Measuring carbon tax incidence using a fully flexible demand system. Vertical and horizontal effects using Irish data

We quantify the vertical (i.e. between income differences) and horizontal (i.e. within income differences) distributional effects of carbon taxation using a fully flexible demand system and Irish data. The model avoids imposing the curvature of the relationship between income and energy demand. We show that neglecting this fact can lead to misleading policy conclusions. We also show that losses in purchase power are the main channel of welfare losses. Losses due to limitations for energy substitution play a minor role. We found that rural households and householders in retirement age are the most affected by carbon taxation. Regarding horizontal effects, we show that higher heterogeneity in the tax burden is experienced by couples with dependent children and those in urban households. These findings highlight the importance of quantifying both horizontal and vertical distributional effects when designing carbon taxes and revenue recycling mechanisms. Within distributional effects are larger than between distributional effects regarding income inequality of the tax and revenue recycling mechanisms. We found that a targeted transfer is preferred over a lump-sum transfer in reducing welfare losses caused by the regressivity of taxation. These findings hold when measuring both horizontal and vertical distributional effects.