John W. Diamond and George Zodrow

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executive summary

The potential for utilizing a federal carbon tax to address the risks of climate change has been discussed in U.S. policy debates on both sides of the aisle. Under a carbon tax, consumers and producers would account for the costs of climate change in their decision making. The policy would reduce greenhouse gas emissions without sacrificing the efficiency of private markets.

This paper, part of the Carbon Tax Research Initiative of Columbia University’s SIPA Center on Global Energy Policy, comprises the second element of a two-part analysis of the effects of a federal carbon tax. It provides an up-to-date (inclusive of the Tax Cuts and Jobs Act of 2017) analysis of the short-run and long-run macroeconomic effects and intergenerational and intragenerational distributional effects of a federal carbon tax in the United States.

The analysis simulates the effects of various carbon taxes using the Diamond-Zodrow (DZ) dynamic overlapping generations computable general equilibrium model under a variety of assumptions regarding tax rates and with three revenue-neutral uses for carbon tax revenue:

  1. Payroll Tax Reduction: All the revenue from the carbon tax is used to reduce the employee portion of the payroll tax;
  2. Equal Per-Household Rebates: All the revenue from the carbon tax is used to finance equal per-household rebates; and
  3. Debt Reduction: All revenue from the carbon tax is used to reduce the national debt for a period of 10 years and then used to finance equal per-household rebates.

Results for a benchmark carbon tax that starts at $50/ton are summarized as follows:

  • When revenues are used to reduce payroll taxes, the carbon tax initially has slightly negative effects on gross domestic product (GDP), but these effects rapidly turn positive and, in the long run, GDP increases by nearly 0.5 percent. Total investment, consumption, and labor supply increase in the long run as well. When revenues are used for debt reduction, long-run GDP and investment increase, while consumption and labor supply fall. In contrast, when revenues are used to provide equal rebates to all households, the carbon tax has more negative effects: both initially and in the long run, GDP decreases by about 0.4 percent, while consumption, labor supply, and the capital stock decline modestly as well.
  • Across the income distribution, a carbon tax coupled with payroll tax reductions would initially have roughly proportional effects on all households with respect to their lifetime incomes—except for a relatively small burden on the lowest-income households and a relatively large burden on the highest-income households. In the long run, this carbon tax policy is regressive across much of the income distribution, but the largest proportional burden is borne by the highest earners. In contrast, when carbon tax revenues are used to finance per-household rebates or debt reduction followed by per-household rebates, carbon taxes are progressive, both initially and (even more so) in the long run. Under these policies, lower-income households gain because the carbon tax revenues (after a ten-year period of debt reduction in the latter case) are distributed equally on a per-household basis.

This paper follows a long literature assessing the economic impacts of carbon pricing and the potential for such policies to increase societal welfare, even before accounting for the benefits of emissions reductions (known as achieving a second or “double dividend,” in addition to the “ first dividend” of an improvement in environmental quality). Our results suggest a double dividend is perhaps more achievable than previous studies have indicated, and we identify unique features and drawbacks of the DZ model that may be causing these differences. In particular, the finding that a carbon tax with debt reductions followed by rebates can increase GDP growth while disproportionately bene ting low income households is new to the literature.


Link to Article: 
The Effects of Carbon Tax Policies on the US Economy and the Welfare of Households