6. The Distributional Burden of a Carbon Tax: Evidence and implications for policy

Ian Parry
Published Date:
March 2015
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Adele Morris and Aparna Mathur

Key Messages for Policymakers

  • The distributional effect, or economic incidence, of a carbon tax is the combination of the ways a carbon tax affects the things people buy and their sources of income.

  • Estimating the retail price increases that would arise from a carbon tax is fairly straightforward. Economists use input-output tables of the goods and services in the economy and data on households’ spending on energy and other products whose prices rise in response to carbon pricing to assess the burdens on different households.

  • Estimates of consumer price effects suggest low-income households could be hit relatively harder than high-income households; the estimated burden as a share of income on the poorest quintile is several times that on the top quintile. These results indicate that the bottom income quintile (as a group) could be held harmless by targeting about 11 percent of the carbon tax revenues directly to those households.

  • A carbon tax looks much less regressive when its burden is expressed relative to household consumption rather than income. It is also less regressive if one takes into account the effects of the tax on the sources of household income, such as from returns on capital assets, wages, and transfer payments. However, assessing the effect of a carbon tax on the sources of income is difficult and remains a subject of active research.

  • Using carbon tax revenues to fund proportional reductions in other federal taxes would produce a less progressive revenue system because most taxes are borne disproportionately by higher-income groups. However, policymakers can use any number of adjustments to the tax system and social safety net programs to construct a more progressive package of reforms. This highlights the case for including a carbon tax as part of a more comprehensive (and badly needed) overhaul of the fiscal system.

  • The economic benefits from using carbon tax revenues to cut other taxes are large, implying potentially high economic costs to diverting revenues for compensation or earmarked spending on other government activities.

  • The burden of a federal carbon tax would vary somewhat regionally, but it is not clear what, if anything, policymakers should do to account for this. For example, states that currently use a lot of coal tend to have relatively low prices for electricity, so the tax would tend to even out electricity prices across the country. Federal transfers to states may not necessarily reach the most burdened households.


A carbon tax policy that is perceived as unfair is less likely to pass and less likely to stay passed. The mere threat of repeal would undermine the price expectations that are critical to inducing large long-term investments in emissions abatement. This chapter reviews the evidence on the potential distribution of burdens of a carbon tax across different households with an eye to informing policy approaches that could enhance both the fairness and net social benefits of a carbon tax.

One way or another, a carbon tax is ultimately borne by people (and not purely legal entities like corporations or small businesses). Most of a carbon tax would likely be “passed forward” to consumers in the form of higher prices for energy and other products. Economists can estimate these consumer price increases straightforwardly using input/output tables of goods and services in the economy, and they can estimate the ultimate effects on households by matching the price increases with survey data about how much different household income groups spend on fossil energy (electricity, gasoline, natural gas, etc.) and on other products whose prices would increase.

However, in practice the distributional outcomes are likely to be more complicated than those simple calculations of higher retail prices would suggest. For one thing, the carbon tax also affects households’ sources of income, not just how they spend their income. For example, a carbon tax could lower capital income and wages, and higher overall prices could increase transfers, such as Social Security payments, to poor households. Moreover, the final economic incidence of a carbon tax hinges critically on how the government uses the revenue, what other tax and spending reforms accompany the carbon tax, and what other changes are made to environmental policies.

Even if we know the effects of a particular proposal across different household groups, it is not obvious how to judge its fairness. Many would argue that the very poorest should not be made worse off, but what about slightly less poor or middle-class households? Moreover, the distribution of burdens across different household groups depends heavily on whether the burdens are measured relative to household income or consumption, and it is not obvious which measure of socioeconomic status (income or consumption) best characterizes well-being. Finally, the average effects of a policy on a particular group of households could mask important variations within the group.

Despite these complexities, we can offer a way to think about and, to a limited extent, quantify the potential distributional impacts of U.S. carbon pricing both before and after the government uses the revenue, thereby providing a framework for more details as the research matures. The focus here is primarily on burdens borne by different household income groups, though we also briefly review impacts on different regions of the United States. Chapter 9 considers impacts on different industries.1

We should emphasize that a concern about the distributional impacts is not a good reason to delay putting a meaningful price on greenhouse gases. Keeping fossil energy prices below their full social cost is economically inefficient, and high-income households benefit more from inefficiently low prices than low-income households do because they consume more at those inefficiently low prices.

The discussion proceeds as follows. Section 2 discusses some basic concepts of tax incidence. Section 3 discusses the evidence on the incidence of the carbon tax itself, before accounting for how the government uses the revenues. Section 4 discusses the different ways carbon tax revenue might be used and how the use of revenue affects both the fairness and economic efficiency of the overall policy package. Section 5 discusses how the carbon tax incidence could vary across the country, and Section 6 briefly summarizes.

1. Basic concepts of tax incidence

The economic burden or incidence of a tax refers to whose economic welfare is reduced by this tax, and by how much. This is quite different from the formal or legal incidence – fuel suppliers, for example, may be responsible for remitting tax payments to the Internal Revenue Service, but they may bear little economic incidence if they can charge higher prices. In fact, the point in the fossil fuel supply chain where the tax is levied (e.g., on fuel suppliers or emissions from industrial smokestacks) matters for the practical implementation of the charge, but makes little or no difference to its ultimate economic incidence.

The total burden of a carbon tax refers here to the overall cost to households of the carbon tax, excluding environmental and other benefits of protecting the climate. Those benefits could be quite large relative to the costs, but they may principally accrue to future generations;2 one should not infer anything about the net benefits of the carbon tax from the focus here on its economic incidence.

If a carbon tax burdens lower-income households as a share of their income (or some other measure of socioeconomic status) relatively more than it burdens higher-income households, then the policy is “regressive,” even if wealthier people bear a greater burden in absolute terms. If the policy imposes the same burden relative to income across all household income groups, then the tax is termed “distributionally neutral.” And if higher-income households are hit relatively harder (as a share of income) than poorer households, then the policy is “progressive.”

Although here we focus (as does most of the economic literature) on comparisons between scenarios of having a carbon tax and not having a carbon tax, a fuller discussion would compare a carbon tax to alternative ways to achieve the same environmental and fiscal objectives. Box 6.1 briefly remarks on this.

Box 6.1The Incidence of Carbon Taxes vs. Alternative Policies

The incidence of a carbon tax and that of its main market-based alternative, an emissions trading system (ETS) or cap-and-trade system, are potentially quite similar. For example, policymakers could auction ETS allowances to generate about the same revenue stream as under a (similarly scaled) carbon tax. Thus in both cases, the incidence depends on how the revenue is used. If policymakers give free allowances to energy companies (as in the U.S. sulfur trading program and early phases of the EU ETS), this creates windfall profits for these firms since they will pass the price on carbon through to their customers anyway. These profits will raise stock prices and thereby compound the regressive effects of the emissions price.1 The Waxman-Markey bill included an ETS that would have distributed some of the carbon allowances free to local electricity and natural gas distribution companies with the proviso that the value of allowances would hold down residential energy prices to limit burdens on households (thereby channeling these policy rents to households rather than firms).2 Policymakers could achieve the same effect with a carbon tax by using some of the revenue to subsidize residential energy bills. This is inefficient, however, because it blunts the incentive to conserve electricity, one of the more cost-effective ways to lower emissions.

In the absence of a price on GHGs, policymakers could cut emissions with a number of policy tools, such as Clean Air Act regulations, clean energy mandates, and energy efficiency standards. These other policies also tend to increase energy prices less than carbon taxes would because they don’t price emissions below the regulated constraints. By raising revenues, however, carbon taxes offer a means to protect poor households, reduce the federal budget deficit, and lower more distortionary taxes.

A carbon tax could be more or less regressive than other ways to cut budget deficits. It is likely to be less regressive than cutting discretionary or entitlement spending that disproportionately benefits the poor, but it might be more regressive than raising progressive income taxes.

1Dinan and Lim Rogers (2002), Parry (2004).2The bill, H.R. 2454, passed the House of Representatives in 2008. A companion bill failed in the Senate the next year.

2. Carbon tax incidence prior to use of revenues

This section focuses on the distributional pattern of a carbon tax on households by income class, not accounting for how the government uses the revenues. First, we discuss the absolute burden of an illustrative carbon tax and the burden relative to income across different income groups. Next we discuss burdens relative to consumption (an alternative measure of socioeconomic status) and the potential effect of the tax on the sources of household income (such as capital income and transfer payments).

The absolute incidence of a carbon tax

A number of studies have estimated the likely incidence of a carbon price by using input/output tables to trace through the effects of the tax through the economy: higher after-tax fuel prices, higher prices for intermediate inputs (e.g., steel), and ultimately higher retail prices for all consumer products. The studies assume the carbon tax raises fuel prices in direct proportion to the amount of carbon in them, and they typically assume all the price increases are passed forward into the consumer prices faced by households. These studies estimate the burden on different household income groups by mapping the estimated price changes to data on how different groups of households spend their income. Usually these calculations assume consumers don’t change what they consume in response to the tax, which is reasonable if the carbon price is modest and the focus is on short-run distributional effects. They also assume that the carbon tax doesn’t have any broader economic effects, for example, that would lower other tax revenues.

Table 6.1 below shows just this sort of calculation for an illustrative $15 per ton CO2 tax, assuming it was imposed in 2010. These estimates are from Mathur and Morris (2014), a study that is typical in this literature.3 The total burden of the tax in 2010 (i.e., the revenues) is $102.3 billion. Not surprisingly (given that people with more income tend to spend more on energy), the burden increases steadily up the income scale from $5.0 billion (5 percent of the total) for the bottom income decile to $19.1 billion (19 percent of the total) for the top income decile.

Table 6.1Burden of a $15 per ton CO2 tax by income decile, 2010

($ billions)
Cumulative burden

($ billions)
Percent of total

burden (%)

% of burden
Source: Mathur and Morris (2014).Notes: The table reports the total burden of the carbon tax to each household income decile. The calculations in Table 6.1 are based on a static analysis of how the burden of the tax would be distributed across households if there were no behavioral response to the tax in terms of consumers shifting away from products rich in carbon to less carbon-intensive products. This may overstate the long-run burden of the tax but by a modest amount. More important, the calculations do not account for revenue recycling. Figures are in 2010 dollars.

The table suggests that if policymakers directed about 11 percent of the tax towards the poorest two deciles, for example, through social safety net programs, then those households would on average be no worse off after the carbon tax than they were before. Of course, individual households within those groups might be better or worse off than average depending on their particulars.

Incidence relative to income

Economists usually express the distribution of burdens against a measure of households’ socioeconomic status, such as annual income. Lower-income households in the United States generally devote a higher share of their household budget to energy and other goods whose prices would rise upon imposition of a carbon tax than higher-income households do. There are two reasons for this. First, poorer households spend a greater share of their current income than higher-income families, who save relatively more. That means that poorer households’ budgets are generally more exposed to general increases in prices than richer households’. Second, poorer households spend proportionately more of their income directly on electricity and other fuels than higher-income households do.

As Table 7.1 of Chapter 7 indicates, households in the bottom income quintile spend far more of their budget (21.4 percent) on energy than the top income quintile (4.1 percent). The two big energy items for all households are motor fuels and electricity. Other energy expenditures include natural gas, fuel oil, and other fuels. Of all the fuels, the electricity budget share falls most with higher income. The bottom line is that a carbon tax that raises the price of fossil fuels is going to look strongly regressive when burdens are expressed relative to income and the analysis focuses only on how households use their income.

Figure 6.1 illustrates this point. It shows the burden to income ratio for a $15 carbon tax by income decile, reported in Mathur and Morris (2014). The carbon tax looks quite regressive, with the bottom income decile suffering a burden equal to 3.5 percent of their income, or about six times the burden (relative to income) for the top income decile (0.6 percent). Figure 6.1 also shows the breakdown of the burden across increases in energy prices (the darker bars) and increased prices for everything else (the lighter bars). The direct effect is more important, particularly for lower-income households. Accounting for the indirect effect makes the carbon tax look a little less regressive overall.

Figure 6.1Estimated burden (relative to income) of a $15 carbon tax by household income decile, 2010

Incidence under other measures of socioeconomic status

Annual income may not be the best way to characterize a household’s well-being. For example, some people (e.g., graduate students, retirees) may be in a stage of life where their annual income is relatively low, despite a lifetime of reasonably good living standards. An ordinarily well-off person may also have low income in a particular year due to transitory factors, like temporary unemployment, illness, maternity leave, and so on.

To account for this, analysts sometimes measure tax burdens against other measures of households’ socioeconomic status, such as their annual consumption, that vary less over a lifetime than income does.4 The consumption approach considerably reduces the measured regressivity of a carbon tax because low-income households have a high consumption to income ratio relative to high-income households.

Figure 6.2, again taken from Mathur and Morris (2014), illustrates this point. It is the same scenario as Figure 6.1, but the burden of the tax is expressed as a share of annual household consumption, rather than annual income. Under this measure, the same $15 per ton CO2 tax would have burdened the poorest 10 percent of households on average by 2.1 percent of their annual consumption and the wealthiest decile by 1.3 percent of their annual consumption. Thus, the relative burden for the bottom decile in this approach is 60 percent higher than for the top decile (rather than 6 times as high).

Figure 6.2Burden of a $15 carbon tax by consumption decile, 2010

Incidence on the sources of income

So far, we’ve discussed results that assume the entire burden of a carbon tax falls on consumers via higher retail prices. However, a carbon tax may have complex effects on the sources of household income, with implications for how fair a carbon tax is likely to be in practice.

First, rather than being fully passed forward into higher consumer prices, some of the burden of the tax may be “passed back” to producers in the form of lower producer prices. Just how much is passed back depends on the relative slopes of demand and supply curves in energy markets – see Box 6.2. To the extent that producer prices do fall, this may lower the returns to capital in energy industries – implying lower stockholder wealth – and lower wages or other costs for workers.

Further, some sources of income, such as Social Security, Supplemental Security Income, and food stamps, are indexed to overall price levels. Thus, if higher fossil energy prices translate into higher overall price levels, some households may automatically receive more income, which will at least partially compensate them for the tax. After-tax income can also be affected by higher prices because income tax schedules are indexed to consumer price levels.

To parse all this out, a good place to start is the rough sketch of income sources across the socioeconomic ladder in Figure 6.4. The chart shows the (pre-tax) income to different household groups by source according to the Congressional Budget Office. All income classes on average receive the majority of their income from wages (and businesses they operate themselves, like sole proprietorships). Most capital income (such as dividends and capital gains) goes to the richest households. Income from private retirement accounts is included in the “other” category. In contrast, the poorest households receive proportionately more income in the form of transfer payments (including Social Security).

Figure 6.3The effect of a carbon tax on consumer and producer prices

Figure 6.4Source of household income by income quintile, 2009

Box 6.2Impacts of a Carbon Tax on Consumer and Producer Prices

The extent to which a carbon tax is passed forward in higher prices to fuel users, as opposed to being passed backward in lower prices to fuel suppliers, depends on the relative slopes of demand and supply curves. Consider Figure 6.3, which shows the market for an energy product, perhaps coal. Without the tax, the price would be P1. After the tax, the fuel price paid by consumers is P2 and the price received by fuel suppliers is P3, with the difference between these prices reflecting the tax on the fuel, equal to carbon dioxide emissions per unit of fuel use times the tax rate. The tax causes fuel output to fall from Q1 to Q2.

If the fuel supply curve is flat, all of the tax is passed forward into higher consumer prices. But if the supply curve is upward sloping then some of the tax is passed backward in lower producer prices, the more so the steeper the slope of the supply curve relative to that of the demand curve. Fuel supply curves are generally thought to be flatter than demand curves – so the majority of the tax is passed forward – but just how much flatter is uncertain (much depends on the mobility of capital across sectors which is high in the longer term but is more limited in the near term).

Tax revenue is given by the areas of the shaded rectangles combined. The amount of tax effectively borne by consumers is the lighter shaded rectangle (the increase in consumer price times fuel consumption) while that borne by producers (which ends up as lower wages for workers, lower prices to suppliers of inputs, and lower returns to shareholders and investors through lower corporate profits, dividends, and capital gains) is the darker shaded rectangle (the reduction in producer price times fuel output).

Figure 6.4 suggests (not surprisingly) that to the extent the carbon tax reduces income to capital, this will largely affect higher-income households. This means that carbon taxes are less regressive in practice, when producers bear at least some of the cost, than if producers could pass everything to consumers, as assumed in the earlier discussion. At the same time, if higher price levels trigger increases in transfer payments (the green bars), that will augment a larger share of income for poorer households than richer households, again a progressive effect.

The distributional pattern from a carbon tax’s effects on wages is a little complicated. Households that receive relatively more of their income from labor and less from transfers will face relatively higher burdens, all else equal. According Figure 6.4, labor income (wages and benefits) comprises 55 percent of the lowest quintile’s total income, and 69 and 64 percent, respectively, of the fourth and fifth quintiles’ income, suggesting any reduction in wages is mildly progressive. However, we haven’t accounted for the extent to which lower-income households tend to work disproportionately more or less in energy-intensive industries (e.g., coal mining) than in other sectors of the economy, and that could affect the results.

Despite the broad insights from Figure 6.4, the effect of a carbon tax on the sources of income is hard to analyze more concretely. The portion of the carbon tax that might be passed back in lower producer prices is still a matter of ongoing research, along with how this portion may decline as investors reallocate capital over the long run. And to the extent that returns on capital are determined internationally, this will tend to cushion the fall in the domestic returns. The effects on capital income also depend on the degree to which capital and labor can be substitutes in production, which is also complicated. Moreover, the data on the sources of income for different groups of people are not consistent across different government surveys. And it is not clear what the effect of a new tax could be on all sorts of important but complex sources of income, like payments employers make to their employees’ retirement accounts.

Some studies find that effects of the tax on the sources of income can offset some or all of the regressivity on the uses of income, at least across part of the income distribution.5 For example, Fullerton et al. (2011) find the burden to income ratio across the income distribution is U-shaped – low-income household still suffer a disproportionately larger burden, but so do high-income households (due to the drop in capital income). Categorizing households by annual consumption produces somewhat different results. In this case, Fullerton et al. (2011) find that the overall burden of carbon pricing is progressive across the bottom half of the distribution and regressive across the top half. (In both cases, the indexing of transfers adds significant progressivity to carbon tax incidence.)

Some recent studies use computational models of the economy to estimate how the burden could fall on workers and shareholders. They also take into account the indexing of transfer payments and how households could change their consumption patterns over time in response to new relative prices, substituting away from higher-cost energy-intensive items. Again, these studies find substantially different conclusions about the regressivity of a carbon tax than studies that just consider the uses of income. For example, Rausch et al. (2011) find that progressivity on the sources of income is sufficiently strong as to offset regressivity on the uses side, leaving a carbon tax distributionally neutral overall.

3. Distributional tradeoffs in the disposition of the revenue

This section explores the tradeoffs between using carbon tax revenues in the most economically efficient or pro-growth way and using it to achieve other (especially distributional) objectives. The discussion compares the carbon tax to what we know about the incidence of other taxes. It explains the tradeoffs inherent in protecting low-income households, the strong economic case for using much of the revenue for cutting other taxes or reducing debt ratios, and then considers some other possibilities for revenue use.

Who pays federal taxes?

Higher-income households pay a disproportionately large share of most federal taxes. Table 6.2 illustrates how different a carbon tax would be in this regard than most other federal taxes. It shows the share of an illustrative $15 carbon tax borne by different household income groups (the same estimates from Morris and Mathur (2012) as in Table 6.1, summed into income quintiles) with analogous information from the Congressional Budget Office about other federal taxes in 2008 and 2009. The top income group, assuming all of the revenue is passed forward to consumers, would pay about 32 percent of the carbon tax and the poorest 20 percent of households would pay about 11 percent. In contrast, the top income group pays the overwhelming majority of individual income taxes and (through their role as shareholders) corporate income taxes, 94.1 and 77.2 percent, respectively. The bottom two income quintiles each pay under 4 percent of the corporate income tax and receive refundable income tax credits, such as the earned income and child tax credits, sufficient to make their net individual income tax burdens negative.

Table 6.2Distribution of carbon tax relative to other federal taxes
Income quintile
Percent of revenue from carbon tax
Carbon tax (estimate for 2010 assuming 100% falls on consumers)11.214.918.922.832.3
Percent of revenue from other federal taxes (2008 and 2009)
Individual income tax−6.6−3.52.713.494.1
Payroll taxes5.39.715.424.045.3
Corporate income tax1.83.25.810.277.2
Excise taxes12.215.118.821.332.1
Source: Table 6.1 above with data from Mathur and Morris (2014) and CBO (2012), Table 2.

Payroll taxes (including employer and employee contributions to Social Security and Medicare taxes) are more evenly distributed, with the top income quintile contributing 45.3 percent of the revenues and the bottom quintile 5.3 percent. Federal excise taxes (primarily on tobacco, alcohol, and motor fuels) are more like the carbon tax, another kind of excise tax, with the bottom quintile paying 11.0 percent of revenues and the top quintile 34.3 percent.

Even if one accounts for the potential effect of a carbon tax on the sources of income (which the estimates in Table 6.2 do not), imposing a carbon tax and using the revenue for proportional reductions in other federal taxes combines a potentially regressive new tax with an assuredly regressive tax cut. This underscores the desirability of thinking carefully about how to embed a carbon tax in a fiscal package that protects the poor but also uses as much revenue as possible in a pro-growth way.

Protecting low-income households vs. cutting other taxes

One way to ensure a carbon tax is progressive is to return all of the carbon tax revenue to households in equal rebates, also called lump-sum transfers.6 But rebates don’t lower any existing taxes, so they don’t increase the after-tax returns from working or for investing and saving and thereby encourage more productive economic activity. This would be a large forgone opportunity. Research shows that using carbon tax revenue to reduce other taxes can greatly improve the economics of a price on carbon and climate policy more generally.7 This is called “revenue recycling” with a “tax swap.”

The most efficient form of revenue recycling would offset the most distortionary taxes, meaning the ones that create the greatest economic drag for the last dollar they bring in.8 Unfortunately, the most efficient tax swap may be the most regressive.9 Most experts believe the most distortionary taxes are likely those on capital income, like dividends, capital gains, and corporate earnings.10 With a federal corporate tax rate of 35 percent and an average state rate of 6.3 percent, the combined U.S. corporate income rate is roughly 39.1 percent, the highest statutory corporate tax rate in the developed world today.11 For comparison, Hassett and Mathur (2011) show that the U.S. corporate tax rate was only slightly higher than the OECD median in 1981. The United States is an outlier in its tax treatment of corporate income, and many argue that the tax system is likely harming U.S. economic competitiveness and driving multinational corporations to shift taxable profits abroad.12

So how much revenue would policymakers need to set aside to make poor households no worse off? Studies show that if policymakers target about 11 percent of the revenue each year to households whose income falls below 150 percent of the poverty level, however that level is defined in each year, it would ensure that roughly the poorest fifth of households (on average) remain no worse off. Mathur and Morris (2014) estimate that 11 percent of carbon tax revenue would be necessary to hold the bottom two deciles of households by income harmless (see above and Morris (2013) for further discussion), while Chapter 7 suggests 12 percent, leaving almost 90 percent of the revenues for other purposes.13

Alternatively, instead of preventing an absolute decline in the well-being of the bottom income group, the government’s objective may be to ensure the burden of a carbon tax is more or less proportional to income for all groups. Grainger and Kolstad (2010) investigate how the potential regressivity of a $15 tax on CO2 could be ameliorated by returning the revenue in a progressive way. Policymakers can target transfers, finance cuts in regressive payroll or excise taxes, target income tax cuts to lower-income groups, or spend more on government programs targeted to lower-income groups. The authors estimate that the carbon tax could be made distributionally neutral by directing transfers (or income tax credits) in the amounts of $119, $112, $105, and $76 to individuals in the first four income quintiles, respectively. The net result of the carbon tax and transfers would burden individuals proportionately at around 1 percent of their net annual income. It would also offset the regressive effects of the carbon tax while leaving $49.6 billion in net revenues for the government.

A number of papers investigate or advocate using a carbon tax to reduce capital income taxes in order to maximize the efficiency gain from the tax swap. Dinan and Lim Rogers (2002) found that using carbon revenues to reduce corporate income taxes could reduce the economic cost of limiting carbon emissions by about 60 percent. Analyzing a 15 percent cut in emissions from the carbon price associated with a cap-and-trade program, CBO estimates that the downward hit to GDP could be reduced by more than half if the government sold allowances and used the revenues to lower corporate income taxes rather than to provide lump-sum rebates to households.14

Metcalf (2008) considers how a carbon tax could be used to reduce capital income taxes through corporate tax integration, meaning a reform that would tax corporate earnings only when shareholders receive dividends and realize capital gains. He finds that the tax could improve the efficiency of the system and that price increases throughout the economy are likely to be modest. Using a general equilibrium model, McKibbin et al. (2012a) find that using the carbon tax revenue to buy down taxes on capital income could slightly boost GDP, employment, and wages through the first few decades of the tax, in part as a result of the tax swap’s beneficial effect on U.S. investment.

Marron and Toder (2013) estimate that cutting the corporate tax rate from 35 percent to 28 percent would reduce U.S. tax revenues by about $800 billion over the next 10 years. Cutting the rate from 35 percent to 25 percent would reduce tax revenues by about $1.15 trillion. While some of that lost revenue could be made up by expanding the corporate income tax base through elimination of corporate tax preferences of various kinds, these preferences have organized supporters who will oppose their elimination. Even if some tax preferences can be phased out, tax reform, whether it be corporate tax reduction or other desirable tax reform, will likely require new revenue elsewhere in the budget, and a carbon tax is a natural fit.

Morris (2013) offers a specific proposal along these lines. She analyzes a tax that starts at $16 per ton of CO2 and rises by 4 percent annually over inflation, along with a cut in $6 billion per year in clean energy subsidies. She finds it could finance a long-term reduction in corporate income tax rates from 35 to 28 percent and still reduce the deficit by over $800 billion over two decades, even after reserving 15 percent of revenue for the protection of the poor.

Other scholars have investigated using carbon tax revenue to reduce personal income or payroll taxes. Parry and Williams (2012) find very striking differences between the costs of a $33 per ton carbon tax with revenues used for personal income tax cuts (a net annual gain of $6 billion or $9 per ton of CO2 reduced) and the same policy when all revenues are returned as lump-sum transfers (an annual cost of $45 billion or $90 per ton of CO2 reduced). Their analysis accounts for some broader distortions created by income taxes (not only reductions in work effort but also incentives for excessive spending on goods that receive favorable tax treatment, like employer medical insurance and owner-occupied housing) that are not included in other studies.

Metcalf (2007) proposes using a carbon tax to cut the income tax tied to payroll taxes paid by workers. Specifically, he proposed an environmental tax credit equal to the employer and employee portions of the payroll taxes paid by the worker in the current year, up to a cap. Capping the rebate makes the tax cut more progressive, and the payroll tax cut is greatest for low-wage workers.

Rausch and Reilly (2012) compare payroll and personal income tax approaches to other carbon tax recycling options and find that of all the scenarios, the payroll tax approach has the most evenly distributed benefits across households as a share of income. The payroll tax swap also makes all household groups better off than baseline policies.15 However, using all the revenue for payroll tax cuts generated less aggregate welfare gain through 2035 than reducing corporate income taxes.

Other ways to use the revenue

Here we briefly touch on use of revenues for deficit reduction, subsidies to household energy bills, and earmarks for other purposes.

Using carbon revenue to reduce the federal deficit may produce even larger benefits than using it to cut current taxes, as this reduces the need for future tax increases and may alleviate upward pressure on interest rates and reduce the risks of financial crises.16 However, in the absence of a carbon tax, policymakers might increase other taxes or reduce spending, so the most realistic fiscal policy baseline against which a carbon tax should be compared isn’t obvious. Gauging the distributional implications of using a carbon tax for deficit reduction is even more difficult given uncertainty over what future tax increases might be avoided due to lower accumulated federal debt.

In general policymakers should be cautious about earmarking some of the revenues from a carbon tax for certain specific purposes as this can significantly increase overall costs to the economy. One potential exception, as discussed in Chapter 10, could be ramping up government funding for basic research and early deployment of emissions-abating technologies, though the costs and benefits of these interventions would need to be carefully assessed, including relative to other potential investments in research and development.

One particular pitfall would be to use the carbon tax revenue to directly reduce households’ energy costs. For example, provisions in the Waxman-Markey emissions trading bill would have used the value of emissions allowances to subsidize residential energy bills (see Box 6.1). But these subsidies reduce consumers’ inclination to conserve energy, thereby undermining the environmental benefits of the carbon tax. Moreover, as emphasized in the introduction, lowering energy prices is a very inefficient way to target low-income households. In general, if we’re worried about effects on certain households, it’s better to channel the revenue to them through a tax reduction or rebates, or for that matter pretty much any way other than through their energy bills.

4. Regional incidence

One concern about a single national price on carbon is that areas of the United States that are heavily dependent on fossil fuels, especially coal, will be more burdened than other regions. And indeed the fossil energy intensity of economic activity does vary a lot across the country, as shown in Figure 6.5 below. The figure shows the emissions intensity of the economy of states, measured as tons of energy-related CO2 emissions per million dollars of Gross Domestic Product (GDP), vary by an order of magnitude across states. In these figures, the emissions include those released where fossil fuels are combusted, including for generating electricity that may be used in another state; they do not include carbon in fuels that are burned in other states. Even so, the most CO2-intensive states include West Virginia, North Dakota, and Wyoming, all large fossil fuel producers. The states with the least CO2-intensive economies, including New York and California, have about one-tenth the emissions intensity of the most emissions-intensive states.

Figure 6.5Energy intensity of state economies in tons of energy-related CO2 emissions per million of dollars of GDP, 2010

Source: Emissions data come from the U.S. Environmental Protection Agency,

Notes: The figures include emissions from combustion facilities like power plants and the carbon in fuels used in transportation and residential and commercial HVAC.

To be sure, emissions intensity isn’t perfectly correlated with the burden of a carbon tax. We noted earlier that the majority of the tax burden will be passed forward to consumers, so states that emit carbon in the production of goods and services that are consumed elsewhere could pass most of that burden to consumers in other states. And just because a state’s economic activity is carbon intensive (hence a high emissions per GDP ratio), it doesn’t necessarily mean that the goods that its residents buy are carbon intensive. One particular exception, however, is for coal-fired electricity, and the research shows that factor affects the regional distribution of a carbon tax.

Some regional analyses show that the burdens of a carbon tax as a share of income won’t vary nearly as much as one might guess from this map.17 First, some of these regional analyses assume all of the costs of a carbon tax are passed along to consumers. People in different regions use different mixes of fuels to heat and cool homes, and they also vary in their gasoline consumption. In other words, areas where electricity prices may go up most may be the same places where they use relatively less gasoline. For instance, gas consumption is highest in the East North Central region, electricity used more in the West South Central region, and home heating oil consumption is highest in New England. In addition, households in most regions consume similar baskets of non-energy goods, resulting in similar patterns of indirect energy consumption. The biggest item that varies on the consumption side is electricity, which is highly coal intensive in some areas. Studies show that a carbon tax could fall slightly harder than average on households in East Central states (such as Wisconsin, Illinois, Michigan, Indiana, and Ohio) because of their higher overall energy consumption as a share of income.

Areas that currently use relatively more coal in their electricity sectors have relatively low electricity rates, so disproportionately raising electricity rates in those areas would serve to flatten the differences in electricity prices across the country. Palmer et al. (2012) find that a $25 per ton tax of CO2 would raise national electricity prices by an average of 12 percent, but that the increase could be as little as 4 percent in southern California or as much as roughly 33 percent in Missouri, Kansas, and most of Appalachia. Rausch et al. (2011) also show the South Central regions would have the largest share (17 to 33 percent) of households that experience a net income loss of 1 percent or more. This is driven primarily by the large share of coal in the electricity mix in that area. They also find that wage rates fall the most in the Mountain states as well as the North and South Central states as the impact on industrial activity and hence labor demand in these regions is relatively large due to high energy and emissions intensities. Conversely, the Northeast and West regions with less carbon-intense economies experience relatively small reductions in wage rates.

In theory, policymakers could target carbon tax revenue regionally, for example, through state grants, to address disparities in the burden. However, as we have seen, the burdens are complex and depend on the extent to which one accounts for both sources and uses of income and other factors. In addition, transferring funds to states, even if factoring in regional burdens, doesn’t necessarily target the households that bear the burden; it depends on how states use the revenue. One can also imagine that the Congressional negotiations around the formula that might govern this targeting would be contentious.

5. Summary

Estimates of the impacts of carbon taxes on consumer prices and the share of income spent on energy across different households suggest a carbon tax could be decidedly regressive, with the burden as a proportion of income several times higher for the bottom income quintile as for the top income quintile. But the estimated incidence is far less regressive if analysts measure burdens relative to household consumption and take into account (as best as possible) how the tax affects households’ sources of income.

Policymakers could ensure that low-income households (as a group) are made no worse off by targeting a small share of the carbon tax revenues, perhaps as little as 11 percent. A robust literature shows that using the preponderance of carbon tax revenues for reductions in other taxes (or the budget deficit) could greatly lower the overall cost of imposing a carbon tax. Some studies indicate that a carefully designed tax swap might produce net economic benefits, not even counting the environmental benefits of the carbon tax. But a tax swap, including the broader fiscal package in which it might feature, should be designed carefully to protect low-income households, lower particularly distortionary taxes, and resist inefficient spending.

The burden of a federal carbon tax would vary somewhat regionally, but it is not clear what, if anything, policymakers should do to account for this. For example, states that currently use a lot of coal tend to have relatively low prices for electricity, so the tax would tend to even out electricity prices across the country. And federal transfers to states may not necessarily reach the most vulnerable households.


The authors gratefully acknowledge the research assistance of Danny Cohen, Will Daniel, Nathan Joo, and Daniel Hanson.

Benefits include lower damages from extreme weather events, reduced sea level rise, and the like. Poor households, coastal communities, farmers, and other sub-groups may be relatively more vulnerable to these risks, and thus the benefits of GHG abatement may have important socioeconomic, regional, and industry-specific distributional effects.

For other studies like this, see Burtraw et al. (2009) and Hassett et al. (2009).

For more discussion see, for example, Hassett et al. (2009), Parry et al. (2007).

For example, CBO (2009) estimated that rebating the value of allowances (akin to the potential tax revenue) in the Waxman-Markey emissions trading bill, would result in a net gain of 0.7 percent of income to the bottom income quintile, with all other income quintiles showing less than 1 percent drop in their purchasing power.

Some estimates suggest that using carbon tax revenue to lower the deficit or other taxes can lower the overall costs of the program by 75 percent relative to a program that gives the revenue away. See Parry (1997).

Of course, given special deductions, accelerated depreciation, and other tax provisions the effective tax rate may be much lower for many firms than the statutory tax rate (see Chapter 8).

It would be hard to compensate all poor households perfectly, however. The burden may evolve over time as households adjust to new prices, and the impacts might vary systematically by region, household demographics and rural/urban location, and other factors that influence households’ consumption patterns. That implies a wide distribution of burdens within each quintile, meaning that average compensation is still undercompensation for a significant number of households (Rausch et al. 2011).

Rausch and Reilly (2012), Figure 7, p. 15 and Table 3, p. 7.

Mathur and Morris (2014) demonstrate this.

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