Do the Costs of a Carbon Tax Vanish When Interactions With Other Taxes are Accounted For?

Previous analyses of U.S. carbon taxes have tended to ignore interactions between this tax and other, pre-existing U.S. taxes. This paper assesses the effects of the carbon tax using a model that addresses these interactions. The model is unique in integrating a detailed treatment of taxes and attention to nonrenewable resource supply dynamics within a disaggregated general equilibrium framework. We find that the GNP and welfare costs of the carbon tax are significantly lower than what would be predicted if tax interactions were disregarded. When the revenues are used to finance reductions in marginal taxes at the personal or corporate level, the welfare costs are 25-32 percent lower than when the revenues finance lump-sum reductions in taxes. Pre-existing distortions -- specifically, the relatively light taxation of fossil-fuel-producing industries in comparison with other industries -- imply that the gross efficiency costs of carbon taxes are about 15 percent lower than would be the case if fossil-fuel-producing industries were not initially tax-favored.

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