April 2021

Recycling Carbon Tax Revenue to Maximize Welfare

Stephie Fried, Kevin Novan, William B. Peterman

Abstract:

This paper explores how to recycle carbon tax revenue back to households to maximize welfare. Using a general equilibrium lifecycle model calibrated to reflect the heterogeneity in the U.S. economy, we find the optimal policy uses two thirds of carbon-tax revenue to reduce the distortionary tax on capital income while the remaining one third is used to increase the progressivity of the labor-income tax. The optimal policy attains higher welfare and more equality than the lump-sum rebate approach preferred by policymakers as well as the approach originally prescribed by economists--which called exclusively for reductions in distortionary taxes.

Keywords: Carbon tax; overlapping generations; revenue recycling

DOI: https://doi.org/10.17016/FEDS.2021.023

PDF: Full Paper

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Last Update: April 02, 2021