Unequal Climate Policy in an Unequal World

We study climate policy in an economy with heterogeneous households, two types of goods (clean and dirty), and a climate externality from the dirty good. Using household expenditure and emissions data, we document that low-income households have higher emissions per dollar spent than high-income households, making a flat carbon tax regressive. We build a model that captures this fact and study climate policies that are neutral with respect to the income distribution. We show that the constrained optimal carbon tax in a heterogeneous economy is heterogeneous: Higher-income households face a higher rate. If uniformity of the carbon tax is desired, this property must be imposed as an additional constraint. In this case, the tax is lower than the unconstrained carbon tax. Finally, we embed this model into a standard incomplete markets framework to quantify the policy effects on the economy, climate and welfare, and we find a Pareto-improving result. The uniform climate policy is welfare-improving for every household.