Carbon Taxes and the "Tax Interaction Effect"

October 8, 2012

A growing number of Republican lawmakers are joining Democrats in supporting a tax on carbon dioxide emissions as a means of aligning market forces and as a way to offset other, distortionary taxes such as those on income and jobs, says Robert P. Murphy, a senior economist with the Institute for Energy Research.

However, there is a downside, known as the "tax interaction effect." A new carbon tax can exacerbate the harms caused by pre-existing taxes, offsetting the potential environmental benefits.

Assuming the social cost of carbon is $50 per ton of carbon emissions, three scenarios are illustrated to show the impact of imposing a carbon tax in different situations:

  • First, a perfectly efficient market that only has a carbon externality. If no other taxes existed, a tax on carbon of $50 per ton would be optimal.
  • Second, a modest income tax exists with a carbon externality. In this scenario, if a carbon tax were imposed, the entire income tax would be eliminated, which would prevent any distortions that the carbon tax would make on the economy.
  • Finally, the scenario that is most realistic, is one in which the income tax is merely reduced and a carbon tax is added. Studies show this would increase total distortions to the economy because of the deadweight loss of keeping the income tax since it costs society more than $1 in order for the government to raise $1 of tax revenue.

Proponents of simply swapping out a carbon tax with an income tax, for example, may be somewhat correct in arguing that a swap would offset the impact of a new tax. However, models show that a revenue-neutral carbon tax would create more deadweight loss on the economy because of the tax-interaction effect.

Source: Robert P. Murphy, "Carbon Taxes and the 'Tax Interaction Effect," Library of Economics and Liberty, October 1, 2012.

 

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