Understanding the Inequality and Welfare Impacts of Carbon Tax Policies

This study develops a general equilibrium life-cycle model to explore the welfare and inequality implications of different ways to return carbon tax revenue back to households. We find that the welfare-maximizing rebate uses two-thirds of carbon-tax revenue to reduce the distortionary tax on capital income while using the remaining one-third to increase the progressivity of the labor income tax. This recycling approach 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.