Do Distributional Concerns Justify Lower Environmental Taxes?

TL;DR

This paper examines how distributional concerns influence the setting of environmental taxes, especially carbon taxes, and finds that optimal taxes are generally close to the Pigouvian benchmark but can be adjusted for income and preference heterogeneity.

Contribution

It derives sufficient statistics for optimal environmental taxation considering regressivity and preference heterogeneity, and applies them to U.S. carbon taxation.

Findings

Optimal carbon tax close to Pigouvian level

Higher taxes for very high-income households feasible

Preference heterogeneity moderates tax adjustments

Abstract

How should taxes on externality-generating activities be adjusted if they are regressive? In our model, the government raises revenue using distortionary income and commodity taxes. If more or less productive people have identical tastes for externality-generating consumption, the government optimally imposes a Pigouvian tax equal to the marginal damage from the externality. This is true regardless of whether the tax is regressive. But, if regressivity reflects different preferences of people with different incomes rather than solely income effects, the optimal tax differs from the Pigouvian benchmark. We derive sufficient statistics for optimal policy, and use them to study carbon taxation in the United States. Our empirical results suggest an optimal carbon tax that is remarkably close to the Pigouvian level, but with higher carbon taxes for very high-income households if this is feasible. When we allow for heterogeneity in preferences at each income level as well as across the income distribution, our optimal tax schedules are further attenuated toward the Pigouvian benchmark.