Carbon tax vs. labor tax

by on June 5, 2009 at 6:31 am in Economics | Permalink

I used to think that a revenue-neutral carbon tax would, in addition to its effects on climate, have superior allocative properties over a tax on labor or capital income.  "Why not tax pollution rather than productive activity?" or something like that.

It turns out I was (mostly) wrong.  I read this passage yesterday and said to myself "Duh!"  A tax on carbon, by raising the prices of goods and services, also lowers the real wage and discourages labor supply (holding constant its effect on climate), just as an income tax does:

However, this does not necessarily mean that revenue-neutral CO2 taxes, or auctioned allowance systems, produce a “double dividend” by reducing the costs of the broader tax system in addition to slowing climate change. There is a counteracting, “tax-interaction” effect (e.g., Goulder 1995). Specifically, the (policy-induced) increase in energy prices drives up the general price level, which reduces real factor returns, and thereby (slightly) reduces factor supply and efficiency. Most analytical and numerical analyses find that the tax-interaction effect exceeds the revenue-recycling effect, implying no double dividend, and that abatement costs are actually higher due to the presence of preexisting tax distortions. A rough rule of thumb from these models is that the costs of revenue-neutral emissions taxes are about 15 percent greater than the direct cost due to interactions with prior tax distortions, implying the optimal tax is 15 percent lower than the Pigouvian tax (e.g., Bovenberg and Goulder 2002).  However, the cost increase is far more substantial for policies that do not exploit the revenue-recycling effect (i.e., cap-and-trade with free allowance allocation or CO2 taxes with revenues not used to increase economic
efficiency). According to cost mark-up formulas derived in Goulder et al. (1999), the increase exceeds 100 percent when the emissions reduction is below 30 percent.

I'm not sure this should be a major factor in one's assessment of a carbon tax, but I hear this analytic error quite often, so I thought it was worth a post.  (I should add I don't understand their qualifying point about revenue-recycling at the end of the excerpt and as I read it I don't think it is correct; an income effect which offsets a substitution effect does not eliminate the distortion from the latter.)  The source paper, which is interesting on the economics of climate change more generally, is here.

1 Joe Torben June 5, 2009 at 7:12 am

I didn’t understand this either (to be honest, I really doubt if the authors did.) That said, I feel that this result is so incredibly counter-intuitive that it is worth an explanation that is a lot clearer.

If raising carbon taxes, and reducing labor taxes by the same amount would “discourage labor supply”, doesn’t it follow that raising labor taxes and using the extra revenue to pay for carbon emissions would encourage labor supply? Because surely we are not right now on that magical spot on the Laffer curve where any change in either direction would be for the worse?

I call BS.

2 Alex R June 5, 2009 at 7:40 am

I’m no economist, but my guess as to their point about “revenue recycling” is that if you make your carbon tax/cap-and-trade revenue neutral, *but* you allow a big chunk to go untaxed/give away free credits to existing emitters, then the marginal effective tax on labor is larger because less revenue comes back to reduce income tax.

As the first couple of commenters point out, this all seems to depend quite a bit on how easy it is to increase the carbon efficiency of economic activity — or for that matter, how much in the way of substitution of low-carbon-input goods for high-carbon-input goods can be made by consumers.

3 Zamfir June 5, 2009 at 7:48 am

Joe, yes, that’s what they say, but compared to a situation of perfect pigouvian taxation, not compared to the current situation. So in the situation of perfect pigouvian taxation it would be good to lower CO2 taxes a little (“pay for more CO2”, as you put it), and increase labor taxes by the same amount, to end up in a situation with more CO2 than optimal, but also a more efficient labour market.

But that doesn’t mean that in the current situation paying for more CO2 would have good effects. They estimate (God knows how) the magic spot at 15% below perfect Pigouvian taxes, so a lot higher than current CO2 taxes.

4 anon June 5, 2009 at 8:17 am

you can’t make labor income untaxed and shift the burden to carbon if the income of labor is used to purchase goods and services that are made with carbon inputs (which is essentially everything.

Yes, but so what? This is not a “tax interaction effect”, it’s a “raise the price of energy” effect. Any CO_2 mitigation strategies will lead to an increase in the price of energy – be it direct regulation, carbon taxes or cap-and-trade – but this cost is hopefully offset by the benefit of mitigating climate change. But carbon taxes and auctioneed permits have the advantage of capturing the ensuing scarcity rent in a transparent way, which helps offset some of the costs of the tax system.

5 Marc Brodeur June 5, 2009 at 9:46 am

But would it be correct to say that currently we have an incredibly inefficient hodgepodge of systems for regulating energy and pollution, and there would be gains if we replaced that with a simpler standard system? (like a nation-wide tax or cap&trade)

6 Sam June 5, 2009 at 10:27 am

I’ve heard this beforem and something I genuinely don’t understand is why a reduction in labour supply due to a (tax related) change in the price of goods that reflects the cost of their externalities is a labour market distortion. Why is this not an optimal response to a change in prices to their ‘right’ level?

Maybe we wouldn’t see an overall increase in Labour supply but why is this what we would expect or want to see?

7 Zamfir June 5, 2009 at 10:48 am

Sam, if I understand it correctly, the point is that when it comes to the trade off between leisure and work-for-consumption, people are already (because of taxes) below the pigouvian optimum with respect to CO2. So a CO2 tax plus lump sum payment would decrease marginal real income after tax, moving the amount of leisure even further away from the optimum.

So using the CO2 income to lower labor taxes would only correct this back, it would not in itself be an improvement over the situation without CO2 tax.

The same reasoning applies to most taxes.

8 Andrew June 5, 2009 at 12:47 pm

Oopsie, wrong thread.

9 Bob Murphy June 5, 2009 at 1:06 pm


I also am not sold on this, so if you really “see” it, a follow-up post with some nice examples would be great.

In particular, is this different from the fact that an income tax discourages savings, whereas a consumption tax does not? In other words, I used to think that both taxes equally discouraged saving, since after all the whole point of saving is to consume (in the future).

But if you do a general equilibrium analysis, you see that’s not true; the income tax changes the present vs. future tradeoff, in a way that the consumption tax doesn’t.

But you’re saying that a consumption tax vs. income tax doesn’t affect the leisure/income tradeoff?

10 ryan yin June 5, 2009 at 5:12 pm

Dr. Cowen,
How do you read the revenue-recycling comment? Or what do you mean by “an income effect which offsets a substitution effect does not eliminate the distortion from the latter”? If I’m reading your comment right, I disagree. Income taxes distort the labor-leisure decision, but if you use income taxes to finance lump-sum transfers, you distort the labor-leisure decision even more — that is, the income effect of income taxes does, in a sense, reduce some of the distortion of the income tax’s substitution effect. As I read them, all the authors are saying is that using a carbon tax revenues for lump sum transfers might very well mean you have don’t even get a single dividend much less a double dividend. What’s wrong with that?

11 Jeffrey Yasskin June 6, 2009 at 12:08 pm

I don’t understand the details of this article, but on the surface it sounds like it also applies to replacing income taxes with consumption/sales/value-added taxes? If carbon taxes raise the price level and so hurt the labor supply, surely sales taxes do the same thing?

12 mulp June 6, 2009 at 5:22 pm

Bob Murphy writes: “In particular, is this different from the fact that an income tax discourages savings…”

I presume you mean a low income tax discourages savings while a high income tax promotes savings, right?

The savings rate during the low income tax Bush years reached zero, while the savings rate during the crushingly high tax Carter years were at their peak, with the savings rate falling as income taxes were cut in between.

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