case, the substitution of the taxes in question is basically trading one type of economic distortion for another. Following Diamond and Mirrlees’ (1971) _production efficiency lemma,_ an optimal commodity tax does not disrupt production efficiency, all distortions being focused only on consumer choice. Reducing pre-existing distortions arising from other indirect taxes (as afforded by revenue recycling) should therefore ameliorate the initial welfare cost of taxing the energy intensive sectors. However, the energy-intensive sectors that are taxed higher - such as basic iron and steel, transportation, basic nonferrous metals, and metal products (excluding machinery) – are intermediate goods, causing production inefficiency with the higher taxes on those goods. The welfare impact is offset somewhat by the reduction of other indirect taxes and their associated distortions through revenue recycling. Being intermediate goods, their demand elasticities are low, signifying high potential for revenue recycling, actually generating the most revenue among the taxes in question, requiring in turn deeper cuts in other indirect taxes in the experiment that maintains revenue neutrality. Cutting other indirect taxes and the economic distortions associated with them will however encourage production and increase carbon emissions in sectors other than the energy-intensive sectors, forcing further and higher increases in the relevant energy tax in order to achieve the target 15 percent reduction in carbon emissions.

As noted in Table 7, other indirect taxes are reduced over 300% when the revenue from a sales tax on energy-intensive sectors is used to reduce other tax distortions – the tax rates become subsidies. The point of this extreme case is that the less directed the tax instrument, the less effective is revenue recycling, its revenue potential actually working against its effectiveness as a Pigovian tax and against the benefit of tax substitution in lowering pre-existing tax distortions.

# **_Set 3 of Simulations:  Sensitivity of the welfare impact to factor market distortions_**

We examine the sensitivity of the welfare results to a few key distortions existing in the factor markets in South Africa. The first is the sectoral differences in productivity for each factor, such as wage differences for labor of the same type across production sectors. The model incorporates such distortions by specifying fixed ratios of the marginal product of a factor in a sector to the average return of that factor, the standard way of introducing factor market distortions. Such differentials are not entirely due to differences in efficiency but also to factor segmentation such as lack of mobility, adjustment cost, etc. We examine their impact on the marginal cost of a new tax policy by specifying a “distortion free” base where these factors of proportionality are all one. The experiment is similar to the marginal cost of public funds analysis in Devarajan _et al._ (2002) but applied to a target level of emissions reduction instead of an additional unit of revenue. Revenue is returned to the households by lump-sum transfer similar to the simulations in Set 1. Since the impact on different household groups retains the same pattern found in the previous two sets of simulations, we only report the aggregate welfare impact.

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