Recycling Carbon Tax Revenue to Maximize Welfare

Fried, Stephie; Novan, Kevin; Peterman, William B.

doi:10.17016/FEDS.2021.023

Working Paper

Recycling Carbon Tax Revenue to Maximize Welfare

Abstract: This paper explores how to recycle carbon tax revenue back to households to maximize welfare. Using a general equilibrium lifecycle model calibrated to reflect the heterogeneity in the U.S. economy, we find the optimal policy uses two thirds of carbon-tax revenue to reduce the distortionary tax on capital income while the remaining one third is used to increase the progressivity of the labor-income tax. The optimal policy attains higher welfare and more equality than the lump-sum rebate approach preferred by policymakers as well as the approach originally prescribed by economists -- which called exclusively for reductions in distortionary taxes.

Keywords: Carbon tax; Overlapping generations; Revenue recycling;

JEL Classification: E62; H21; H23;

https://doi.org/10.17016/FEDS.2021.023