When Can Carbon Abatement Policies Increase Welfare? The Fundamental Role of Distorted Factor Markets

Abstract

This paper employs analytical and numerical general equilibrium models to assess the efficiency impacts of two policies to reduce U.S. carbon emissions-a revenue-neutral carbon tax and a non-auctioned carbon quota-taking into account the interactions between these policies and pre-existing tax distortions in factor markets. We show that tax interactions significantly raise the costs of both policies relative to what they would be in a first-best setting. In addition, we show that these interactions put the carbon quota at a significant efficiency disadvantage relative to the carbon tax: for example, the costs of reducing emissions by 10 percent are more than three times as high under the carbon quota as under the carbon tax. This disadvantage reflects the inability of the quota policy to generate revenue that can be used to reduce pre-existing distortionary taxes. Indeed, second-best considerations can limit the potential of a carbon quota to generate overall efficiency gains. Under our central values for parameters, a non-auctioned carbon quota (or set of grandfathered carbon emissions permits) cannot increase efficiency unless the marginal benefits from avoided future climate change are at least $17.8 per ton of carbon abatement. Most estimates of marginal environmental benefits are below this level. Thus, our analysis suggests that any carbon abatement by way of a non-auctioned quota will reduce efficiency. In contrast, our analysis indicates that a revenue-neutral carbon tax can be efficiency-improving so long as marginal environmental benefits are positive.

How Much Carbon Pricing Is in Countries’ Own Interests? The Critical Role of Co-Benefits

“…That is, the economic costs from the tax-interaction by itself (when it is not counteracted by the revenue recycling benefit) outweigh the gains from pricing co-benefits. This underscores the importance, long emphasized in the literature (e.g., Parry et al 1999) of implementing carbon pricing as part of a tax shift, rather than an increase in the tax burden-unless the extra government spending yields gains in economic efficiency that are comparable to those from reducing distortionary taxes.…”

Short-Run Allocation of Emissions Allowances and Long-Term Goals for Climate Policy

“…One important element already mentioned is that auction revenues can be recycled in ways that reduce the overall cost of the regulation. In particular, by reducing preexisting taxes, they can enhance the efficiency of the economy as a whole (Parry 1995;Parry et al 1998). Auctions may also promote innovation, relative to grandfathering.…”

Greenhouse Gas Auctions and Taxes: Some Political Economy Considerations

“…Several economists, environmentalists, and politicians have promoted the auctions approach. Some economists argue that auctions are a simple mechanism for distributing allowances among firms and that auction or tax revenues can offset some of the costs of environmental policy (Burtraw 2008;Parry, Williams, and Goulder 1999). Some environmentalists argue that revenues should be used by the government to help address climate change.…”