a carbon tax (the avoided damage from climate change), which could easily be just as important as the distribution of costs, but is much harder to estimate.
Distribution across Income Groups
It is natural to think that a carbon tax will be quite regressive. The most obvious effect of a carbon tax is to raise the prices that consumers pay for direct energy goods: electricity, natural gas, gasoline, heating oil, and so on. And these goods represent a larger share of the budget for poor households than for wealthier households.
Williams et al. (2015) show that the burden imposed by higher direct energy good prices caused by a carbon tax, expressed as a percentage of income, is roughly five times as large for the bottom income quintile (the poorest 20% of households in the United States) as it is for the top income quintile. Those figures are based on current- year income, and it is well-known that such measures tend to overstate how regressive increases in consumer prices are, relative to measures based on income over a longer term (or proxies for longer-term income such as current-year consumption). But even using estimates from Hassett et al. (2009) based on current-year consumption, the burden from direct energy good price increases is 2.5 times as large for the bottom decile as for the top decile.
However, the effects of a carbon tax on consumer prices go well beyond just the effects on direct energy goods. Every good in the economy has some energy use somewhere in its production process, and almost certainly some associated carbon emissions, so one would expect a carbon tax to influence the prices of all goods. Direct energy goods account for only about half of all carbon emissions in the United States. And the effects on the prices of other goods are spread much more evenly through the income distribution. Hassett et al. (2009) find that when using measures based on current-year consumption, the distribution of this indirect burden is slightly progressive, though very close to equal across the income distribution. Thus, taking into account the effects on all prices, not just on prices of direct energy goods, shows that the carbon tax is not as regressive as it might first appear.
Moreover, a carbon tax doesn't just affect prices of consumer goods; it can also affect sources of income such as wages and returns to capital. Most studies of the distributional effects of carbon taxes (or carbon pricing in general) miss those effects because they assume that the entire carbon tax is passed forward into produce prices. In fact, some portion of it will be passed backward, affecting the prices of factors of production used to produce carbon-intensive goods.
The few studies that include effects on sources of income find that these effects make the carbon tax more progressive. Carbon-intensive goods tend also to be capitalintensive in production, so a carbon tax causes a drop in capital demand relative to demand for labor. Moreover, even to the extent that the tax is passed forward into product prices, this also raises the price of capital goods, acting as an implicit tax on capital. Together, these effects cause the carbon tax to fall disproportionately on capital income relative to labor income, and capital income goes disproportionately to higher income people. Moreover, income from government transfers—which goes disproportionately to poorer households—are typically indexed for inflation, and this helps to compensate poorer households for the consumer price effects of the carbon tax.
Williams et al. (2015) finds that effects on incomes substantially reduce the regres- sivity of a carbon tax, though the tax remains slightly regressive. Rausch et al. (2011) finds an even stronger result, with these effects sufficient to make the carbon tax slightly progressive.
Finally, the use of the revenue from the carbon tax can dramatically influence the overall distributional implications of the policy. Williams et al. (2015) find, for example, that using carbon tax revenue to cut taxes on capital income makes the top income quintile better off (even ignoring any environmental gains), while making the other four quintiles worse off (with the loss getting larger as a percentage of income as one moves down the income distribution). Conversely, returning the revenue via equal-per-capita lump-sum transfers to households makes the bottom three quintiles better off and the top two worse off (with the gain getting smaller or the loss getting larger as one moves up the income distribution). Returning the revenue via cuts in labor taxes falls in between, with a roughly flat distribution of burden. Marron et al. (2015) find quite similar results using a substantially different model.
These results indicate that the use of the carbon tax revenue is more important than the effect of the carbon tax itself in determining the overall distributional effect of the policy. The carbon tax by itself is mildly regressive. Combining it with a regressive use of revenue (such as a cut in taxes on capital) makes it substantially more regressive. Combining it with a progressive use of revenue (such as lump-sum transfers) makes it substantially progressive.
-  Grainger and Kolstad (2010) and Mathur and Morris (2014) find generally similar results toHassett et al. (2009). In addition, Grainger and Kolstad (2010) find that adjusting for household sizemakes the carbon tax somewhat more regressive, and both papers look at policy options to reducethe regressivity of the tax.
-  Many economists incorrectly view a carbon tax as having similar effects to a broad-based consumption tax such as a VAT because they see it as raising consumer good prices. But the carbon taximplicitly taxes all production—whether used for consumption or investment.
-  This point was first made by Parry and Williams (2010) and then was studied in more detail byFullerton et al. (2011).