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.