The Green Tax Swap is Not Enough

From time to time, I have mentioned a “Green Tax Swap” as an appropriate policy to raise the price of carbon emissions while protecting lower-income workers from the higher costs of the carbon-intensive goods and services that they consume. Gib Metcalf provides a good discussion of implementation and distributional consequences here. Some new research by Don Fullerton and Holly Monti suggests that it would be more difficult than is presently believed to make the swap distributionally neutral. Here’s the abstract:

Pollution taxes are believed to burden low-income households that spend a greater than average share of income on pollution-intensive goods. Some propose to offset that effect by returning revenue to low-income workers via reduced labor tax. We build analytical general equilibrium models with both skilled and unskilled labor, and we solve for expressions that show the change in the real net wage of each group. A decomposition shows the effect of the tax rebate, the effect on the uses side of income (higher product prices), and the effect on the sources side of income (relative wage rates). We also include numerical examples. Even though the pollution tax injures both types of labor, we find that returning all of the revenue to the low-skilled workers is still not enough to offset the effect of higher product prices. Moreover, changing wage rates may further hurt low-skilled labor. In almost all of our examples, the rebate of all revenue to low-skilled labor still does not prevent a reduction in their overall real net wage.

Here’s the part of the paper that struck me as new, compared to prior research that focused primarily on how lower-income workers spend their income (as opposed to how they earn it):

Based on our data, the dirty sector is low-skilled intensive, so the pollution tax reduces demand for low-skilled labor and suppresses their wage. In addition, the low-skilled wage may fall if the pollution tax induces substitution into high-skilled labor and out of low-skilled labor. Their relative wage can only rise if low-skilled labor is a good enough substitute for pollution to offset the fact that the polluting sector is low-skill intensive and the fact that the tax rebate is not enough to offset their disproportionate spending on the dirty good. In almost all of our numerical examples, the real net wage of low-income workers falls. Only in rare cases would the return of revenue protect low-income workers.

The implication of the new research is not that a Green Tax Swap is not worth doing but that by itself it is not distributionally neutral. It would have to be accompanied by progressive changes in the tax system beyond the full rebate of the carbon tax revenues in the form of, say, payroll tax relief.

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