Reducing Carbon Emissions Interactions with the Tax System Raise the Cost by Ian W H Parry Reducing the amount of carbon dioxide Americans pump into the atmosphere will involve economic costs These costs are larger than previously thought because emissions reduction policies are likely to aggravate economic distortions created by the tax system But most of this added cost can be avoided if the policy chosen to reduce emissions raises revenues for the government and these revenues are used to cut other taxes Continued accumulation of heat trapping gases in the atmosphere raises the prospect of future global warming and associated changes in climate Many countries will attend a conference this December in Kyoto Japan to consider steps to reduce emissions of carbon dioxide CO2 the most important heat trapping gas Introducing emissions targets may produce important benefits in terms of avoided future climate change Nonetheless it makes sense to consider which policy approaches might reach these objectives at the lowest economic cost to each country Recent research suggests that much will be at stake in this respect the costs of even modest reductions in CO2 emissions may differ substantially under different types of regulatory policies To understand why requires a look at how these policies may interact with taxes that already exist in the economy The Tax Interaction Effect Government spending in the United States is financed primarily by taxes on labor and capital income Putting aside the potential benefits from these spending programs the taxes tend to distort economic behavior That is they reduce employment and investment below levels that would maximize economic efficiency For example because personal income taxes reduce take home pay the partner of a working spouse may be discouraged from joining the labor force an older worker may retire earlier or a worker with one job may be discouraged from working additional hours in a second job Employers are likely to hire less labor if social security taxes make employees more expensive Similarly capital gains and corporate income taxes reduce the incentives for individuals to save and for firms to invest in new production capacity Environmental taxes and regulations tend to discourage economic activity because they raise the costs to firms of producing output Typically this leads to a lower overall level of employment and investment in the economy These spillover effects of environmental policies in labor and capital markets add to the distortions created by the tax system The resulting economic cost has been termed the tax interaction effect What would happen if a tax on carbon emissions as proposed by the European Union were introduced The new tax would increase the costs to firms of purchasing coal and oil in particular which in turn would increase the cost of electricity and gasoline Most likely firms would scale back their production activities a little in response to these higher costs SUMMER 1997 ISSUE 128 RESOURCES 9 REDUCING CARBON EMISSIONS leading to a fall in the level of investment and employment as happened for example in the 1970s when the price of energy increased But employment and investment are already too low because of pre existing taxes in the economy This aggravation of distortions created by the tax system would be part of the overall economic cost of a carbon tax This is not the end of the story however because a carbon tax would raise revenues for the government These revenues could be used to reduce other taxes in the economy such as personal and corporate taxes and thereby reduce the distortion in the level of employment and investment The economic gain from this so called revenue recycling effect could reduce the overall economic costs of a carbon tax significantly The Rise and Fall of a Hypothesis Considerable confusion has arisen recently about the implications of tax distortions in the economy for the costs of carbon and other environmental taxes In particular a number of analysts have mistakenly argued that there would be a double dividend from environmental taxes These analysts have correctly pointed to the potential benefits from the revenuerecycling effect but have failed to recognize the cost from the tax interaction effect Essentially the double dividend hypothesis asserts that environmental taxes can both reduce pollution emissions and reduce the overall economic costs associated with the tax system At first glance this hypothesis seems to be self evident if the revenues raised are used to reduce other taxes that discourage work effort and investment In some European countries where high taxes among other factors have contributed to double digit unemployment rates the double dividend hypothesis has been particularly appealing If environmental tax revenues were used to reduce taxes on labor income so the hypothesis goes unemployment and pollution might be reduced simultaneously More generally some people have argued that it is better to finance government spending by taxing economic bads such as pollution rather than economic goods such as employment and investment Economists generally agree that revenue recycling would reduce the net economic cost of environmental taxes However recent studies suggest that environmental taxes are likely to increase rather than decrease 10 RESOURCES SUMMER 1997 ISSUE 128 the costs associated with the tax system overall As Lans Bovenberg Netherlands Bureau for Economic Analysis Lawrence Goulder Stanford University and RFF and others have demonstrated the adverse effects on employment and investment caused by environmental taxes are generally not fully offset even if the tax revenues are used to reduce other taxes That is the tax interaction effect dominates the revenuerecycling effect Thus if there were no environmental benefits it would be better to finance public spending by taxes on for example labor income rather than on pollution emissions Why is this A tax creates economic costs by inducing households and firms to consume and produce less of the taxed activity and more of other activities The greater the shift away from the taxed activity the greater the cost of the tax Taxes on labor income can only be avoided by people working less and spending more time at home In contrast environmental taxes have a much narrower focus and are easier to avoid A carbon tax can be avoided by an overall reduction in the level of production and employment However it can also be