Household heterogeneity, aggregation, and the distributional impacts of environmental taxes

This paper examines the incidence of an environmental tax using theoretical and numerical general equilibrium models that allow for heterogeneous households, fully general forms of preferences, differential spending and income patterns, differential factor intensities in production, and fully general forms of substitution among inputs of capital, labor, and pollution. First, we focus on the household aggregation problem and find that the incidence of an environmental tax can be qualitatively affected by the level of consistency with which household heterogeneity is integrated into the analysis. Distributional impacts of environmental taxes based on partial and general equilibrium analyses that fail to consistently integrate household heterogeneity are thus likely to be biased significantly. Second, we apply the heterogeneous household model to analyze the distributional effects of a U.S. carbon tax. We find strong evidence that such a tax would be regressive. While this result is robust with respect to varying households’ and firms’ characteristics, the regressivity is dampened considerably if labor is a good substitute for pollution relative to capital.