Reducing Carbon Emissions Interactions with the Tax System Raise the Cost by Ian W.H. ParryReducing the amount of carbon dioxide Americans pump into the atmospherewill involve economic costs. These costs are larger than previously thoughtbecause emissions reduction policies are likely to aggravate economic distor-tions created by the tax system. But most of this added cost can be avoided ifthe policy chosen to reduce emissions raises revenues for the government andthese revenues are used to cut other taxes. Continued accumulation of heat-trapping gases in theatmosphere raises the prospect of future global warm-ing and associated changes in climate. Many countrieswill attend a conference this December in Kyoto,Japan to consider steps to reduce emissions of carbondioxide (CO2)—the most important heat-trapping gas.Introducing emissions targets may produce importantbenefits in terms of avoided future climate change.Nonetheless, it makes sense to consider which policyapproaches might reach these objectives at the lowesteconomic cost to each country. Recent research sug-gests that much will be at stake in this respect: thecosts of even modest reductions in CO2emissionsmay differ substantially under different types of regu-latory policies. To understand why requires a look athow these policies may interact with taxes that alreadyexist in the economy.The Tax-Interaction Effect Government spending in the United States is financedprimarily by taxes on labor and capital income. Puttingaside the potential benefits from these spending pro-grams, the taxes tend to “distort” economic behavior.That is, they reduce employment and investmentbelow levels that would maximize economic efficiency.For example, because personal income taxes reducetake-home pay, the partner of a working spouse maybe discouraged from joining the labor force, an olderworker may retire earlier, or a worker with one jobmay be discouraged from working additional hours ina second job. Employers are likely to hire less labor ifsocial security taxes make employees more expensive.Similarly, capital gains and corporate income taxesreduce the incentives for individuals to save and forfirms to invest in new production capacity. Environmental taxes and regulations tend to dis-courage economic activity because they raise the coststo firms of producing output. Typically, this leads to alower overall level of employment and investment inthe economy. These “spillover” effects of environmentalpolicies in labor and capital markets add to the distor-tions created by the tax system. The resulting econom-ic cost has been termed the tax-interaction effect.What would happen if a tax on carbon emissions(as proposed by the European Union) were intro-duced? The new tax would increase the costs to firmsof purchasing coal and oil in particular, which in turnwould increase the cost of electricity and gasoline.Most likely, firms would scale back their productionactivities a little in response to these higher costs,SUMMER 1997 / ISSUE 128 RESOURCES 9REDUCING CARBON EMISSIONS10 RESOURCES SUMMER 1997 / ISSUE 128leading to a fall in the level of investment and employ-ment (as happened, for example, in the 1970s whenthe price of energy increased). But employment andinvestment are already “too low” because of pre-exist-ing taxes in the economy. This aggravation of distor-tions created by the tax system would be part of theoverall economic cost of a carbon tax.This is not the end of the story, however, because acarbon tax would raise revenues for the government.These revenues could be used to reduce other taxes inthe economy, such as personal and corporate taxes,and thereby reduce the distortion in the level ofemployment and investment. The economic gain fromthis so-called revenue-recycling effect could reduce theoverall economic costs of a carbon tax significantly. The Rise and Fall of a HypothesisConsiderable confusion has arisen recently about theimplications of tax distortions in the economy for thecosts of carbon and other environmental taxes. Inparticular, a number of analysts have mistakenlyargued that there would be a “double dividend” fromenvironmental taxes. These analysts have correctlypointed to the potential benefits from the revenue-recycling effect, but have failed to recognize the costfrom the tax-interaction effect. Essentially, the double dividend hypothesis assertsthat environmental taxes can both reduce pollutionemissions and reduce the overall economic costsassociated with the tax system. At first glance, thishypothesis seems to be self-evident, if the revenuesraised are used to reduce other taxes that discouragework effort and investment. In some European coun-tries, where high taxes, among other factors, havecontributed to double-digit unemployment rates, thedouble dividend hypothesis has been particularlyappealing. If environmental tax revenues were used toreduce taxes on labor income, so the hypothesis goes,unemployment and pollution might be reducedsimultaneously. More generally, some people haveargued that it is better to finance government spend-ing by taxing economic “bads,” such as pollution,rather than economic “goods,” such as employmentand investment.Economists generally agree that revenue recyclingwould reduce the net economic cost of environmentaltaxes. However, recent studies suggest that environ-mental taxes are likely to increase rather than decreasethe costs associated with the tax system overall. AsLans Bovenberg (Netherlands Bureau for EconomicAnalysis), Lawrence Goulder (Stanford University andRFF), and others have demonstrated, the adverseeffects on employment and investment caused byenvironmental taxes are generally not fully offset, evenif the tax revenues are used to reduce other taxes. Thatis, the tax-interaction effect dominates the revenue-recycling effect. Thus, if there were no environmental benefits, itwould be better to finance public spending by taxeson, for example, labor income rather than on pollu-tion emissions. Why is this? A tax creates economiccosts by inducing households and firms to consumeand produce less of the taxed activity and more ofother activities. The greater the shift away from thetaxed activity, the greater the cost of the tax. Taxes onlabor income can only be avoided by people workingless and spending more time at home. In contrast,environmental taxes have a much narrower focus, andare easier to avoid. A carbon tax can be avoided by anoverall reduction in