On the Optimal Use of Revenues from a CO2 Tax and the Importance of Labor Market Conditions

Abstract

This paper focuses on the environmental, economic and budgetary impacts of a carbon tax in the presence of mixed recycling strategies and a detailed modelling of labor market conditions, both employment and involuntary unemployment. This focus matches the terms of the policy debate in many small energy-importing economies. The revenue-recycling policies that appear most promising are those that use carbon tax revenue to finance investment tax credits, reductions in social security contributions and reductions in personal income taxes. Although none of these mechanisms would individually lead to simultaneous improvements in the three margins, a mixture of the three would. Our sensitivity analysis suggests that labor markets conditions are a critical factor in determining the possibility of generating these positive effects. Ignoring labor supply responses, employment and unemployment effects leads to systematic underreporting of the three dividends and thereby undermines the political viability of environmental tax reform.