A CARBON TAX IN BROADER 

U.S. FISCAL REFORM: 

DESIGN AND DISTRIBUTIONAL ISSUES

May 2014

by

Adele C. Morris 

The Brookings Institution

Aparna Mathur

American Enterprise Institute

U.S. POLICY

A CARBON TAX IN BROADER 

U.S. FISCAL REFORM: 

DESIGN AND DISTRIBUTIONAL ISSUES

May 2014

by

Adele C. Morris 

The Brookings Institution

Aparna Mathur

American Enterprise Institute
ii Center for Climate and Energy Solutions

© 2014, Center for Climate and Energy Solutions. All Rights Reserved.
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues iii

FOREWORD iv

ACKNOWLEDGEMENTS v

EXECUTIVE SUMMARY vi

I. INTRODUCTION 1

II. RATIONALE FOR A CARBON TAX AND

THE CONNECTION TO BROADER FISCAL REFORMS 3

III. ESTIMATED REVENUE AND EMISSIONS REDUCTIONS 5

IV. CONSIDERATIONS IN SETTING THE PRICE ON CARBON

AND ITS TRAJECTORY OVER TIME 9

V. TAX ADMINISTRATION AND OTHER DESIGN ISSUES 13

VI. THE COST OF A CARBON TAX 17

VII. ECONOMIC INCIDENCE OF A CARBON TAX ACROSS HOUSEHOLDS AND REGIONS 21

VIII. PROTECTING THE POOR, IMPROVING THE EFFICIENCY OF THE TAX SYSTEM,

 AND REDUCING THE DEFICIT 25

IX. LINKING A CARBON TAX WITH CHANGES IN OTHER ENVIRONMENT AND ENERGY POLICIES 31

X. ADDRESSING EMISSIONS LEAKAGE AND THE CONCERNS OF

 ENERGY-INTENSIVE, TRADE-EXPOSED (EITE) INDUSTRIES 35

XI. CONCLUSIONS AND RECOMMENDATIONS 37

ENDNOTES 39

REFERENCES 43

CONTENTS
iv Center for Climate and Energy Solutions

FOREWORD Eileen Claussen, President, Center For Climate And Energy Solutions

Economists generally agree that a price on carbon would be the most efficient means of reducing the emissions 

that are the major cause of global climate change. 

This report by Adele Morris and Aparna Mathur, economists with the Brookings Institution and the American 

Enterprise Institute respectively, examines the issues and options for designing one type of carbon pricing 

mechanism—a carbon tax. The authors find that a $16 tax on carbon could raise more than $1.1 trillion in the 

first 10 years and more than $2.7 trillion over a 20-year period. A broader tax base that included emissions of 

other greenhouse gases (e.g., non-energy carbon dioxide and methane) would raise even more revenue. This 

mechanism could be included in a revenue-neutral tax reform bill that reduces taxes on productive activities, such 

as labor, investment and saving, by establishing a tax on harmful pollution.

Several countries, as well as a number of sub-national governments around the world, have established carbon 

taxes, or energy taxes based on the carbon content of fuel. Several more are studying the idea because of its price 

certainty, revenue potential, and use of market forces to reduce emissions at the lowest-possible cost. In California, 

for example, the Senate President pro Tempore recently introduced a bill that would place a carbon tax on 

transportation fuels as an alternative to including the fuels in California’s cap-and-trade program. 

Other U.S. states may soon follow suit—the U.S. Environmental Protection Agency’s regulation of carbon dioxide 

emissions from power plants could give states the choice between imposing traditional command-and-control 

regulations and establishing a more efficient pricing mechanism, such as a carbon tax.

At this point, political considerations, rather than economic analysis, are driving many policymakers’ views of a 

carbon tax. We respectfully offer this report in the hopes of tipping the balance towards a more substantive debate 

of a topic with critical implications for our economy, environment, and national security.
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues v

ACKNOWLEDGEMENTS

Many people contributed to the development of this report. The authors gratefully acknowledge the research 

assistance of Danny Cohen, Will Daniel, and Daniel Hanson. In addition, the authors would like to thank Joe Aldy 

for his thoughtful review and insightful comments. Janet Peace and Jason Ye from the Center for Climate and 

Energy Solutions (C2ES) were also very instrumental in the development of this report.

C2ES would like to acknowledge the Alex C. Walker Educational and Charitable Foundation for providing financial support for this project. 
vi Center for Climate and Energy Solutions

EXECUTIVE SUMMARY 

Economists refer to the climatic damages of human-induced greenhouse gases as “external costs” because the 

emissions impose a cost on society that is not reflected in the prices of goods and services that produced them. 

Policymakers can correct this market failure by putting a price on greenhouse gas (GHG) emissions, for example 

by taxing GHG emissions, and thereby cost-effectively reducing emissions through market forces. A GHG emissions 

tax would reduce emissions by changing the relative prices of fuels and other goods and services according to their 

emissions intensity. Such a tax would also produce revenue, raising the option of including the measure in a broader 

package of fiscal reforms. The largest source of greenhouse gas emissions is carbon dioxide from the combustion of 

fossil fuels, so many economists particularly advocate an excise tax on the carbon content of those fuels, or a “carbon 

tax.” (The terms “carbon tax” and “GHG emissions tax” are used interchangeably throughout this report, unless 

specified otherwise.)

This report examines the issues and options for designing a carbon tax in the United States. It reviews the 

rationales for a carbon tax in the context of broader fiscal reform, explains the design issues, describes the potential 

revenue and environmental benefits, and explores options for using the revenue. The paper’s key points include:

A well-designed carbon tax could improve the long-run U.S. fiscal situation while reducing emissions. For 

example, estimates suggest that a tax on the carbon content of fuels in the energy sector that started at $16 per ton 

of carbon dioxide in 2014 and rose at 4 percent over inflation per year would raise more than $1.1 trillion in the 

first 10 years and more than $2.7 trillion over a 20-year period. A broader tax base that included emissions of other 

greenhouse gases (e.g., non-energy carbon dioxide and methane) would raise even more revenue. The long-term 

revenue and emissions reductions would depend on a host of hard-to-predict factors such as economic growth and the 

evolution of energy technologies.

The carbon tax with the least economic cost would be predictable, start modestly, ramp up gradually, and 

minimize administrative costs.

• Over the long run, the price on carbon should be consistent with the “social cost of carbon,” as best as it can be 

estimated, and it can be updated as new information develops. A gradual and predictable policy would promote 

efficient turnover of long-lived industrial plants and equipment, allow households to adjust with minimal disruption, and incentivize innovation and deployment of new technologies. Some economists recommend that the 

real rate of increase in a tax should match the returns on relatively low-risk capital assets, which is about four or 

five percent above inflation.

• A tax applied as broadly as feasible to fossil fuels, non-energy sources of carbon dioxide emissions, and other 

greenhouse gases (based on their global warming potential relative to carbon dioxide) would deliver the same 

incremental incentive to reduce emissions in all sectors, and therefore be the most economically efficient.

• A carbon tax could be applied either “upstream,” where the fossil fuels enter the economy, or “downstream,” 

where the carbon is emitted to the atmosphere. An upstream tax on the carbon content of fossil fuels could 

price 80 percent of U.S. greenhouse gas emissions by taxing fewer than 3,000 entities, thus minimizing administrative costs while offering broad coverage.

• Carbon that is not emitted, for example because it is sequestered underground or embodied in long-lived 

products, should be eligible for a tax rebate or credit.

A carbon tax could create opportunities within a tax reform package that may not otherwise exist. Taxing 

something we do not want (e.g, greenhouse gas emissions) rather than something we want more of (e.g., productive 

labor and investment) could help lower the economy-wide cost of the program and may even have economic benefits 

in addition to its environmental benefits.
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues vii

• The overall economy-wide effects of a carbon tax would depend on three factors: the price increases that result 

from the tax (i.e., who bears those prices and by how much); the final disposition of the carbon tax revenue (i.e., 

how the revenue is used); and how these changes would ripple through the broader economy. 

• Including a carbon tax as part of a broader fiscal reform could ameliorate the potential regressivity of a carbon 

tax, which could result because lower-income individuals may spend a larger share of their income on energy. 

Directing about 15 percent of annual revenues toward households whose incomes fall below 150 percent of the 

poverty line would ensure that the poorest fifth of households would not be made worse off under a carbon tax. 

Regional variations in the burden of a carbon tax as a share of income would be modest due to regional patterns 

of fuel consumption and use, but some particularly coal-intensive states could face relatively larger burdens.

• Revenues from a carbon tax could fund reductions in other taxes. As seen in Table ES, policymakers could:

o Reduce the U.S. statutory marginal corporate income tax, currently the highest in the developed world, while 

simplifying the tax provisions that allow most corporations to pay far lower effective rates.

o Reduce payroll or personal income taxes, prevent cuts in social safety net spending, and reduce the federal 

budget deficit.

A carbon tax could reduce the need for other climate and energy policies. An appropriate tax would lower GHG 

emissions and spur clean energy innovation, making less-efficient energy and climate policies unnecessary.

• One scholar estimates that about $6 billion in annual direct and tax expenditures for clean energy deployment 

could be replaced with a modest carbon tax with the same impact on deployment.

• A broad national carbon tax could reduce greenhouse gas emissions more effectively and less expensively than 

sector-by-sector and state-by-state regulation under the Clean Air Act.

• Federal funding for basic research and development would remain important under a carbon tax because those 

activities would be under-funded by market forces alone.

Emissions leakage and concerns of energy-intensive, trade-exposed industries could be managed under a carbon 

tax. A number of approaches could apply: 

• The carbon tax could start modestly, giving energy-intensive, trade-exposed (EITE) firms time to lower their 

carbon-intensity.

• A border carbon adjustment could tax select imports of EITE goods from countries with less ambitious climate 

policy goals. 

• The carbon tax revenue could fund reduction in other taxes that make U.S. firms less competitive.

• The United States could use its policy as leverage to encourage other countries to take stronger climate action.
viii Center for Climate and Energy Solutions

TABLE ES: Summary of Options for Using Carbon Tax Revenue

REVENUE USE EFFECTS ON ECONOMY PROGRESSIVE

COMPENSATES 

THOSE WHO BEAR 

CARBON PRICE?

Lump-sum rebates to 

households

Does not lower burden 

of tax system on the 

economy. Could boost 

consumption in a 

slack economy.

Yes Likely under-compensates 

higher-income households.

Reduce federal budget 

deficit

Economy benefits 

from lower future tax 

burdens and greater 

investment now.

Maybe. Depends on 

structure of future tax 

system and who benefits 

from higher investment.

Maybe 

Reduce (or prevent 

increases in) payroll or 

labor income taxes 

Benefits economy to the 

extent it encourages more 

work. Benefits could 

be substantial.

Depends on implementation. Does not help those 

without earned income. 

Depends. Could undercompensate higherincome households.

Give revenue to utilities to 

lower electricity rates

Increases costs by blunting 

incentives to conserve 

and driving abatement to 

costlier sectors.

Depends on how it is 

implemented by state 

utility regulators. 

Yes for electricity 

consumers, but does not 

benefit consumers of 

other energy.

Reduce capital taxes 

(corporate income tax or 

capital gains tax)

Economic benefits could 

be substantial. Some think 

that using some revenue 

for an investment tax credit 

may be even better.

Likely not; the evidence on 

the incidence of corporate 

taxes is mixed. 

Maybe

Fund climate, energy, and 

adaptation R&D

Could benefit economy 

if revenue goes to useful 

research the private sector 

would not do otherwise. 

In large sudden volumes 

it could bid up the price 

of research inputs. Total 

revenue is far more than 

would be appropriate 

to devote to only 

this category.

No Maybe. Could lower costs 

of abatement in the future.

Give revenue to states or 

other sub-federal entities

Depends on what states 

do with it. Could benefit 

economy if they reduce 

deficits or other taxes.

Depends on what states do 

with it. 

Depends on what states do 

with it. 
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 1

I. INTRODUCTION

A full assessment of climate policy options requires 

understanding the policies’ potential benefits and costs. 

Such an assessment necessarily draws from the different 

technical disciplines that study trends in global temperatures, model the potential impacts of increasing greenhouse gas (GHG) concentrations in the atmosphere, and 

assess the likely economic impacts of policies designed 

to abate GHG emissions—including macroeconomic 

outcomes and distributional impacts.1

 This paper examines the issues and options for designing an economically 

efficient policy for reducing GHG emissions and leaves 

the scientific case for such a policy to others. 

We start with the premise that policies that charge 

emitters of GHGs in proportion to the damage caused by 

their emissions would create widespread market signals 

that efficiently lower emissions across the economy over 

time. The price signals would shift consumer demand, 

drive new investment, and encourage technology 

development toward less emissions-intensive goods and 

services. While other environmental policies, such as 

investments in basic research on low-emissions technologies, might be justified, economists widely agree that a 

price on GHGs, and carbon dioxide (CO2

) in particular, 

would be an important element in an economically 

efficient environmental policy portfolio.2

 There are 

multiple ways to put a price on carbon, but the two most 

comprehensive are an emissions tax and a cap-and-trade 

system. Given the recent focus on tax reform and deficit 

reduction in the United States, this paper explores 

the design options and implications of a carbon tax 

embedded in broader fiscal reform. 

When economists talk about a GHG or carbon tax, 

they generally have several key features in mind. First, 

the tax would be an excise tax on the carbon content of 

fossil fuels. It would apply to other sources of CO2 and 

non-CO2 greenhouse gas emissions (with the tax scaled 

to those gases’ heat-trapping properties relative to CO2

) 

to the extent emitters and emissions are readily identifiable and taxing them would be administratively feasible. 

Second, the tax would be applied to fossil fuels as they 

enter the economy, at the choke points in their distribution system so that a large share of emissions could be 

taxed via a minimum number of firms. Next, the price 

signal would start modestly (although views differ on 

what that means) and ramp up gradually in real terms. 

Finally, the policy would allow tax credits for carbon 

in fuels that is not subsequently emitted, for example 

because it is sequestered underground or embodied in a 

long-lived product, such as plastics. All in all, economists 

generally recommend that the excise tax be simple and 

comprehensive, with few exemptions, complications, 

and ancillary policies. Of course, in practice it may not 

be that simple. Legislation may diverge substantially 

from the economists’ ideal, and some tax design details 

raise important challenges for which there is not a single 

obvious resolution, such as whether and how to address 

the burdens of the carbon tax on the poor. 

This paper reviews options for the design of a GHG 

tax in the United States. It first surveys the possible 

justifications for establishing a carbon tax and discusses 

its potential role in a broader fiscal reform package.3

We review evidence on how much revenue a carbon tax 

could raise, and by how much it could reduce emissions. We consider issues such as how to set the carbon 

price trajectory, options for using the revenue, and the 

likely distributional effects of different approaches. 

We also discuss how the tax could allow changes in 

command-and-control regulation of greenhouse gases 

and other energy policies, and how to prevent a U.S. 

carbon price from disadvantaging U.S. firms relative to 

their competitors in countries that do not equivalently 

control emissions. 
2 Center for Climate and Energy Solutions
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 3

II. RATIONALE FOR A CARBON TAX AND THE CONNECTION TO 

BROADER FISCAL REFORMS

An externality is a cost or benefit that is not transmitted 

through market prices. Human-induced greenhouse gas 

(GHG) emissions are a textbook example of a negative 

externality. The effect of GHG emissions on the environment will be felt by many individuals who did not directly 

engage in the activity that led to the emissions. Fossil fuels 

contain carbon and emit carbon dioxide (CO2

) into the 

atmosphere when burned. Without a charge for those 

emissions, the prices for those fuels reflect only the private 

costs to produce, distribute, and market them. Thus 

arises the case for an excise tax on the carbon content of 

those fuels to internalize those external costs and thereby 

ensure that market prices reflect the full social cost of 

emitting activities—including the estimated environmental damages of the emissions.4

One can compare a carbon tax to other ways of 

controlling GHG emissions.5

 A carbon tax that is consistent with a reasonable estimate of the marginal social 

damage from GHG emissions enhances economic efficiency by changing prices to more fully reflect the social 

costs associated with fossil fuels. In addition, studies have 

demonstrated that a tax is more efficient than commandand-control regulation in controlling carbon. A carbon 

tax is more efficient than a command-and-control 

regulation because it encourages many ways to reduce 

emissions at least cost, including through energy conservation and fuel switching in power plants.6

 In addition, 

a federal carbon tax would allow state- and local-level 

programs to reduce emissions further. In contrast, under 

a federal cap-and-trade system, additional GHG efforts 

in some states could free up allowances to allow greater 

emissions in other states.7

A carbon tax is also more efficient than subsidies 

for clean energy technologies for several reasons. First, 

it is very hard to target subsidies toward the most costeffective abatement, both because the government does 

not know which technologies will be most cost effective 

and because it is hard to implement a program that is 

not prone to political favoritism. Second, it is nearly 

impossible to preclude subsidizing abatement that would 

happen anyway.8

 Clean energy subsidies can also have 

the perverse effect of increasing the overall supply of 

energy and making it cheaper, partly offsetting the 

benefits of the subsidies. In short, it is easier to be cost 

effective in discouraging things we do not want than 

encouraging things we do want.

A carbon tax also promotes pollution-abating innovation, both because it offers relatively higher and more 

predictable returns from new technologies and because 

it incentivizes innovation across an array of potential 

activities. A carbon tax can be straightforward to administer if designed properly, and because an exact dollar 

figure is assigned, it may indicate a transparent level of 

effort to other countries, potentially fostering international agreements on environmental policies. And some 

economic research suggests that given the different structures of the uncertainties in the incremental benefits 

and costs of an extra ton of GHG abatement, setting a 

carbon price trajectory may be a better bet than setting 

annual country-level emissions targets.9

 Of course, over 

the long run, it is important to ensure that cumulative 

emissions of all countries do not exceed levels that would 

risk undue damages.

Scholars have studied the idea of embedding a GHG 

tax in a broader fiscal reform package. To be sure, tax 

reform may be hard enough without introducing issues 

as contentious as a carbon tax. However, a carbon tax 

could create opportunities within a tax reform package 

that would not otherwise exist. 

First, if we need revenue, taxing something we do not 

want (e.g., GHGs) rather than something we do want 

(e.g., productive labor and investment) intuitively makes 

sense. In other words, a well-designed carbon tax can be 

more economically efficient than other taxes because it 

helps correct a market failure as well as raise revenue. A 

few studies suggest that a carbon tax that substitutes for a 

more distortionary tax (such as income from investments 

or working) could even improve welfare irrespective of its 

environmental benefits by making the tax system more 

efficient.10 Of course, there are drawbacks to a carbon 
4 Center for Climate and Energy Solutions

tax, which is why embedding it as part of an overall 

package of fiscal reform is desirable. These drawbacks 

include the potential regressivity of a carbon tax, 

meaning it could impose a higher burden on low-income 

households as a share of their incomes than it would on 

high-income households. Further, the burden of the tax 

is likely to be higher in areas that are coal dependent 

than in areas that use other fuels for electricity. We 

discuss these and other issues, as well as the potential for 

a tax swap later in this paper. 

Second, a carbon tax can raise significant revenue 

over at least several decades. How much revenue 

depends on the tax rate and how quickly emissions fall. 

For example, estimates suggest that a price on carbon 

starting at about $16 per ton of CO2 in 2014 and rising 

at 4 percent over inflation would raise over $87 billion 

in the first year and increase to over $190 billion per 

year 20 years later.11 The revenue would continue to 

increase through the following two decades or so, but 

eventually the decline of the tax base (i.e., emissions) 

would outpace the increase in the tax rate, and total 

revenue would fall. Such a decline in revenue could be a 

fiscal concern but it would also signal the environmental 

success of the program.

Third, a carbon tax may be regressive, and even if not, 

it would still burden poor households that can ill afford 

higher energy prices. It is more economically efficient 

to address distributional effects through a broader 

progressive tax reform or targeted spending policy 

than to rebate the revenue in lump-sum payments to all 

households. However, a small share of revenue, around 

15 percent, targeted to the poorest 20 percent of households would ensure they are no worse off than without 

the carbon tax.

Fourth, a carbon tax could allow lower clean energy 

subsidies and less burdensome regulation. Numerous 

tax expenditures, loan guarantees, and other subsidies 

currently encourage deployment of renewable energy 

technologies and related research and development 

(R&D). With a carbon tax in place, some of those subsidies would compensate investors for what they would do 

anyway or distort investment toward higher cost abatement. Embedding a carbon tax in broader fiscal reform 

should allow lower federal direct and tax expenditures 

on those programs. 

Also, without action by lawmakers, the U.S. 

Environmental Protection Agency (EPA) has started 

to regulate GHGs under its Clean Air Act (CAA) 

authority.12 The CAA, with its emphasis on controlling 

pollution to specific emissions standards and state-level 

implementation, is ill suited to controlling GHGs at 

least cost. However, the CAA is the strongest existing 

authority the Obama Administration has, and EPA has 

plans underway to apply Section 111(b) of the CAA to 

control GHG emissions from new stationary sources and 

use Section 111(d) of the CAA to control GHG emissions 

from existing stationary sources.13 Some analysts believe 

that innovative interpretations of the law could allow 

more cost-effective flexibility, but any flexibility measures 

would likely be tested at length in court.14
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 5

III. ESTIMATED REVENUE AND EMISSIONS REDUCTIONS

To take just a few of the many studies that have modeled 

carbon pricing in the United States, this section reviews 

evidence from five illustrative analyses of a U.S. carbon 

tax. Like many of the studies in this literature, these five 

studies estimate the tax revenue and emissions reductions relative to a scenario, called the baseline, in which 

there is no carbon tax. The results hinge on the tax rate, 

which greenhouse gas (GHG) emissions fall under the 

tax, and the particular economic model and assumptions 

the scholars use. As summarized in Table 1, the five 

studies use different computational economic models to 

simulate slightly different tax policy scenarios. The policy 

scenarios start in different years, the carbon taxes start 

at different levels, and some of the scenarios increase the 

tax levels at different rates. The studies are listed in order 

of stringency of the policy considered, going from the 

lowest price per ton of carbon dioxide (CO2

)-equivalent 

in 2015 to the highest: 

• McKibbin et al. (2012a) use the G-Cubed model 

to simulate a tax that would equal about $18 per 

metric ton of CO2 in 2015 and apply only to CO2

from the energy sector. 

TABLE 1: Illustrative Economic Studies of U.S. GHG Tax Policy Scenarios

STUDY

TAX RATE 

IN 2015 (PER 

METRIC TON 

CO2-EQUIVALENT, 

2012 U.S. 

DOLLARS)

ANNUAL 

TAX RATE 

INCREASE 

(PERCENT)

ANNUAL 

REVENUES 

IN 2030 

($ BILLIONS, 

2012 U.S. 

DOLLARS)

PERCENT 

EMISSION 

REDUCTIONS, 

RELATIVE 

BASELINE 

IN 2030 TAX BASE

YEAR 

POLICY 

STARTS

McKibbin et 

al. (2012a)

17.76 4.0 real 196 11 CO2 from 

fossil fuels 

used in the 

energy sector

2012

Paltsev et al. 

(2007)

21.16 4.0 real 276 31 CO2 and 

other GHGs

2015

Rausch & 

Reilly (2012)

21.63 4.0 real 183 19 CO2 2013

Shapiro et al. 

(2008)

27.27 Variable; Tax 

increases 

about $1.80 

each year

331 30 CO2 2010

Rausch et al. 

(2010)

28.99 4.0 real 295 25 CO2 and 

other GHGs

2015

All values are converted to 2012 dollars using the CPI-U deflator. Values in 2015 dollars are converted to 2012 dollars by assuming inflation after 2012 is 2.5 percent per year, following Rausch et al. (2010). Shapiro et. al (2008) nominal carbon price comes from Table A.1 of their report. Metcalf (2010) reports the relevant 

data from Rausch et. al (2010) in a convenient format. 
6 Center for Climate and Energy Solutions

• Paltsev et al. (2007) use the EPPA model to estimate 

the tax trajectory necessary to achieve a cumulative emissions goal of 237 billion metric tons of 

CO2-equivalent from 2012 to 2050.15 The tax would 

equal about $21 per metric ton in 2015 and apply 

broadly to all GHGs. 

• Rausch & Reilly (2012) use the USREP model to 

analyze a tax of about the same level as Paltsev et al. 

(2007), but it only applies to CO2

 and not other GHGs.

• Shapiro et al. (2008) use the NEMS model to derive 

a tax scenario that, if applied globally by 2030, would 

stabilize CO2

 concentrations in the atmosphere at 

450 to 550 parts per million through the end of the 

21st century. Instead of constant percent increase in 

the tax rate, the scenario assumes the each year the 

tax rate goes up by the same dollar amount.

• Rausch et al. (2010) use the USREP model to 

simulate congressional cap-and-trade proposals. 

The focus of the study is on the effect of the 

measures on households, but the results are also 

useful for comparison to the other policy simulations presented here. 

REVENUES

The studies’ estimated trajectory of GHG tax revenues 

from 2015 through 2030 appear in Figure 1. All of the 

studies predict substantial and rising revenues. McKibbin 

et al. (2012a) estimate revenues of nearly $100 billion 

in 2015, and all other estimates are at least as high. 

Comparing these studies suggests a couple of lessons. 

First, all else equal, including non-CO2 gases under the 

tax will raise more revenue than taxing only carbon. 

For example, Shapiro et al. (2008) impose a significantly 

higher tax rate in 2015 than Paltsev et al. (2007) but 

predict similar revenue in 2015, in part because the 

Shapiro study taxes only CO2. 

Also, more recent studies predict lower carbon tax 

revenues than earlier studies because they account for 

recent trends in the U.S. energy sector and emissions. 

Two major factors have driven down U.S. emissions since 

the earlier studies: the great recession and the degree 

to which natural gas has displaced coal in electricity 

production. Despite a very similar tax rate, Rausch & 

Reilly (2012) estimate significantly less revenue than 

Paltsev et al. (2007). That is because the more recent 

study only taxes carbon and calibrates to more recent 

projections of fuel prices and emissions levels. Thus 

we can conclude that to some extent, the revenue and 

environmental performance of a carbon tax will depend 

on trends in the energy sector that are driven by factors 

other than the tax. 

Unexpected technological developments, such as the 

recent widespread deployment of horizontal drilling and 

fracking to release large supplies of natural gas, can have 

a significant effect on emissions, both in the baseline 

and in the response to a carbon price. These technology 

developments (and more general macroeconomic trends) 

could work to make emissions goals harder or easier. One 

FIGURE 1: Estimated Carbon Tax Revenue in Five Illustrative Studies 

$0

$50

$100

$150

$200

$250

$300

$350

2015 2020 2025 2030

Annual Revenue in Billions of 2012 U.S. Dollars

McKibbin et al (2012)

Shapiro et al (2008)

Paltsev et al (2007)

Rausch et al (2010)

Rausch & Reilly (2012)

Year
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 7

key advantage of the carbon tax relative to many other 

approaches is that it encourages new technologies exactly 

in line with their propensity to reduce GHG emissions. It 

is hard to estimate the returns from aligning technology 

incentives with abatement goals, but over a long period 

of time, it is likely to be very important.

Finally, comparing all of these studies suggests that even 

in the most modest scenario, a U.S. carbon tax could bring 

in substantial and rising levels of revenue through the first 

decades of the policy. Section VIII below considers in detail 

the economics of how to manage this revenue to the benefit 

of the U.S. macroeconomy and households.

EMISSIONS

Revenue is an important consideration, but the environmental performance of a carbon tax is another critical 

factor. Figure 2 graphs the percent reduction in emissions relative to the baseline (for the taxed set of gases) 

estimated in the five studies.16 All of the studies estimate 

significant abatement in taxed emissions by 2030. For 

instance, Rausch et al. (2010) predict that emissions 

will fall by about 15 percent in 15 years. With the lowest 

tax rate, McKibbin et al. (2012a) predictably finds the 

smallest reduction in emissions, but even in that study, 

emissions decline by 11 percent relative to baseline by 

2030. Paltsev et al. (2007) find that non-CO2 gas emissions decline at relatively low tax rates. Thus, including 

those gases under the tax makes sense to the extent that 

it is administratively feasible. 

CARBON TAXES IN DEFICIT REDUCTION 

PROPOSALS

Given the revenue potential, it is no wonder that a 

number of prominent deficit reduction proposals have 

considered a carbon tax. One source of deficit-reducing 

ideas is the options paper by the U.S. Congressional 

Budget Office (CBO) (2011). In one revenue option, 

CBO considered a cap-and-trade system for cutting 

GHGs in which cap would be set so that allowances 

would trade at $20 per metric ton at first and then rise 

at a nominal rate of about 5.6 percent annually. This is 

equivalent to a carbon tax if the government auctions the 

allowances. CBO estimated that this policy would raise 

about $1.2 trillion from 2012 to 2021. It also estimated 

that emissions from the covered sectors would fall by 

about 20 percent from their projected amounts in 2025 

and by 50 percent from their projected amounts in 2050.

Galston and MacGuineas (2010) recommend enacting 

a broad-based carbon tax in their comprehensive deficit 

plan. They would use some carbon tax proceeds to 

reduce the payroll tax and the rest to reduce the deficit. 

They propose a tax starting at $23 per ton of CO2, 

increasing at 5.8 percent per year. They argue their 

proposed partial tax swap approach should foster growth 

in output and employment. 

Of the six independent deficit reduction proposals 

commissioned by the Peterson Institute’s Solutions 

Initiative (2011), four proposed a carbon tax. For 

example, the proposal from scholars at the American 

FIGURE 2: Percent GHG Abatement Relative to Baseline in Five Illustrative Studies

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

2015 2020 2025 2030

Percent Change in Emissions Relative to Baseline

Rausch et al (2010)

Paltsev et al (2007)

Shapiro et al (2008)

Rausch & Reilly (2012)

McKibbin et al (2012)

Year
8 Center for Climate and Energy Solutions

Enterprise Institute, which appears in Antos et al. (2011), 

chose to “address environmental externalities in a more 

cost-effective and market-based manner,” by replacing 

energy subsidies, tax credits, and regulations with a 

carbon tax. Their proposed tax would be similar to a 

tax version of CBO (2011). It would take effect in 2013 

and phase in at a uniform pace over five years so that the 

2017 tax equaled the level prescribed for that year in the 

CBO option, slightly more than $26 per metric ton of 

CO2 -equivalent, and increase at a nominal 5.6 percent 

annual rate through 2050.

The Bipartisan Policy Center’s Debt Reduction Task 

Force chaired by Pete Domenici and Alice Rivlin also 

considered, but did not ultimately propose, a carbon 

tax of $23 per ton of CO2 emissions starting in 2018, 

increasing at 5.8 percent annually. 17 The task force 

estimated that the carbon tax would have raised about 

$1.1 trillion in cumulative revenue by 2025, while 

resulting in carbon emissions in that year of 10 percent 

below 2005 levels. 

In addition, a number of individual economists have 

offered detailed proposals for implementing a carbon 

tax to reduce the deficit and/or reduce other taxes.18

For example, Morris (2013b) suggests an approach that 

would “within twenty years ...reduce annual emissions by 

12 percent from baseline levels, generate enough revenue 

to lower the corporate income tax rate by 7 percentage 

points, and decrease the deficit by $815 billion, all while 

protecting the poorest households from undue burden.” 

Aldy (2013) offers a similar proposal. The conclusion 

here is that a well-designed carbon tax is a solid option 

for funding deficit reduction and tax reform, and it is 

supported by many experts.
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 9

IV. CONSIDERATIONS IN SETTING THE PRICE ON CARBON AND 

ITS TRAJECTORY OVER TIME

From an economic perspective, the appropriate price on 

carbon is a reflection of its external costs. The “external 

costs” are the damages to the environment that are 

projected to result from emitting greenhouse gases 

(GHGs) into the atmosphere. Ideally, as noted above, 

policymakers would globally internalize those costs 

by putting a price on emissions that approximates the 

present (monetary) value of the incremental damages 

from a ton of GHG emissions over its life in the atmosphere and subsequent absorption in terrestrial ecosystems and the ocean. This value is known as the “social 

cost of carbon,” or SCC, and a large body of research 

has sought to understand it and value it. Another way 

to think about the SCC is that it captures the marginal 

benefit of controlling emissions, or equivalently, the net 

damages avoided.19 While a full treatment of potential 

climate change outcomes is beyond the scope of this 

paper, the U.S. National Research Council (2012) 

describes the potential for increasing global mean 

temperatures, sea level rise, ocean ecosystem changes, 

and disruptions in precipitation patterns. 

Several challenges to estimating the social cost of 

carbon arise in practice. First, many of the potential 

environmental and human health impacts are hard to 

monetize because their damages are not revealed in 

ordinary market outcomes. For example, what monetary 

value applies to the risk of disappearing arctic ice floes 

and the resulting extinction of polar bears in the wild? 

What if as the earth warms, vector borne diseases proliferate, and new populations become vulnerable to malaria? 

Researchers have developed some methodologies to 

estimate these damages, for example by assessing peoples’ 

willingness to pay to avoid them, but different approaches 

can lead to wildly different estimates.20 A related problem 

arises in trying to account for low probability but very high 

damage scenarios of climate disruption. Some scholars 

argue that even a very small probability of catastrophic 

outcomes justifies large carbon prices now.21

A particular challenge for estimating the SCC is 

accounting for potential damages in the distant future. 

Over long time horizons any non-negligible discount rate 

results in low present values, and all sorts of important 

ethical and analytical issues arise in determining what 

discount rates and inter-generational measures of wellbeing should apply.22

Finally, environmental damage derives from global 

concentrations of GHGs. The United States has diminishing control over those concentrations because the U.S. 

share of annual global emissions is falling as emissions 

from developing economies rise. So even if the United 

States adopted a carbon tax at “the correct” SCC, the 

actual resulting marginal benefits of the U.S. carbon 

price also depend on other countries’ emissions. In 

this way controlling emissions is the ultimate “common 

property” challenge. This is absolutely not a reason not 

to control U.S. emissions. In fact, many other countries, 

including the European Union, Australia, and Sweden, 

have started to price carbon through cap-and-trade 

programs or carbon taxes. Nevertheless, many countries, 

especially rapidly developing countries, are far less likely 

to undertake ambitious action to reduce emissions if the 

United States does not. Leveraging U.S. action into action 

by other countries is central to achieving meaningful 

outcomes over the long run. 

A number of studies have sought to estimate a SCC. 

A full literature review is beyond the scope of this paper, 

but one study that is particularly relevant for policy 

purposes is the exercise by the Obama Administration 

to develop SCC estimates for calculating the potential 

net benefits of the myriad federal regulations that affect 

GHG emissions. In a recent update, an interagency team 

examined the estimates from a variety of models that 

include outcomes that might be affected by climatic 

disruption: net agricultural productivity, human health, 

property damages from sea level rise, and the value of 

ecosystem services.23 The interagency group identified 

four SCC estimates for 2015 that span the analyses they 

reviewed: $12, $38, $58, and $109 (in 2007 dollars) per 

metric ton of carbon dioxide (CO2

). The group based the 

first three estimates on the average SCC across several 
10 Center for Climate and Energy Solutions

integrated assessment models and socio-economic and 

emissions scenarios using discount rates of 5, 3, and 2.5 

percent, respectively. The high value of $109 represents 

the SCC under a scenario of higher-than-expected 

impacts from temperature change. 

Some scholars believe that the “true” SCC is higher 

than the range cited in the report, and others believe 

that it is lower. Any estimate of the SCC necessarily 

involves important assumptions about the appropriate 

discount rate and how to monetize ecological and social 

outcomes, along with the use of models that themselves 

include many estimated parameters and assumptions. 

There are complicated debates around all of these 

methodologies. As this literature matures, one should 

view any SCC estimate as just that. 

To stabilize GHG concentrations, economies across 

the globe must essentially de-carbonize.24 To achieve any 

particular cumulative emissions target (or equivalently, 

concentration stabilization target) at least cost, it makes 

sense to incentivize abatement such that firms do not 

prematurely scrap expensive long-lived capital, but also 

do not delay deploying new less emissions-intensive 

capital. A full treatment of the inter-temporal optimization problem for abatement is beyond the scope of this 

paper.25 However, many economists recommend that the 

real rate of increase in the tax be no higher than the 

returns on relatively low-risk capital assets, which is about 

4 or 5 percentage points above inflation.26 This would 

avoid the pitfall that rapidly rising taxes can accelerate 

emissions if fossil carbon resource owners speed up 

extracting their resources in anticipation of higher 

future taxes.27

Despite these complications in determining the SCC, 

we can safely say the marginal benefit from the United 

States abating GHG emissions is not zero, and it is not 

infinite. We also safely say that it is very uncertain.28

Simplistically, the policy problem is to set a carbon price 

that reasonably captures our current best estimate of 

potential damages (but not so high it fails politically), 

ramp it up over time, and prepare to update it as new 

information develops.29

One challenge is determining that updating process. 

The more certainty and advance notice policymakers 

provide in the tax design, the more cost-effectively firms 

and households can adapt to the price changes. Given 

that electric power plants and major industrial facilities 

have lifetimes of 50 years or more, it makes sense to 

provide as much certainty and advance notice as feasible. 

And indeed, predictability of price is one of the key 

benefits of a carbon tax. Also, concentrations of GHGs 

change much more slowly than annual emissions, so 

abrupt changes in price signals and emissions are unwarranted. On the other hand, the scientific evidence could 

evolve and that could change the optimal policy. Giving 

firms notice of tax rates at least a decade in advance, 

for example with a rolling schedule of announcements, 

could strike a reasonable balance.

A related challenge surrounds not just how and when 

the carbon price should change, but who should decide 

and on what basis. Congress or a delegated agency could 

update the tax according to a formula that targets a 

particular long-run goal for U.S. emissions.30 In general, 

though, congress eschews delegating tax rates to the 

executive branch or third parties, and it is hard to 

imagine an exception here. Reaching consensus on a 

long-run goal also adds another hurdle to the legislation, 

especially if the bill is focused on fiscal reform. Further, 

setting an economic variable like a tax rate by a formula 

with unknown future parameters could inadvertently 

impose politically infeasible stringency. Congress could 

insert some built-in discretion or orderly retreat from 

such stringency if necessary, but that would itself raise 

uncertainty about the environmental performance of the 

program along with introducing uncertainty in the price 

signal for investors. It may be most feasible to set a longrun trajectory for the tax and establish periodic congressional reviews of evidence provided by expert agencies 

on the economic and environmental performance of 

the tax, as well as new climate science. Congress and the 

president could revise the U.S. tax rate path accordingly 

as they see fit.31

Another way to approach carbon tax design is to think 

of it purely as a revenue instrument. In that case, policymakers would work backward from how much revenue 

the tax should produce. The tax rate would likely be 

higher or lower than its environmental merits dictate, 

but it would achieve its fiscal purpose. In that sense it 

would be more like a gasoline tax that funds transportation infrastructure than a measure designed specifically 

to address environmental externalities. Of course, 

tax rates lower than the SCC (assuming we knew the 

appropriate level) would be inefficiently low and external 

costs would not be fully internalized. Additional policy 

measures would be necessary to appropriately address 

the market failure of environmental damages, and in 

that case policymakers are likely choosing a less cost-
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 11

effective approach than setting the carbon price at the 

SCC. Even if the government uses carbon tax revenues 

optimally and the price signal matches the SCC, however, 

there may be a political limit on the acceptability of 

higher energy prices, particularly in the short run before 

people have time to adjust.

Finally, the United States could look to other carbon 

pricing programs for examples. Table 2 summarizes a 

number of benchmark carbon prices (primarily 2015 

forward prices), including the SCC from the U.S. government report, sub-federal programs in the United States, 

and carbon prices abroad.32 While all of these programs 

price carbon, a number of these do not price all fossil 

energy carbon. For example, the Australian’s carbon tax 

excluded oil, and the Regional Greenhouse Gas Initiative 

only prices emissions from the power sector. 

One problem with looking to other carbon pricing 

programs, such as the European Union’s cap-and-trade 

program, for a benchmark on ambition is that those 

programs’ prices can be depressed by ancillary policies, 

such as renewable mandates and efficiency standards 

that drive down emissions. Thus those countries may 

have policies that impose much higher costs of abatement than the trading price would suggest.

TABLE 2: Benchmark CO2 Prices

CARBON PRICE BENCHMARK PRICE PER METRIC TON OF CO2-EQUIVALENT (2012 US$)

U.S. 2015 SCC, 5% discount rate* 12.18

U.S. 2015 SCC, 3% discount rate* 40.97

Trading price of allowances in the European Union’s 

Emissions Trading System (EU ETS)** 

9.20

Carbon tax in British Columbia, Canada*** 29.70

Carbon tax in Australia, as of July 2012† 23.00

Carbon tax in Sweden†† 151.08

EPA projection for CO2 allowance trading price under 

H.R. 2454 in 2015, Scenario 3†††

14.95

Settlement price of California’s GHG cap-and-trade 

allowances, advance auction of 2015 vintage‡

10.00

Regional GHG Initiative, Auction 18 clearing price for 

CO2 allowances, December 5, 2012‡‡

1.93

Note: Using the average exchange rate for July 2012, foreign currency was converted into U.S. dollars where US$ 1 is equal to: EUR 0.91; CN$ 1.01; AUS$ 23; SEK 

6.95. 

* U.S. Government Interagency Working Group on Social Cost of Carbon, Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis Under 

Executive Order 12866 (Washington, DC: White House, 2013). http://www.whitehouse.gov/sites/default/files/omb/assets/inforeg/technical-update-social-cost-ofcarbon-for-regulator-impact-analysis.pdf.

** “European Union Allowance,” Thomson Reuters Point Carbon, last accessed March 25, 2014, http://www.pointcarbon.com

*** “How the Carbon Tax Works,” Province of British Columbia, last accessed March 25, 2014, http://www.fin.gov.bc.ca/tbs/tp/climate/A4.htm.

† Center for Climate and Energy Solutions (2011).

†† Swedish Energy Agency, Energy in Sweden 2011 (Kungsgatan, Sweden: Swedish Energy Agency, 2012), https://energimyndigheten.a-w2m.se/FolderContents.

mvc/Download?ResourceId=2609. 

††† See Scenario 3 of EPA’s Analysis of the American Clean Energy and Security Act of 2009 H.R. 2454 in the 111th Congress (Washington, DC: U.S. Environmental Protection Agency, 2009), http://www.epa.gov/climatechange/Downloads/EPAactivities/HR2454_Analysis.pdf.

‡ California Environmental Protection Agency Air Resource Board, California Air Resources Board Quarterly Auction 1 (Sacramento, CA: California Environmental 

Protection Agency, 2012), http://www.arb.ca.gov/cc/capandtrade/auction/november_2012/updated_nov_results.pdf.

‡‡ Potomac Economics, Market Monitor Report for Auction 18 (New York, NY: Regional Greenhouse Gas Initiative, Inc., 2012), http://www.rggi.org/docs/Auctions/18/Auction_18_Market_Monitor_Report.pdf.
12 Center for Climate and Energy Solutions
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 13

V. TAX ADMINISTRATION AND OTHER DESIGN ISSUES

The more sources that are covered, the broader the 

scope of the price signal and the more marginal costs of 

abatement will equalize across the economy. Equalizing 

abatement costs is the most economically efficient 

approach because it delivers the same incremental 

incentive to abate in all sectors and ensures that overall 

costs are as low as possible. As noted by Ramseur et al. 

(2012), the tax could apply at the “upstream” stage in the 

fuel distribution system, when the carbon-containing 

fossil fuel is first sold following production. Or, the point 

of taxation could be “downstream” where the pollution is 

released to the atmosphere. To get the broadest coverage 

with the fewest taxpayers and minimal administrative 

costs, the tax should be applied at the choke point in 

the energy distribution system, such as at the petroleum 

refineries for oil, wells or processing plants for natural 

gas, and for coal at mines or coal-fired power plants 

and industrial facilities. Imported fuels could also be 

taxed at the border. Metcalf and Weisbach (2009) show 

that collecting the tax upstream from fewer than 3,000 

entities could cover 80 percent of U.S. greenhouse gas 

(GHG) emissions. 

Other GHG emissions could also be taxed, but 

in general the broader the tax beyond the facilities 

mentioned, the more administratively challenging 

it would be. Certain carbon emissions from cement 

and steel manufacturing might be feasible to tax, but 

methane emissions from ruminant livestock may not be.

Carbon in fossil fuels that is not emitted should arguably not be subject to the tax. This would be particularly 

important to incentivize technologies that capture and 

store carbon, for example, when carbon dioxide (CO2

) 

is stripped from the combustion gases of a power plant 

and stored underground in an approved manner. Other 

examples of non-emitted carbon include petroleum 

distillates such as tar that are not burned, and carbon in 

plastic, waxes, and other non-combusted products made 

of fossil fuels. Producers of such goods could receive 

tradable tax credits that would compensate them for the 

carbon tax embedded in the prices of their feedstocks. 

The United States exports some fossil fuels, particularly coal.33 Policymakers could exclude carbon in those 

exported fuels from the tax, as Australia has, to ensure 

the competitiveness of U.S. exporters. Alternatively, they 

could tax carbon in exported fuels to raise more revenue 

and possibly lower emissions abroad.

EXISTING ENERGY TAXES

The design of a carbon tax could take into account the 

myriad existing levies on fossil fuels and other environmental taxes and incorporate a carbon tax in existing 

revenue instruments. The list of such levies is long. 

Some examples:

• The federal government imposes a motor fuels 

excise tax, which is $0.184 per gallon of gasoline. 

Of that, 0.1 cent is dedicated to the Leaking 

Underground Storage Tank Trust Fund and the 

remainder is earmarked to the Highway Trust Fund. 

• In addition, congress enacted a gas-guzzler tax as 

part of the Energy Tax Act of 1978. It levies a tax 

on automobiles that achieve fuel mileage below 

22.5 miles per gallon. Tax rates range from $1,000 

to $7,700 per vehicle. In 2010, the gas-guzzler tax 

raised $85 million. 

• The Energy Policy Act of 2005 resurrected the Oil 

Spill Liability Trust Fund tax at the original rate 

of 5 cents per barrel, and it rose to 8 cents per 

barrel in 2009. It falls on crude oil received at U.S. 

refineries as well as imported petroleum products. 

Domestic crude oil for export is also subject to the 

tax if the tax has not been previously paid. 

• The United States also already has a small excise 

tax on coal, and it may be possible to superimpose a 

carbon tax onto it for some producers.34 It funds the 

Black Lung Disability Trust Fund and applies to coal 

mined domestically, but excludes lignite. The tax is 

4.4 percent of the sales price up to a limit of $1.10 

per ton of underground coal and $0.55 per ton of 

surface-mined coal. According to the federal budget 

for fiscal year 2011, this tax raised $610 million 

in 2010.
14 Center for Climate and Energy Solutions

• Gasoline for speedboats is taxed at the same rate 

as highway gasoline and diesel fuel, and the funds 

are allocated to the Aquatic Resources Trust 

Fund. Finally, commercial vessels using the inland 

waterway system pay a fuel tax of 20 cents per gallon 

of fuel sold and an additional 0.1 cent tax per 

gallon for the Leaking Underground Storage Tank 

Trust Fund. 

In addition, states levy a variety of environmental 

taxes, including taxes on motor fuels. The rates vary 

across states, but they averaged 23.5 cents per gallon of 

gasoline, 24.5 cents per gallon of diesel fuel, and 23.4 

cents per gallon of gasohol in 2012. States typically levy 

these fees through a general sales tax on purchases. 

State governments also levy a variety of pollution fees, 

hazardous waste charges, tire disposal fees, and other 

assorted charges. 

In theory, it might be possible to add a carbonbased upcharge to these existing taxes, for example by 

separately raising the gasoline tax and the other fuel 

excise taxes. However, doing so would likely be less 

economically efficient than a single broad carbon tax 

applied across all fuels because not all carbon falls under 

an existing tax, and it would be hard to ensure that the 

increases in the various taxes properly reflect carbon 

content and rise in concert over time. In addition, raising 

any tax is politically difficult, and adding a carbon fee 

to a multitude of existing taxes would seem to make the 

political lift that much heavier. However, it could lower 

overall administrative costs to impose a separate carbon 

tax at the same point in the distribution system as other 

fossil fuel taxes.

So what should happen to these other taxes if the 

federal government institutes a carbon tax? Should 

the carbon tax sit on top of them, or should it replace 

them? Two considerations apply. The first is whether 

there are other external costs to each fuel besides GHG 

emissions. For example, many external costs apply to 

driving besides CO2 emissions, including traffic congestion and emissions of non-GHG pollutants. Thus a case 

may be made for a tax on motor fuels that is greater than 

the carbon tax. However, some of those external costs, 

especially congestion, vary significantly by location and 

time and have little to do with the gasoline consumption 

of vehicles. Other policy measures, such as congestion 

pricing, could be better instruments to address those 

social costs. 

The other consideration is how the government 

might fund the activities currently financed by those 

existing taxes, should they be eliminated. For example, 

if a carbon tax replaced the coal tax or the tax on motor 

vehicle fuels, would policymakers need to earmark some 

of the carbon tax revenue to assist black lung victims or 

fund highways? In the view of many experts, the Highway 

Trust Fund is already underfunded as the real value 

of the motor vehicle fuel tax declines and tighter fuel 

economy standards erode the tax base. 

Although the United States imposes several individual 

taxes on fossil energy, in aggregate they are much 

smaller than energy taxes abroad.35 Metcalf (2009) 

notes that the United States’ reliance on these taxes 

is far below that of other developed countries.36 The 

United States collects 0.79 percent of gross domestic 

product (GDP) in these taxes at the federal and state 

level. In contrast, the Czech Republic, Denmark, Turkey, 

and the Netherlands, among others, collect around 3 

percent of GDP from environmental taxes and charges. 

If the United States relied on environmental taxes to 

the same extent as other countries in the Organization 

for Economic Cooperation and Development, it would 

collect far more revenue than it does. For example, if 

the United States collected 3 percent of GDP in environmental taxes, it would have brought in over $314.5 

billion, a 250 percent increase from the $114.5 billion in 

actual revenue from those sources.

OFFSETS

Another issue in the design of a tax is whether or not 

the government should allow firms to comply with their 

tax obligations by surrendering tax credits generated by 

GHG offset projects. Offsets would be certified emissions 

reductions undertaken by entities not covered by the 

tax, such as landowners who plant carbon-sequestering 

forests. Providers of offsets and taxed entities can both 

benefit if abatement outside the taxed sectors is lower 

cost than within the taxed sectors. On the other hand, 

offsets are necessarily complicated. Offsets would reduce 

revenue to the government, require substantially more 

regulation and oversight, and introduce the prospect 

of giving credit toward abatement that would have 

happened anyway. Some offsets, such as those that 

promote conversion of farmland to forest, may also 

produce ancillary benefits (such as improved habitat) 

as well as unintended consequences (such as higher 

food prices). 
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 15

Allowing offsets could result in vastly different 

investment patterns than would arise in a system that 

does not. For example, EPA analysis of the American 

Clean Energy and Security Act of 2009 (H.R. 2454 of the 

111th Congress), also known as ACESA, estimated that in 

the early decades under a cap-and-trade system, unfettered access to offsets would induce U.S. firms to spend 

several times more on imported offsets than on domestic 

abatement.37 Much of this investment would have been 

in the energy sectors of large developing countries, and 

it would have generated large and politically sensitive 

transfers to competing economies. Thus offsets, while 

possibly inducing additional low-cost abatement, could 

complicate tax administration and blunt incentives to 

transform the U.S. energy system. Other policies could 

take up the objective of encouraging cost-effective emissions abatement outside the taxed sources. 

IMPROVING INCENTIVES TO RETAIN THE TAX

One critique of a carbon tax, as opposed to a cap-andtrade system, is that taxpayers always have the incentive 

to repeal it, and the incentive could grow along with 

the tax rate. Tradable emission allowance systems, in 

contrast, create a constituency of allowance holders that 

want to protect the program because it protects the value 

of their allowance assets.38 Allowing firms to comply with 

future tax liabilities early could help this problem. For 

example, the government could allow firms to purchase 

tradable tax compliance credits by paying taxes now 

for a specified level of emissions in the future (at the 

tax rate in the law that applies in that future year).39

The government would get the revenue early, and firms 

could procure tax compliance at known rates, insuring 

against future policy changes that raise tax rates above 

current levels. Firms who hold these credits are likely to 

support the continued implementation of the program, 

even its strengthening, since that would increase the 

value of their tradable tax credit assets. A strong political 

consensus for the continuation of the program increases 

investors’ confidence the program will endure, and that 

strengthens incentives to invest in abatement and lowcarbon technologies. Over the long run this can lower 

the overall costs of achieving environmental goals.
16 Center for Climate and Energy Solutions
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 17

VI. THE COST OF A CARBON TAX

Policymakers are keenly interested in the likely effect of 

a carbon tax on their constituents and the U.S. economy. 

To be sure, when we talk here about the “cost” of the 

tax, we mean the overall cost to the U.S. economy of 

abating emissions, not accounting for the environmental 

and economic benefits that come with it. The cost of not 

taking action could be enormous, but analytically that 

falls under the benefits from mitigation. One should not 

infer anything about the net benefits of the carbon tax 

from the focus in this section on the costs of abatement 

and other economic effects of the tax, which include 

the broader macroeconomic shifts that flow from the 

particular policy approach to pricing greenhouse 

gases (GHGs). 

Economists call all the ways people may be made 

better or worse off as a result of a policy its “economic 

incidence” or “distributional effects.”40 One often hears 

about how a particular policy approach might benefit 

or burden corporations as opposed to individuals or 

vice versa. Although the legal system treats firms as if 

they were people, the ultimate economic burdens and 

benefits of any policy fall not on legal entities but on the 

owners of firms (shareholders), workers, consumers, and 

other individuals. 

To analyze the impacts of tax changes, economists use 

computerized economic models to estimate two scenarios. 

The first is the likely emissions and economic trajectory 

without the carbon tax. This is called the businessas-usual (BAU), baseline, or reference scenario. The 

policy scenario tracks the results from a specific policy 

intervention, and we usually compare a policy scenario 

to the baseline or another policy scenario. Depending on 

the nature of the policy scenario, analysts specify the tax 

policy and estimate its effects, or they derive the tax rates 

necessary to achieve a particular emissions target. Some 

models, called general equilibrium models, also estimate 

all the other changes in the economy that can result from 

a price on carbon, such as shifts in prices for goods and 

services, wages, terms of trade, and so on.

The overall economic effect of a carbon tax is the 

net result of three factors: the incidence of the price 

increases that result (i.e., who bears those prices and 

by how much), the final disposition of the carbon tax 

revenue, and all the changes that ripple through the 

broader economy. Figure 3 below illustrates how a 

carbon tax reduces emissions. The curve sloping up illustrates the marginal abatement cost curve in a given year 

for the emissions covered by the tax. The vertical axis is 

the cost of abating one ton of carbon dioxide (CO2

). The 

horizontal axis is the amount of emissions reduction relative to BAU emissions. The incremental cost of abating a 

ton starts low for the first tons of abatement (the part of 

the curve near the origin). As the opportunities for lowcost abatement are used up, the marginal cost gradually 

goes up as emissions reductions increase, moving from 

left to right on the graph.41 A tax on emissions of $P per 

ton of CO2 will reduce emissions until it is cheaper to pay 

the tax than reduce emissions more, so emissions fall 

FIGURE 3: Abatement Cost and Tax Revenue 

are Different

Tax Reveue

Triangle = 

total cost of abatement

P

$/ton

CO2

Reduction

from

businessas-usual

emissions

Marginal

abatement cost

Q = Emissions after the tax
18 Center for Climate and Energy Solutions

by the length of the arrow. The width of the brace (Q) 

below the horizontal axis represents the emissions that 

remain after the tax of P is imposed. Thus the tax of $P 

is the cost of the last ton abated under the policy.

The shaded triangle pointing towards the origin 

shows the total abatement cost; it is the sum of the cost of 

abatement for all the tons reflected in the arrow, leading 

up to the last ton abated at a cost of $P. The rectangle 

labeled “Tax Revenue” is the price of emissions per ton 

(the tax rate) times their quantity Q (in tons). Figure 3

shows that, depending on the level of abatement, the 

tax revenue (the rectangle) can be a lot larger than the 

overall costs of abatement (the triangle). 

When the program goes into effect, prices go up to 

reflect the tax and abatement as costs of production. The 

rectangle is not a real resource cost, but rather a transfer 

from those who bear the burden of the tax payments and 

those who get the revenue. 

Who bears the incidence of a tax? One might think 

that firms bear the full cost of the taxes they pay.42

However, economic analyses estimate that in the long 

run taxed firms and other firms further down their 

supply chain will pass most of their costs to consumers 

through higher prices. Harberger (1962) pioneered 

the general equilibrium study of tax incidence, which 

considered not only what happens in the taxed sector but 

in all the ancillary sectors (that is what general equilibrium means). This shifting of tax burdens across sectors 

and economic actors is what economists mean when 

they talk about the transmission of “price signals.” Put 

another way, the statutory incidence of a tax on carbon is 

not equal to the economic incidence. 

Whether firms can pass through the entire cost of the 

tax and emissions abatement to their customers depends 

on how prices are determined in their market (e.g., how 

responsive demand and supply are to prices) and the 

time frame under consideration. In the long run, capital 

and labor are malleable and mobile. That means that 

factor markets will reallocate those resources in light 

of the new relative prices on fuels, energy, and everything else affected by the carbon price. Through this 

reallocation, competitive markets will pass most of the 

price signal along to consumers in higher retail prices 

for energy and other goods and services. Those higher 

energy prices are integral to the economic efficiency of 

the tax. They lower the cost of the program by inducing 

more efficient energy use and greater investment in 

developing energy-efficient technologies.43

Even if covered entities and other energy-intensive 

firms can eventually pass along most of their costs of 

meeting environmental goals in output prices, such a 

policy can affect shareholders and workers. Consider, 

say, coal producers, with highly specialized facilities and 

equipment. Even if they pass the price on carbon to their 

customers, they can be worse off because at higher prices 

they will sell less than they did before, meaning less 

revenue to cover their fixed capital costs. The owners of 

the firms can reallocate their capital over the long run, 

but in the short to medium run this is costly and timeconsuming.44 Likewise, workers with skills specific to coal 

mining may be let go as output falls. They may have to 

retrain or move in order to find work, and their new jobs 

may pay less than their old ones. Even more likely, some 

occupations will simply not be growth fields, and new 

workers will move in other directions.

As global efforts to control GHG emissions ramp 

up, we expect emissions-intensive production to shrink 

substantially. But falling output in those markets does 

not necessarily mean all those shareholders are hurt over 

the long run. As output falls and capital is redeployed, 

the costs of production fall along with output.45 Unless 

stockholders were receiving above-normal profits, the 

capital deployed to the sector will fall without long-run 

damage to the returns to the last dollar still invested. 

The primary burden on owners of capital and workers 

in fossil industries will be from the adjustment costs 

they incur in moving to other sectors, unless they own 

immobile assets such as coal deposits. 

The government can minimize adjustment costs by 

introducing the carbon price gradually and predictably, 

allowing time for efficient turnover of physical capital 

such as industrial plants and equipment. Key to reducing 

these adjustment costs is the formulation of credible 

long-run expectations around the price of carbon. 

Likewise, a predictable phase-in also allows fossil energy 

workers and the labor market more generally to adjust 

through attrition and retraining, without the need for 

layoffs and displacement. The gradual ramp up also 

allows consumers to shift their consumption patterns, for 

example by purchasing more energy-efficient appliances 

as their old ones die a natural death. Thus the incidence 

of the program can depend on the timing of emissions 

reductions as well as their level.46

Despite the clear advantage of predictable policy, 

research indicates that even if the carbon constraint is 

unanticipated and firms incur capital adjustment costs, 
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 19

the share of the overall burden of the carbon constraint 

that falls to energy firm shareholders (relative to 

consumers) is likely to be small. Bovenberg and Goulder 

(2001) explain that a price on carbon can lower stock 

values by lowering profits and the stream of dividends 

as firms incur capital adjustment costs. The authors 

used a general equilibrium model of the U.S. economy 

to estimate the share of cap-and-trade allowances (the 

value of which is analogous to revenue from a carbon 

tax) that the government would have to give to firms in 

order for stock prices not to fall. They find that to keep 

oil and gas shareholders whole, the government would 

need to give them only 15 percent of the value of emissions allowances they would need to cover their emissions 

from those fuels. Coal producers would need only about 

4 to 5 percent. The reason that these firms need so little 

compensation to preserve their stock values is that they 

can shift most of the cost on to their customers, even 

from the start of the program.

As Viard (2009a) points out, even if stockholders 

do experience a hit to their stock values from a 

price on carbon, that by itself is not an argument for 

compensating them. As residual claimants, shareholders are affected by all sorts of tax, regulatory, and 

environmental policy changes for which they are not 

compensated. Moreover, one can argue that some have 

benefited from the existence of a market failure that is 

now being corrected.

So far, this discussion has focused on those who 

would be negatively impacted by a carbon tax. But just as 

owners of capital and workers in some sectors are made 

worse off in the short run as a result of a price on carbon, 

those in certain other sectors, such as renewable energy, 

could be made better off. But importantly, the winners 

are only winners in the short to medium run, because 

higher returns to capital attract new capital, which drives 

returns back down to long-run equilibrium levels. That is 

not to say that there will be no net costs. Depending on 

how high the tax is and how the revenue is used, broad 

measures of economic activity and welfare could indeed 

be lower under a carbon tax than the reference case as a 

result of the real resource costs associated with abating 

emissions. Rather, the differential effects of the policy in 

different sectors will dissipate over the long run.

Finally, the overall effect on the economy is not just 

the direct abatement costs and transfers depicted in 

Figure 3. A host of macroeconomic shifts can occur, 

and we turn to those in Section IX. Our key point is 

that reducing emissions is not likely to be a free lunch, 

but policymakers can minimize burdens by properly 

designing and implementing the policy. 
20 Center for Climate and Energy Solutions
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 21

VII. ECONOMIC INCIDENCE OF A CARBON TAX ACROSS HOUSEHOLDS 

AND REGIONS

If a policy burdens lower-income households relatively 

more than higher-income households as a share of 

household income or other measure of socioeconomic 

status, then economists call the policy regressive. In 

general, lower-income households spend a higher 

percentage of their income on energy and other goods 

whose prices would go up under a carbon tax. That 

suggests a carbon price could be regressive. However, its 

effect in reality is more complicated. As described above, 

some of the tax will be passed backward to producers 

through lower wages for workers and lower returns to 

shareholders. Moreover, congress is unlikely to impose a 

carbon tax in isolation, without other policy changes that 

also have distributional effects. And a carbon tax could 

replace alternative policies that would themselves have 

had distributional effects. For example, a carbon tax 

could substitute for other ways of reducing the federal 

budget deficit, such as cutting discretionary spending 

that disproportionately helps the poor. A carbon tax 

could also substitute for other ways of reducing GHG 

emissions. Almost no analysis has been done on the 

distributional effects of GHG regulations, mandates, 

subsidies, or standards. A carbon tax could be more 

or less regressive than other environmental policies, 

depending on exactly what they are. 

The incidence of a carbon tax depends heavily on 

what happens to the tax revenue. For example, devoting 

the carbon tax revenue to lowering corporate income 

taxes is more likely to be regressive than sending the 

revenue back to households equally in rebate checks. In 

the next section, we look at the initial incidence of the 

tax and three particular objectives for using the carbon 

tax revenue: preventing the poor from becoming worse 

off; improving the economic efficiency of the tax system; 

and reducing the U.S. federal budget deficit.47

MEASURING REGRESSIVITY

Many analyses compare a carbon tax to a scenario of 

current policies without a carbon tax. Even this simplified approach results in mixed evidence because the 

measured effects of a carbon tax depend on a number 

of factors. These factors include what analysts assume 

happens to the revenue and numerous analytical details 

such as the sorting of households by income or other 

socio-economic characteristics (such as consumption 

levels) and whether the analysis takes into account 

households’ size and sources of income. 

Rausch and Reilly (2012) use a general equilibrium 

model to study the distributional effects of a number of 

different approaches to using carbon tax revenue. They 

find that nearly all but the richest households are better 

off in a scenario in which a carbon tax is used to reduce 

payroll taxes or for social programs than they are under 

baseline policy.48 Like nearly all studies of this kind, 

they find that the most progressive approach is to hand 

out the revenue in lump-sum rebates to households. 

Most of their tax-swap scenarios come out either 

progressive or only mildly regressive, with the relative 

welfare changes of the poor about 0.4 percentage points 

greater than for the rich. Importantly, their work takes 

into account how households get their income as well 

as how they spend it. In particular, as Dinan (2012) 

notes, higher price levels trigger changes in other 

federal policies. Social security, other benefits, and 

income tax schedules are indexed to consumer price 

levels. Thus the price on carbon can trigger higher 

cost-of-living increases in government benefits and 

lower effective tax rates. Thus through the indexing of 

entitlement benefits to prices a carbon tax can increase 

federal spending and result in higher tax burdens on 

future taxpayers. Whether those will be high-income or 

low-income households depends on the tax structure in 

the future.

Other studies find that a carbon price could be 

regressive or progressive, depending on how the revenue 

is used. The Congressional Budget Office (CBO) (2009) 

estimates the effect of the cap-and-trade program that 

would have been established by the American Clean 

Energy and Security Act. The CBO estimated the 

effect on households’ purchasing power as a result of 
22 Center for Climate and Energy Solutions

the estimated price on carbon that the bill would have 

produced, which is similar to the outcomes we would see 

with an analogous carbon tax. Dividing the results by 

income quintile, the CBO found that the price on carbon 

by itself is regressive; the lowest quintile faced the highest 

percentage loss of after tax purchasing power—about 2.5 

percent. After that CBO simulated rebating the value of 

allowances (akin to the potential tax revenue) and other 

effects of the program on household income, however, 

the poorest 20 percent of households showed a potential 

net gain of 0.7 percent to their after-tax income. In 

addition, all other income quintiles showed less than a 1 

percent drop in their purchasing power. 

Hassett et al. (2009) and others show that a carbon 

price is less regressive or proportional if analysts 

measure households’ extra expenditure against their 

overall economic status over a lifetime rather than their 

incomes in a particular year, for example by measuring 

the burden against their consumption rather than their 

income in a particular year.49 Using consumption in this 

way accounts for the fact that some people with relatively 

low annual income (such as students and retirees) 

may be in a stage of life where they have relatively low 

incomes despite a lifetime of reasonably good living 

standards. In the same vein, Mathur and Morris (2014) 

find that a carbon tax of $15 per ton of carbon dioxide 

(CO2

) (assuming no return of the revenue and no effect 

on consumption patterns) would have burdened the 

poorest 10 percent of households on average by about 

3.5 percent of their annual income or about 2.1 percent 

of their annual consumption. The richest households’ 

burden would be about 0.6 percent of annual income or 

1.3 percent of annual consumption. If all the revenue is 

returned through lower income taxes, only the poorest 

30 percent of households have a net burden higher 

than about 0.5 percent of income. The highest income 

households benefit the most from a tax swap because 

they pay proportionately more in income taxes than 

everyone else. 

In a series of other papers, Hassett and coauthors 

explore how changing the incidence assumptions and 

allowing for rebate of carbon tax revenues changes 

conclusions about the regressivity of the tax. For 

example, Metcalf et al. (2012) allow both forward 

shifting of the price signal to consumers as well as 

backward shifting of the tax to suppliers of labor and 

capital, and they allow for revenues to be allocated to 

households in different ways. The paper concludes that 

distributing some or all of the value generated by the 

carbon price back to households—either directly or 

indirectly through industry—makes the policy progressive no matter how one ranks households.

Grainger and Kolstad (2010) investigate how the 

regressivity of a $15 tax on CO2 could be ameliorated 

by returning the revenue in a progressive way. This 

could be done by targeted transfers, financing cuts in 

regressive payroll or excise taxes, targeting income tax 

cuts to lower-income groups, or by spending 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. 

HIGH-INCOME AND ENERGY-INTENSIVE 

HOUSEHOLDS

Even if the burden on higher-income households is a 

relatively small share of their income, they will pay more 

of the total costs. Wealthier people use more energy and 

consume more emissions-intensive goods, like air travel 

and manufactured products, just as they consume more 

in general. Thus compensation that is directed primarily 

at the lowest income households is not really compensating those who bear greater levels of burden. Rather, it 

is compensating those whose burden is a relatively high 

proportion of their income.

People who tend to use more energy and energyintensive goods and services will be more burdened by the 

program than those with more energy-lean lifestyles, at 

least initially. This means, for example, that people who 

travel by air, drive long distances in large vehicles, own 

large and poorly insulated homes, and own old appliances 

will feel the pinch more than those who use public transport and live in smaller or more energy-efficient housing. 

Some patterns of consumption are easier to change than 

others, and different people will have different preferences and ability to pay. All of those factors go into a 

consumer’s “price elasticity of demand” for energy. 

Consumers who are “price inelastic,” for example 

because they live in a rural area and must drive long 
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 23

distances to work and shop, will be burdened proportionately more than consumers who are “price elastic.” Nearly 

everyone is more price elastic in the long run than in the 

short run. Given enough time (and certainty that higher 

energy prices are here to stay), we can change where we live, 

what we drive, where we work, and the equipment we use.

REGIONAL INCIDENCE

One other concern about a single national price on 

carbon is that areas of the U.S. heavily dependent on coal 

for electricity will be burdened more than other regions. 

And indeed coal use does vary a lot across the country. 

But regional analyses show that the burdens of a carbon 

tax as a share of income would not vary nearly as much as 

many fear.50 That is because 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, gasoline consumption is highest in the East 

North Central region (Wisconsin, Illinois, Michigan, 

Indiana, and Ohio), electricity used more in the West 

South Central region (Texas, Oklahoma, Arkansas, and 

Louisiana), 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. 

Studies such as Morris and Mathur (2014) show that 

the immediate effects of a carbon tax could fall slightly 

harder than average on households in the East North 

Central states listed above because of their higher overall 

energy consumption as a share of income.
24 Center for Climate and Energy Solutions
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 25

VIII. PROTECTING THE POOR, IMPROVING THE EFFICIENCY OF THE TAX 

SYSTEM, AND REDUCING THE DEFICIT

We observed above that consumers will ultimately bear 

most of the carbon price burden through higher prices 

and that the final economic incidence of the tax depends 

critically on what happens to the revenue. For example, 

using the revenue to reduce taxes on capital income 

would mean that whoever bears those taxes, mostly 

shareholders, would experience higher after-tax returns 

than they otherwise would while consumers pay higher 

energy and other prices.51 The net effect on individuals 

depends on how they get and spend their income.52

PROTECTING LOW-INCOME HOUSEHOLDS

Whether or not the carbon price is regressive and by 

how much, the lowest income households are least able 

to afford energy price increases. Thus it is appropriate 

to consider ways to compensate poor households as 

part of the overall fiscal package. It would be hard to 

address the regressivity of a carbon price perfectly. 

The regressivity of a carbon tax also evolves over time 

as households adjust to new prices, and those adjustments might vary systematically by region, household 

demographics, rural/urban location, and other factors 

that influence households’ consumption patterns. Thus a 

practical approach to address the regressivity of a carbon 

tax cannot exactly match the real-world variation in its 

incidence, but rather must endeavor broadly to hold the 

lowest income households harmless.

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, 

and 18 percent would be enough to protect the bottom 

three deciles. To account for some uncertainty in these 

estimates, policymakers could target about 15 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, to ensure that roughly the 

poorest fifth of households remain no worse off. 

Fifteen percent might be slightly larger than the burden 

of the tax borne by the lowest quintile, in part because 

the figure does not account for price-indexed safety net 

programs or any other benefits that quintile accrues from 

tax reform. However, some overcompensation is likely 

warranted to account for the large variability of energy 

costs across poor households and the vulnerability of 

low-income households above the poverty line. 

BROADER ECONOMIC EFFECTS OF A CARBON TAX

As mentioned in Section VI the macroeconomic effects 

of a carbon tax come not only from its direct abatement 

costs. Important general equilibrium effects can arise in 

the U.S. economy as a result of the new relative prices of 

fuels and how those prices and related adjustment costs 

move through the economy. It can affect employment, 

wages, currency values, trade, and many other outcomes. 

For example, McKibbin et al. (2012a) show that a tax on 

carbon in the U.S. can create a complex chain of shifts 

in investment returns across the globe, changes in trade 

volumes and prices, the value of the U.S. dollar relative 

to other currencies, and so on. Some of these effects also 

depend on how monetary authorities respond to higher 

overall price levels. 

Some studies suggest that policies that result in lower 

direct abatement costs might produce higher gross 

domestic product (GDP) losses than those that result 

in higher direct abatement costs, even for the same 

environmental performance. For example, McKibbin et 

al. (2012b) find that a price on carbon that is confined 

to the electric power sector could produce slightly lower 

GDP losses relative to baseline than a policy that achieves 

the same emissions reductions economy-wide. Their 

result arises because the economy-wide carbon price 

applies to oil, which is inelastically demanded, and that 

raises adjustment costs relative to a policy that focuses 

on the coal and natural gas used in the electricity sector, 

which are more substitutable. 

IMPROVING THE EFFICIENCY OF THE TAX SYSTEM 

THROUGH A TAX SWAP

A carbon tax also raises the real price of nearly everything because fossil energy is embedded in the supply 
26 Center for Climate and Energy Solutions

chain. Higher overall real price levels depress the returns 

to working and investing by shrinking the basket of 

goods people can buy with their earnings. Thus higher 

real price levels act like an income tax. Because income 

is already taxed (for example through income, payroll, 

and capital taxes), the carbon tax introduces another 

distortion on top of the ones already there. Evidence 

suggests that this piling on of distortions, known as the 

“tax interaction effect,” could be even more costly than 

the direct abatement costs.53

The good news is that the carbon tax revenue can 

offset the tax interaction effect by reducing other taxes 

or the deficit, which would otherwise ultimately require 

higher taxes in the future. Taxes, in addition to raising 

revenue, cause what is called “excess burden.” These are 

costs that arise from distortions in behavior that result 

from the tax. A simple example illustrates the idea of 

“excess burden.” Consider a toll on a bridge. Some people 

pay the toll and cross the bridge. Others drive a longer 

distance to get where they want to go without crossing the 

bridge and paying the toll. The costs of that extra driving 

do not produce revenue, but they do burden the driver. 

That cost is the “excess burden” of that toll. 

Income taxes reduce the returns of working and 

create a disincentive to work. Some people work slightly 

less than they otherwise would because to them that 

last hour of work just is not worth it once they factor 

in the taxes. The higher the marginal tax rate, the tax 

on the last dollar earned, the greater the disincentive 

to work. This tax-induced disincentive to work results 

in a lower-than-efficient amount of labor supply in the 

economy, and that inefficiency is costly. Likewise, taxes 

on capital income (like the corporate income tax) lower 

investment, and that reduces future consumption below 

what it would have otherwise been.54 The excess burden 

produced by the last dollar of revenue can vary a lot 

across different kinds of taxes. Using carbon tax revenue 

to reduce other marginal tax rates thereby reduces the 

excess burden of the fiscal system, and it can greatly 

improve the economics of a price on carbon and environmental policy more generally.55

For it to work, though, this “revenue recycling” has 

to be in the form of lowering tax rates, not just giving 

money back to households in a lump-sum fashion. While 

rebates carry some political appeal, they do not reduce 

any of the existing distortions in the tax system, so they 

do not provide any efficiency gains to offset the tax 

interaction effect. The rebates are progressive and more 

than compensate the poor, but they would not lower the 

overall costs to the economy. 

So what taxes should policymakers reduce? The usual 

suspects suggested by the literature include reducing 

corporate income taxes, payroll taxes, personal income 

taxes, and future taxes (by reducing the budget deficit). 

Each approach has advantages and disadvantages, which 

we consider next. 

CORPORATE TAX REFORM

The most efficient form of revenue recycling would offset 

the most distortionary taxes, meaning the ones that 

create the greatest excess burden for the last dollar they 

bring in.56 Some experts believe the most distortionary 

taxes are likely those on capital income, like dividend, 

capital gains, and corporate earnings.57 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. For comparison, Hassett 

and Mathur (2011) show that the U.S. corporate tax 

rate was only slightly higher than the Organization for 

Economic Cooperation and Development median in 

1981. By that measure, the United States is an extreme 

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.58 Others 

point out that few corporations pay the highest corporate 

rate due to special depreciation rules, credits, and 

various tax avoidance strategies. 

Nonetheless, modeling and econometric evidence 

support the hypothesis that a carbon tax/corporate 

income tax swap would be a smart revenue recycling 

strategy. Dinan and Lim Rogers (2002) find 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, the Congressional Budget Office 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.59

Metcalf (2007a) 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 
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 27

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. 

Rausch and Reilly (2012) model a number of different 

potential uses for the revenue of a carbon tax and find 

that the greatest long-run welfare gains arise from a 

scenario in which half the revenue is used to lower 

corporate income tax rates and half is used to provide 

investment tax credit. 

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 ten 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 is 

corporate tax reduction or other desirable tax reform 

will likely require new revenue elsewhere in the budget, 

and a carbon tax could be a natural fit.

Morris (2013b) offers a specific proposal along these 

lines. She analyzes a tax that starts at $16 per ton of 

carbon dioxide (CO2

) and rises by 4 percent annually 

over inflation, along with a cut of $6 billion per year in 

energy subsidies. She finds it could finance a permanent 

reduction in corporate income tax rates from 35 percent 

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.

But lowering corporate income taxes would likely 

help rich households more than poor households. Put 

another way, the most economically efficient recycling 

benefits poor households (who pay very little in taxes) 

proportionately less than rich households (who pay 

much more in taxes). Thus there is an intrinsic tradeoff 

between optimizing the macroeconomic benefits of 

the tax reform and making it distributionally neutral 

or progressive.60

PAYROLL AND PERSONAL INCOME TAXES

Metcalf (2007b) proposes using a carbon tax to cut 

the income tax tied to payroll taxes paid by workers. 

Specifically, he proposes 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 rate reduction is greatest 

for low-wage workers. Parry and Bento (2000) find that 

efficiency gains are particularly large when revenue 

recycling lowers taxes that favor some kinds of consumption (such as housing or health insurance) over others. 

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.61 However, using all the revenue for payroll tax 

cuts generated less aggregate welfare gain through 2035 

than reducing corporate income taxes.

DEFICIT REDUCTION

Using carbon revenue to reduce the federal deficit could 

also make sense. The deficit raises the future tax burdens 

necessary to finance and repay the debt. Reducing the 

federal deficit increases current investment, because it 

reduces the competition for investment dollars from the 

federal government and the resulting upward pressure 

on interest rates.62 It may also avoid some of the debates 

about who wins and who loses from a tax reform, since 

the beneficiaries of a lower deficit depend on what the 

tax system would have otherwise looked like in the 

future and not current beneficiaries. On the other hand, 

so far large deficits have not resulted in high interest 

rates, political momentum for deficit reduction waxes 

and wanes, and a lack of identifiable winners could be a 

liability rather than a strength.

In any case, a carbon tax cannot be the whole solution 

to the looming long-run fiscal imbalances from projected 

growth in Social Security and Medicare spending. First, a 

feasible carbon tax alone cannot solve this fiscal imbalance, 

and second, carbon tax revenues will eventually drop off 

as the tax changes behavior and erodes the tax base, i.e., 

reduces emissions (as intended). If the tax rate increases in 

real terms over time, however, it could become a growing 

source of revenues through 2030 to 2040, depending on the 

escalation rate and stringency of the program.
28 Center for Climate and Energy Solutions

OPTIONS FOR THE REVENUE CAN INCREASE 

ECONOMIC BURDEN

There are ways to use the revenue from a carbon tax 

that undermine its environmental benefits. We saw 

such an approach in cap-and-trade proposals of the 

111th Congress that would have given free allowances to 

local electricity and natural gas distribution companies 

(LDCs) with the proviso that they use the value to benefit 

consumers, i.e., lower their energy bills. To the extent 

that the LDCs benefit consumers in a way that reduces 

consumers’ inclination to conserve energy, then that 

raises the overall cost to the economy of achieving the 

emissions goal. By reducing the abatement that would 

occur in the electricity sector, this approach would have 

driven abatement to more costly sectors.63

While such an approach may improve the political 

viability of a policy, it nonetheless worsens its economic 

efficiency by increasing the overall cost of meeting the 

program’s goals, which could potentially hurt the very 

consumers one may wish to protect. Burtraw (2009) 

points out other implications of this approach. Since 

state public utility commissions control how LDCs 

would pass along the free allowance benefit, 50 different 

systems of redistribution could emerge. The same thing 

could happen if policymakers give carbon tax revenue 

back to households via credits on their energy bills. In 

general, if we are worried about effects on households, it 

is much better to return the revenue to them through a 

tax reduction or rebates, or for that matter pretty much 

any way other than through their energy bills.

From an environmental perspective, all abatement is 

created equal. Policymakers may opt to promote some 

kinds of abatement over others, for example by adopting 

a renewable electricity standard along with the carbon 

tax, directly subsidizing certain technologies with tax 

credits, or rewarding certain abatement with earmarked 

revenue. Even if they serve other goals, such policies 

raise the cost of achieving a particular emissions target 

if they distort incentives away from the least cost abatement options. If policymakers want to reduce emissions 

beyond what would be accomplished by a particular tax 

level, it is likely to be more efficient to raise the tax than 

adopt a set of less direct ancillary policies.64

EARMARKING THE REVENUE FOR SPENDING

Some ways to use the carbon tax revenue (or revenue 

from other taxes) could help lower the long-run costs 

associated with stabilizing greenhouse gas concentrations. In particular, even with a price on carbon, the 

private sector is likely to under-supply basic research 

and development on energy-efficient and low-carbon 

technologies. That is because such research represents a 

“public good,” a market failure in which the developer of 

a new technology cannot appropriate all of the associated social benefits and therefore invests less in it than 

would be socially optimal.65

The federal government could retain some of the 

revenue to cover the federal government’s own higher 

expenses on energy and greater spending on benefits 

for the poor, as discussed above. It could also distribute 

the proceeds to states, which could use it as they wish.66

Finally, revenue could fund lower carbon technology 

research and development (R&D) or measures to help 

society be more resilient to extreme weather, both 

domestically and abroad. 

Importantly, however, there is no particular connection between the amount of revenue a carbon tax raises 

and the appropriate level of spending on R&D, adaptation, or anything else except protecting the poor from 

higher prices. Thus earmarking carbon tax revenue for 

specific spending purposes is in general unlikely to be 

economically efficient. It may prove politically expedient, 

however, for policymakers to link the tax in some way to 

supporting popular programs that might otherwise be 

cut, such as Social Security. Such a linkage may also be 

desirable to address concerns about the distributional 

outcomes of the carbon tax, as discussed in Section VII.

At the risk of over-simplifying the rich and varied 

literature on the incidence and excess burden of 

different tax instruments Table 3 provides an overview of 

the general options and implications of alternative uses 

of carbon tax revenue. 
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 29

TABLE 3: Summary of Options for Using Carbon Tax Revenue

REVENUE USE EFFECTS ON ECONOMY PROGRESSIVE

COMPENSATES THOSE 

WHO BEAR CARBON 

PRICE?

Lump-sum rebates to 

households

Does not lower burden of 

tax system on the economy. 

Could boost consumption 

in a slack economy.

Yes Likely under-compensates 

higher-income households.

Reduce federal budget 

deficit

Economy benefits from 

lower future tax burdens 

and greater investment now.

Maybe. Depends on 

structure of future tax 

system and who benefits 

from higher investment.

Maybe 

Reduce (or prevent 

increases in) payroll or labor 

income taxes 

Benefits economy to the 

extent it encourages more 

work. Benefits could 

be substantial.

Depends on implementation. Does not help those 

without earned income. 

Depends. Could undercompensate higher-income 

households.

Give revenue to utilities to 

lower electricity rates

Increases costs by blunting 

incentives to conserve 

and driving abatement to 

costlier sectors.

Depends on how it is 

implemented by state 

utility regulators. 

Yes for electricity 

consumers, but does not 

benefit consumers of 

other energy.

Reduce capital taxes 

(corporate income tax or 

capital gains tax)

Economic benefits could be 

substantial. Some think that 

using some revenue for an 

investment tax credit may 

be even better.

Likely not; the evidence on 

the incidence of corporate 

taxes is mixed. 

Maybe

Fund climate, energy, and 

adaptation R&D

Could benefit economy 

if revenue goes to useful 

research the private sector 

would not do otherwise. 

In large sudden volumes 

it could bid up the price 

of research inputs. Total 

revenue is far more than 

would be appropriate to 

devote to only this category.

No Maybe. Could lower costs 

of abatement in the future.

Give revenue to states or 

other sub-federal entities

Depends on what states 

do with it. Could benefit 

economy if they reduce 

deficits or other taxes.

Depends on what states do 

with it. 

Depends on what states do 

with it. 
30 Center for Climate and Energy Solutions
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 31

IX. LINKING A CARBON TAX WITH CHANGES IN OTHER ENVIRONMENT 

AND ENERGY POLICIES 

A price on carbon could lower greenhouse gas (GHG) 

emissions and spur innovation in low-GHG technology, 

and, therefore, a carbon tax could make many other, 

less-efficient energy and environmental regulations 

unnecessary. The question then arises which specific 

spending, tax, and regulatory measures would become 

redundant in the context of a carbon ̨tax.

THE CLEAN AIR ACT AND STATE AND 

LOCAL POLICIES

In 2007, the U.S. Supreme Court ruled in Massachusetts v. 

EPA that carbon dioxide (CO2

) and other GHG emissions meet the definition of “air pollutants” under the 

Clean Air Act (CAA). With the definition confirmed, 

the Court then required U.S. Environmental Protection 

Agency (EPA) to determine whether emissions of GHGs 

from new motor vehicles (the specific sector cited in the 

lawsuit) cause or contribute to air pollution, which may 

reasonably be anticipated to endanger public health 

or welfare.67 EPA determined that those emissions do 

pose a danger, and pursuant to that finding EPA can set 

other GHG emissions standards, such as for industrial 

facilities like power plants and refineries. EPA has begun 

imposing conditions on new or significantly renovated 

industrial facilities.68 EPA is now working on a proposed 

rule to control GHG emissions from existing power 

plants, pursuant to instructions from President Obama 

in June 2013.69

Thus, without new legislation, EPA regulation of 

GHGs under the CAA is the likely path for U.S. climate 

policy.70 Burtraw et al. (2011) review the possible legal 

approaches EPA could use and find that the ultimate cost 

of regulation under the CAA hinges on the stringency 

of standards and how much flexibility firms have in the 

way they comply. For example, a broad-based “tradable 

performance standard” limits GHG emissions per unit 

of energy consumed or electricity produced, and it 

would allow firms that over-comply with the standard to 

sell credits to firms who under-comply. Morris (2013c) 

suggests EPA could offer states the option to adopt an 

excise tax on the carbon content of fossil fuels used in 

the power sector. By allowing more abatement where it 

is cheapest, these approaches could significantly reduce 

the overall cost of achieving a collective emissions 

goal. However, such flexibilities require an innovative 

interpretation of the CAA and could face lengthy 

court challenges.

Inflexible emissions standards would be more costly 

than achieving the same reductions with a price signal. 

First, such standards prompt larger investments in 

energy-efficient technology than a carbon tax. Although 

that sounds like a good thing, it means that the equipment of a regulated source is cheaper to run and 

could be used more than it otherwise would be. Linn 

et al. (2012) estimate that this efficiency effect could 

undermine the standards’ emissions benefits by about 

11 to 13 percent. Second, an emissions performance 

standard does not necessarily provide efficient incentives 

to innovate. As Aldy and Stavins (2012) note, once a firm 

satisfies the standard, it has little incentive to develop 

cleaner technology. And where an innovative firm 

develops superior technology, there may be no incentive for others to deploy it. Furthermore, going above 

and beyond the standard may result in the government 

tightening the standard. 

Policymakers adopting a carbon tax could partially or 

fully preempt EPA regulatory power over GHG emissions 

under the CAA. Some business interests would likely 

argue that some degree of CAA preemption is essential 

to the acceptability of a carbon tax. Such preemption 

is not without precedent. The American Clean Energy 

and Security Act (ACESA) would have preempted parts 

of EPA’s GHG authority, limiting its ability to regulate 

GHGs from stationary sources.71

For example, EPA would have been prevented from 

regulating GHGs through a National Ambient Air 

Quality Standard, and would have been prevented from 

establishing a GHG performance standard for covered 

sources under the proposed cap-and-trade program 

(e.g., power plants). Additionally, EPA would have lost 
32 Center for Climate and Energy Solutions

the authority to deem GHGs hazardous or international 

air pollutants solely on the basis of their climatic effects. 

The bill also would have preempted New Source Review 

for GHGs, another dimension of potential regulation of 

GHGs. On the other hand, ACESA would have preserved 

CAA authority over mobile sources of GHGs, such as 

passenger vehicles.72

Under certain assumptions about how ACESA 

would have been implemented, EPA predicted that the 

price on carbon would start at around $15 per ton of 

CO2.

73 Some might argue that if CAA preemption was 

acceptable given the domestic performance of ACESA, 

then it should be acceptable for an even higher carbon 

tax. Others would argue that both CAA regulation 

and ACESA could produce much greater emissions 

abatement than a modest domestic carbon tax. That 

is because EPA could adopt very tight GHG emissions 

standards under the CAA, and ACESA would have 

prompted significant emissions abatement abroad 

through offset projects in addition to the domestic abatement at $15 per ton. Of course, it is unclear just how EPA 

will regulate GHGs under the CAA, and the regulations’ 

performance will be a function of not just the standards 

but also how long it will actually take for them to enter 

into force. It could be more effective to adopt a modest, 

but increasing, carbon tax now than to pursue regulations that could take a decade or more to implement and 

reduce emissions.

That said, there may be good reasons not to 

completely preempt the CAA. Lessons from the Acid 

Rain Program suggest that if regulators do not update 

their goals when they learn more about the cost 

effectiveness of more stringent abatement, then market 

mechanisms may turn out inefficiently weak, leaving 

potentially large net benefits unrealized.74 One way to 

balance these factors would be for congress to suspend, 

but not preempt, EPA’s authorities to regulate GHGs 

from certain sources for a period of time, such as eight 

to ten years. This would ensure that congress has time 

to observe the performance of the tax for more than a 

decade before EPA initiates new CAA rules and closer to 

two decades before EPA rules and state implementation 

plans could be finalized. 

In theory, the federal government could preempt 

state and local GHG policies. But this would prevent 

jurisdictions with higher willingness’ to pay from 

exercising their preference for greater environmental 

protection. Indeed, one advantage of a carbon tax over 

a cap-and-trade system is that sub-federal policies have a 

better chance of actually reducing emissions beyond the 

abatement induced by the federal program. For example, 

if the federal government adopts a cap-and-trade system, 

then an especially ambitious state-level renewable 

electricity standard would simply allow other states to 

emit more by making more allowances available elsewhere via the tradable permit market. A federal carbon 

tax would incentivize abatement nationwide at the same 

marginal cost, even if some states adopt additional 

abatement policies. 

Of course, retaining myriad state policies will result 

in inefficient disparities in the carbon price across the 

U.S. economy and a risk to businesses of multiple layers 

of regulation. Nonetheless, some would argue that states 

should have a right to take more stringent action if they 

wish, just as they can choose different tax rates and other 

regulatory policies. To avoid litigation from the states, 

the federal carbon tax legislation could make explicit 

its intent whether or not to preclude additional GHG 

measures by state, local, and tribal governments. 

An economically efficient carbon tax policy would, 

however, require state utility regulators to preserve the 

carbon price signal to consumers through their regulated electricity prices and the law should specify this.

REVISING EXISTING REGULATIONS AND SUBSIDIES

Federal agencies have promulgated a host of regulations 

that control GHGs directly or indirectly, for example 

through energy efficiency standards and biofuel 

mandates. The federal government also directly subsidizes clean energy technology through myriad grants, 

tax expenditures, loan guarantees, and federal procurement policies.75 A well-designed carbon tax would internalize the social costs of GHG emissions and address 

that market failure. Other market failures may remain 

that may justify continuing certain additional GHG 

policies, but they are importantly distinct from “market 

barriers.” For example, a principal-agent problem (a 

type of market failure) applies if rental markets do not 

allow landlords to finance energy efficiency investments 

with higher rents. On the other hand, if people do not 

buy certain energy-saving products because they do not 

like the other features of the products, that is a market 

barrier, but not a market failure. The question arises 

how significant remaining true market failures would be 

with a price on carbon and whether the government can 

cost-effectively address them. 
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 33

The net benefits of many energy-related regulations and mandates are hotly debated, with many 

economists on the skeptical side.76 For example, Allcott 

and Greenstone (2012) find that the benefits of energy 

efficiency investments are lower than many engineering 

studies suggest, and that the benefits can vary widely 

across different kinds of energy users. Gayer and Viscusi 

(2012) examine the analyses that federal agencies undertake in setting energy efficiency regulations, and they 

find substantial methodological flaws and conclude that 

the costs of the rules are greater than the benefits. They 

note the obvious alternative to efficiency standards of 

educational programs like Energy Star, which give better 

information to consumers about the likely energy costs 

of owning certain products, like cars and appliances. 

Whatever the strength of the economic case for energyrelated standards and mandates, it would be weaker in 

the context of a carbon tax.

A carbon tax could also weaken the case for directly 

subsidizing the deployment of clean-energy technology 

and some energy-efficient products. In general, subsidizing these investments in the presence of an efficiently 

set carbon tax would either compensate investors for 

what they would do anyway or distort their investment 

toward higher cost abatement. Neither is efficient. Morris 

(2013b) suggests that about $6 billion in annual direct 

and tax expenditures that support clean energy could be 

eliminated with the passage of a carbon tax, assuming 

that some policies that are set to expire would be 

extended in the absence of broader climate policy.

In contrast to the subsidies for deployment of clean 

energy, most economists argue that federal funding 

for basic research and development is justified even 

with an efficient price on carbon. The private sector 

under-supplies these activities because firms cannot 

capture their full social value, including positive 

technological spillovers. 
34 Center for Climate and Energy Solutions
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 35

X. ADDRESSING EMISSIONS LEAKAGE AND THE CONCERNS OF ENERGYINTENSIVE, TRADE-EXPOSED (EITE) INDUSTRIES

So far, we have considered the case when a carbon tax 

is passed through to consumers via higher prices for the 

goods and services that have fossil energy in their supply 

chain. However, under certain market conditions, the 

carbon prices will not flow through to consumers, even 

in the long run. Some U.S. firms produce goods in a 

fossil fuel-intensive process, and they compete directly 

with firms in countries that do not regulate greenhouse 

gases (GHGs). We call these energy-intensive, tradeexposed (EITE) industries. All else equal, a carbon 

tax imposed in the United States and not in other 

countries could put U.S. EITE firms at a disadvantage if 

they cannot pass along their higher input costs without 

losing business to their competitors.77 These competitive 

effects could lower the environmental benefits of a U.S. 

carbon tax by driving production and new investment to 

countries with less ambitious climate policy. This shift is 

known as emissions leakage. 

Of course, all sorts of factors determine how competitive a particular firm is, but clearly this is a concern for 

certain EITE industries, notably metals, chemicals, glass, 

pulp and paper, and cement. The size of the carbon-taxinduced disadvantage correlates with how dependent 

a firm is on fossil energy (directly and indirectly), how 

exposed it is to foreign competition (including the supply 

elasticity of its competitors), and the environmental 

and tax policies applicable to competing firms. It also 

depends on how much U.S. firms can adapt to new relative prices to stay ahead of the competition, such as by 

developing new technologies, and how easily consumers 

can substitute from the domestic EITE goods to goods 

imported to the United States.

Another potential outcome of disparate global 

energy policies is called price-based emissions leakage. 

In theory, other countries’ emissions could increase 

if the United States and other large economies adopt 

serious efforts to reduce their fossil energy consumption. 

As U.S. fuel demand shifts back, globally traded fuel 

prices could fall, and other countries’ fuel consumption 

could increase. 

Empirically, what do we know about the significance 

of leakage and competitiveness problems? It depends 

on a host of assumptions about U.S. policy and policies 

abroad, but some evidence suggests leakage from a 

carbon tax would be quite small. For example, McKibbin 

et al. (2012b) estimate the effects of a unilateral U.S. 

carbon tax that begins at $23 per ton of carbon dioxide 

(CO2

) in 2012 and rises at 4 percent over inflation to $46 

in 2030. Using a general equilibrium model of the global 

economy, they find no evidence of energy-related emissions leakage, in part because they find that the price of 

oil in other currencies does not fall, despite significant 

reductions in oil consumption by the United States. 

Aldy and Pizer (2009) review the literature on the 

effect of unilateral climate policy on manufacturing 

industries. They show that European industries, in 

particular lime, cement, iron, and steel, could experience 

an increase in production costs of about 20 percent for 

a price on CO2 of about 20 Euros. Aldy and Pizer (2009) 

estimate the effects of a (unilateral) $15 per ton price 

on CO2 on U.S. manufacturing industries. Their work 

sought to isolate the competitiveness effect of the policy 

from its broader effects on industry generally through 

declines in consumption. They found that overall, U.S. 

production shifted abroad by about 0.7 percent as a 

result of the policy. Looking specifically at EITEs, they 

found that industries with energy costs that exceed 10 

percent of shipment value (e.g., metal foundries, cement, 

and lime) would expect at most a 1 percent shift in 

production overseas. The largest effect was in industrial 

chemicals, with a competitiveness-induced decline in 

production of 0.9 percent. The conclusion of this is that 

trade effects of a modest carbon price are likely to be 

small overall, but they could be important for industries 

with particularly emissions-intensive production technologies and strong foreign competition. 

Before we launch in to the ways in which policymakers 

could address concerns of EITE industries, we should 

stress that the first, best outcome is for the United States 

to leverage its domestic action into analogous action 
36 Center for Climate and Energy Solutions

by other countries. Any problems for EITE industries 

from a carbon policy derive directly from unequal 

efforts across countries.78 And all major economies must 

reduce emissions to stabilize concentrations of GHGs in 

the atmosphere. 

U.S. climate diplomats could do a number of things to 

promote equivalent efforts across major trading partners. For example, they could shape negotiations under 

the United Nations Framework Convention on Climate 

Change (UNFCCC) so that countries can supplement 

their emissions targets with commitments in the form of 

carbon pricing, allowing compliance by either achieving 

their emissions targets or by demonstrating significant 

effort through imposing agreed price signals. McKibbin 

et al. (2012c) outline just such an approach. Price-based 

commitments would reduce the risk of inadvertent stringency or laxity, help achieve and document compliance, 

and allow parties to compare their efforts transparently. 

An international commitment to a specific price trajectory on carbon domestically would also create a hurdle 

for future congresses to unravel the tax and thus would 

reinforce the expected price signal. Finally, the United 

States could promote carbon pricing as a key low-carbon 

growth strategy. By sharing its views and experiences, the 

United States could demonstrate the pro-environment, 

pro-growth potential of carbon taxes that help keep 

more distortionary taxes lower. This would also foster 

cost-effective environmental protection in economies 

least able to afford the burdens of inefficient regulation.

Assuming the United States does all it can to foster 

carbon pricing abroad that is at least as stringent as its 

own, we now turn to the problems that could arise for 

EITE firms. The first is import competition. For example, 

U.S. steelmakers may be concerned that domestic buyers 

of steel would turn to foreign competitors, who could 

produce steel more cheaply with untaxed fossil fuels 

abroad. The second is export competition. For example, 

U.S. exporters of chemicals that use taxed fossil fuel 

inputs are less able to compete in their export markets 

with manufacturers that use inputs that are not taxed. In 

theory these problems are symmetrical, but the vagaries 

of World Trade Organization (WTO) rules may make the 

first problem easier to address than the second. 

Fischer and Morgenstern (2009), Böhringer et al. 

(2012), and Fischer and Fox (2012) review the policy 

measures that have been proposed to reduce emissions 

leakage and competitive disadvantage. One is a border 

carbon adjustment (BCA), and WTO rules may limit this 

to imports. A BCA approach would tax imports of GHG 

emissions-intensive goods from less-regulated regions 

by an amount that reflects the difference between the 

carbon policy in the originating country and the United 

States. The idea would be to carefully specify the most 

intensely EITE goods (such as aluminum) and set import 

tariffs on those goods from countries with substantially 

weaker climate policy. This is less straightforward than 

it sounds because many countries adopt policies, such 

as renewable electricity mandates, that do not clearly 

equate to a carbon price. Further, the carbon intensity 

of an EITE good may vary a lot within a country, even 

within a firm. Moreover, introducing BCAs could 

give rise to unwieldy and protectionist policies if not 

carefully limited. 

Another approach would either exempt EITE industries from the carbon tax or reduce its rate. However, 

this approach forgoes both revenue and the potential 

for cost-effective emissions abatement. It also introduces 

large returns to lobbying for the exemption. A third 

proposal involves transferring some of the carbon tax 

revenue to EITEs in proportion to their output. Outputbased rebates, as this approach is known, operate as a 

subsidy to production and incentivize emissions-intensive 

firms to keep up production even as its input costs go up. 

This approach helps reduce the potential loss of jobs in 

those industries, but it also helps keep prices of energyintensive goods lower than they would otherwise be, 

reducing the environmental benefits of the tax.

Finally, the real effect of the carbon tax on EITE firms 

depends on what happens to the revenue. An interesting 

line of research would explore how the carbon tax 

revenue could be used for tax reforms that would make 

U.S. firms more competitive. In principle, this could 

offset some of the competitive effects on EITE firms, 

even if the reform is not targeted just to them. And it 

may be possible to construct an efficiency-enhancing 

tax reform targeted to EITEs. If some kind of explicit 

measure to protect EITE firms is necessary, a carefully 

circumscribed BCA is probably the most efficient. 

Ideally, the tariff authority would last only as long as 

large and trade-distorting policy differences persist. 
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 37

XI. CONCLUSIONS AND RECOMMENDATIONS

A carbon tax could, if designed correctly, improve the 

long-run U.S. fiscal situation while controlling U.S. 

greenhouse gas (GHG) emissions. If the United States 

uses revenue from a carbon tax to fund a long-term 

reduction in other taxes, the tax swap could potentially 

enhance the overall economic efficiency of the tax code. 

For example, revenue from a carbon tax could allow the 

United States to reduce its statutory marginal corporate 

income tax rate, which is currently the highest in the 

developed world, to a more internationally competitive 

level. It could also reduce payroll taxes or personal 

income tax rates. The carbon tax could also prevent 

cuts in social safety net spending and reduce the federal 

budget deficit. A price on carbon could also supplant 

more-costly and less-effective measures to reduce 

emissions, promote clean energy and energy efficiency, 

and drive innovation, saving both budget and regulatory costs. An important dimension to the adoption of 

a carbon tax is the extent to which congress suspends 

or preempts existing legal authorities to control GHG 

emissions at the federal and state levels.

Policymakers can adopt a number of approaches 

that could hold poor households harmless, including 

reserving a share of the carbon tax proceeds for targeted 

spending or rebates to qualifying households. Policies 

that return revenues to households in ways that blunt 

their incentives to reduce energy consumption, such 

as via rebates on energy bills, would be substantially 

less efficient in lowering emissions than policies that 

compensate households in other ways. 

Several measures could mitigate any adverse effects 

of a carbon tax on energy-intensive, trade-exposed 

industries. First, the United States can pursue diplomatic 

efforts to leverage its action into analogous actions by 

major trading partners. Such efforts are also key to 

maximizing the global climate benefits of U.S. policy. 

Second, the United States can limit the effects of the tax 

by adopting a modest initial carbon price and raising 

it gradually. Third, revenue from the carbon tax can 

fund reductions in other taxes that make U.S. firms 

less competitive internationally. Finally, the United 

States could adopt limited border carbon adjustments 

to impose surcharges on imports of energy-intensive 

goods from countries with significantly less ambitious 

climate policy.

The proposal in Morris (2013b) illustrates one possible 

way to package these design elements in a way that could 

appeal to a variety of stakeholders. It estimates that a tax 

that starts at $16 per ton of carbon dioxide (CO2

) and 

rises at 4 percent over inflation each year could fund 

the long-term reduction in statutory corporate income 

tax rates from 35 percent to 28 percent and reduce the 

federal budget deficit by almost $200 billion in the next 

decade and about $815 billion over the next two decades, 

while reducing CO2 emissions by 9.3 billion tons over 20 

years. Using estimates from Mathur and Morris (2014), 

the proposal reserves 15 percent of the revenue to protect 

the welfare of the poorest twenty to thirty percent of 

households, or roughly the households with incomes at 

150 percent of the poverty level and below.

Underpinned by sound science and thoughtful design, 

a carbon tax could fit into broader fiscal reform in a way 

that serves both environmental and economic goals. 
38 Center for Climate and Energy Solutions
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 39

ENDNOTES

1 For an in-depth overview of science of climate change and projected impacts, see the Center for Climate and 

Energy Solutions (2011).

2 Carbon is shorthand here for greenhouse gases generally because carbon dioxide comprises the lion’s share of 

overall GHG emissions. Morris (2013a) cites polls of economists on the role of carbon pricing in climate policy.

3 Other reviews of carbon tax design include Ramseur et al. (2012), Metcalf and Weisbach (2009), and Metcalf 

(2008). This paper also draws from Morris (2009), which reviews the economics of allocating cap-and-trade allowances.

4 This concept goes back at least to Pigou (1952). For more theory of environmental taxation, see Bovenberg and 

Goulder (2002). 

5 Aldy and Stavins (2012) contrast different approaches to GHG mitigation. For an overview of how market-based 

policies can achieve climate goals more cheaply and efficiently than other policy options, see Center for Climate and 

Energy Solutions (2012).

6 Hsu (2011) surveys arguments in favor of a carbon tax over other environmental policies.

7 Goulder and Stavins (2011) explore the interactions of state and federal climate policies.

8 McKibbin et al. (2011) use a general equilibrium model to compare energy efficiency subsidies to a carbon tax. 

They find that a carbon tax can reduce emissions by about twenty times more than the subsidy approach for similar fiscal 

footprints.

9 For example, see Pizer (1999).

10 Rausch and Reilly (2012).

11 McKibbin et al. (2012a).

12 In fact, EPA must do so pursuant to its 2009 decision that current and projected concentrations of greenhouse 

gases “threaten the public health and welfare of current and future generations.” See U.S. EPA (2013a).

13 See Center for Climate and Energy Solutions (2014).

14 See Burtraw et al. (2011). 

15 See Paltsev et al. (2007), Tables 4 and 6. 

16 For studies that did not report this information directly, we estimate the values from the available graphs. For 

example, we estimate baseline emissions levels from Figure 4 in Rausch et al. (2010) and the corresponding policy scenario 

emissions from the table on page 2 of Metcalf (2010).

17 Domenici and Rivlin (2010), p. 41.

18 See for example Metcalf (2007), Marron and Toder (2013), and Morris (2013b).

19 The benefits of GHG mitigation also depend on the ancillary effects of mitigation, such as the co-control of 

other pollutants. 
40 Center for Climate and Energy Solutions

20 Estimates for the willingness to pay can even differ by how the abatement occurs. For example, Kotchen et al. 

(2011) find that American households have an average annual willingness to pay for climate change abatement of $79 for 

a cap-and-trade approach, $85 for a carbon tax, and $89 for a GHG regulation. Aldy et al. (2012) find that the average 

American is willing to pay $162 per year for a clean energy standard of 80% clean energy by 2035.

21 Examples of this literature are Weitzman (2011) and Nicholas H. Stern, The Economics of Climate Change: the Stern 

Review (Cambridge, UK: Cambridge University Press, 2007).

22 Discount rate is a type of interest rate that reduces or “discounts” the value of a future cash-flows to account for 

the time value of money.

23 See U.S. Government Interagency Working Group on the Social Cost of Carbon, U.S. Government (2013). 

24 Some GHGs degrade or are taken up by the ocean or terrestrial ecosystems each year. This means net emissions 

must be zero to stabilize concentrations.

25 Metcalf and Weisbach (2009) review this literature and explain that the optimal rate of growth in the tax 

depends, among other things, on whether one wishes to maximize net social welfare or minimize the costs of achieving a 

particular environmental objective.

26 For example, Metcalf et al. (2008) find that for a given cumulative abatement, welfare costs are lower with 

a higher initial tax rate and a 4% annual tax rate increase than with a lower initial tax rate and a more rapid 10% real 

increase. 

27 See for example Sinn (2008). Edenhofer and Kalkuhl (2011) show that this result can indeed arise if the initial 

carbon tax level is low and the tax rate grows faster than the discount rate of resource owners. 

28 National Research Council (2010), p. 359 notes that the SCC could vary by two orders of magnitude.

29 Metcalf and Weisbach (2009) advocate this approach.

30 Such an approach appears in the Managed Carbon Price Act of 2012 (H.R. 6338 of the 112th Congress) introduced by Rep. Jim McDermott (D-WA) in August 2012. Carbon tax proposals of the 113th Congress have eschewed using a 

formula, see Center for Climate and Energy Solutions (2013a). 

31 See Metcalf and Weisbach (2009), p. 520, for more discussion of this issue.

32 See Center for Climate and Energy Solutions (2013b).

33 For trends in U.S. coal production and export, see “Quarterly Coal Report,” U.S. Energy Information 

Administration last modified, January 2, 2014, http://www.eia.gov/coal/production/quarterly. 

34 Congress enacted the Black Lung Benefits Act of 1977 to compensate individuals with the disease known 

as pneumoconiosis or “black lung disease.” See U.S. Internal Revenue Service, Coal Excise Tax Audit Technique Guide

(Washington, DC: Department of Treasury, 2005), http://www.irs.gov/pub/irs-mssp/coal.pdf.

35 OECD (2013) shows that the U.S. has one of the lowest average effective federal tax rates on energy in the 

developed world.

36 Viard (2009b).

37 U.S. EPA (2009).

38 The Carbon Pollution Fee discussion draft—as released by Rep. Henry Waxman (D-CA), Sen. Sheldon 

Whitehouse (D-RI), Rep. Earl Blumenauer (D-OR), and Sen. Brian Schatz (D-HI) in March 2013—requires covered entities 

to purchase permits for the compliance year. For an overview of carbon tax proposals in the 113th Congress (2013-2014), 

see the Center for Climate and Energy Solutions (2013a), the Center for Climate and Energy Solutions (2014).
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 41

39 Examples of federal tradable tax credit programs include the Low-Income Housing Tax Credit, the New 

Markets Tax Credit, and the solar Investment Tax Credit.

40 This paper focuses on the incidence of abatement policy within the U.S.; the complex distribution of the global 

environmental benefits is important, but outside the scope of this paper. 

41 Abatement supplied at a cost below zero implicitly appears in the reference scenario.

42 Here “firm” is shorthand for the owners of the firm, i.e., stockholders. Again, we focus on the distributional 

effects on people, not corporations—legal entities for which the concept of welfare makes no sense.

43 A detailed discussion of the relationship between energy efficiency and energy prices is beyond the scope of this 

paper, but an extensive literature explores the “energy efficiency gap,” the apparent underinvestment in energy-conserving 

technologies and practices.

44 Ho et al. (2008) examine the dynamics of the incidence of climate policy on firms, from the very short run to 

the long run. 

45 If carbon capture and storage technology costs fall significantly, coal production might not shrink.

46 Lasky (2003) surveyed economic models and found that with 10 years notice before instituting a carbon 

constraint, consumers would initially bear between 94 and 96 percent of the burden of the carbon price.

47 Morris and Mathur (forthcoming) provides a more detailed review of the literature on the distributional effects 

of a carbon tax.

48 Rausch and Reilly (2012), Figure 8, p. 14.

49 A good introduction to these issues is Parry et al. (2007). 

50 Morris and Mathur (2014) demonstrate this.

51 A share of capital taxation is likely to be borne by workers in taxed firms in the form of lower wages. 

52 Rausch et al. (2010) review this literature.

53 Parry and Williams (2011) explain the tax interaction effect in more detail.

54 See Feldstein (2006) for more on the distorting effects of corporate income taxes.

55 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%. See Parry (1997). 

56 See Goulder et al. (1999), Parry et al. (1999), Parry and Oates (2000), Parry and Bento (2000), and CBO 2007.

57 Feldstein (2006).

58 Toder (2012).

59 Elmendorf (2009).

60 See Dinan and Rogers (2002).

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

62 See Rubin et al. (2004) for a more complete discussion of the downsides to a large federal budget deficit.

63 A similar effect could arise if allowances are distributed free to price regulated utilities if regulators do not allow 

the price signal of the carbon constraint to be passed through to retail consumers.

64 One exception would be instances where clear market failures remain.

65 Fischer and Newell (2008).
42 Center for Climate and Energy Solutions

66 Equivalently, states could individually or collectively adopt a carbon tax, and the federal government could 

collect it for them. 

67 A thorough analysis of EPA’s regulatory trajectory appears in McCarthy and Park (2011). Also see 

Wallach (2012).

68 See U.S. EPA (2013).

69 Presidential Memorandum – Power Sector Carbon Pollution Standard, Compilation of Presidential Documents, 

DCPD-201300457, (June 25, 2013). http://www.gpo.gov/fdsys/pkg/DCPD-201300457/pdf/DCPD-201300457.pdf. 

70 Anderson and Richardson (2012) survey a number of other statutes that provide (or conceivably could provide) 

authority for agencies to regulate GHGs, absent a specific preemption. For example, these include the Clean Water Act, 

which could be triggered if climate disruptions and/or acidification from CO2 absorption extend to navigable waterways. 

71 Holt and Whitney (2009).

72 Ibid. p. 55–56.

73 U.S. EPA (2009). 

74 Burtraw and Szambelan (2009). 

75 Morris et al. (2012) review the economics of these policies.

76 See Gayer and Viscusi (2012) for example.

77 The concerns of EITE industries do not apply only to a carbon tax; they can arise with other approaches to 

GHG regulation. Morgenstern (2010) notes that effects on EITE firms of CAA regulation of GHGs by EPA depend on how 

flexible EPA’s compliance standards are.

78 Morris et al. (2013b). 
A Carbon Tax in Broader U.S. Fiscal Reform: Design and Distributional Issues 43

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This report examines the issues and options for designing a carbon tax in the United States. Reviewing the rationales for a 

carbon tax in the context of broader fiscal reform, it explores design issues, environmental benefits and the options for using 

the resulting revenue. 

The Center for Climate and Energy Solutions (C2ES) is an independent non-profit, non-partisan organization promoting 

strong policy and action to address the twin challenges of energy and climate change. Launched in 2011, C2ES is the successor to the Pew Center on Global Climate Change.