Climate Policies and the Tax-Interaction Effect, in Context

The tax-interaction effect is, arguably, a lynchpin in the modern apparatus substantiating a trade-off between economic efficiency and environmental quality. In recent years, it has come into particular focus in discussions of climate policy, meriting mention inside and outside of academia. Given relatively simple scenarios, the tax-interaction effect demonstrates that resultant distortions in the labor market explode the cost of most conventional environmental policy tools. It is the aim of this discourse to introduce concepts that will add realistic complexity to scenarios exhibiting the tax-interaction effect, allowing it to be placed better into the context of a real-world economy. This is done by synthesizing conclusions across widely differing bodies of literature to suggest perspectives which bring forward related, important and untapped concepts. Four findings are presented. First, recent developments in understanding of work effort open the possibility for previously modeled labor distortions to divert from real behavior. Second, pre-existing labor supply market failures possibly distort work incentives in tandem with labor taxes. Third, perspectives and results from environmental willingness to pay literature and median voter theory dictate that carbon policy distorts the labor market differently in the presence of a voting system. Each finding is conducive to reconsideration of climate policy costs as well as the tax-interaction effect in a real setting. Sections are written for a broad audience in academia and policymaking alike.