Carbon pricing policy design and revenue management: economic models and policy practice

Over the past 25 years, a growing number of countries have adopted policies that place a price on the emissions of carbon dioxide (CO2) and other greenhouse gases. Regardless of whether such carbon pricing is implemented through taxes or emissions trading schemes (ETS), these policies can raise substantial amounts of public funds. How should the revenues raised by carbon pricing policies be managed? This chapter surveys both the economic models and the policy approaches that have been used to address this question from the perspectives of economic efficiency, equity, and political feasibility. First, from an efficiency-maximizing perspective, public finance models typically find that capital income tax reductions will be the optimal use of carbon revenues. Recycling the revenues through labor income tax cuts ranks second, whereas rebating the revenues directly to households as lump-sum payments entails the largest efficiency costs. In contrast, based on equity considerations, lump-sum rebates can be preferable to labor tax reductions in addressing the regressivity of carbon prices. In contrast, an ETS with free permits and corporate income tax cuts is likely the most regressive option, but will compensate industries and thus achieve political feasibility at the lowest cost.