Environmental Policy for Fiscal Reform: Can a Carbon Tax Play a Role?

This paper compares the effects of using revenues from a carbon tax to either reduce the national debt or reduce federal personal or corporate income tax rates. It differs from other analyses by looking at a carbon tax as a purely revenue raising measure, not as an optimal Pigouvian tax or as an instrument to achieve a predetermined reduction in emissions. Thus it addresses the question of whether a carbon tax would be part of an optimal tax policy even if there were no damages to the United States from CO2 emissions. We use a computable general equilibrium model (NERA’s NewERA model) that consists of a top-down macro model of the U.S. economy and a detailed bottom-up model of the North American electricity sector. The NewERA model is an integrated energy and economic model that includes a detailed plantlevel representation of the electricity sector with an aggregate level representation of the rest of the economy. The analysis shows that using revenues for either debt or tax rate reduction can reduce the welfare losses from a carbon tax; however, the savings from reducing either federal debt or the marginal rates of other distorting taxes are still less than the economic costs imposed by the narrowly based tax on CO2 emissions. The higher the carbon tax, the greater the disparity becomes.