Environmental Tax Reform: Mixed Revenue Recycling Strategies

The effects of the reducing taxes at the different margins suggests that multiple policy objectives may be achievable with an environmental tax reform based on mixed recycling strategies. In the simulations that follow we consider the application of carbon tax revenue to reducing the effective tax rates on direct and indirect taxes in combination. The revenues generated from carbon taxation are used to finance a reduction in the personal income tax rate, the corporate income tax rate, the value added tax rate and to provide corporate income tax credits for private investment.

We first consider a direct tax channel: a combination of reductions in the personal income tax and the corporate income tax margins; second, we consider an indirect tax channel, a combination of reductions in the VAT and an increase in investment tax credits; finally, we consider a case of mixing reductions in the personal income tax, with increases in the investment tax credits. In all cases, we consider the use of part of the revenues generated to provide income tax credits, VAT rate reductions and investment tax credit for the purchase of energy efficient technologies.

In each case, we consider a detailed grid of alternatives for the share of CO2 tax revenues allocated to reductions in each tax margin to determine the most desirable outcome with respect to economic performance and distributional considerations. This approach allows us to understand in detail the nature of the trade-offs we are facing along the efficiency and equity fronts. For example, in the case of the direct tax replacements, the more the share of the personal income tax and the less the share of the corporate income tax the better the distributional effects and the less desirable the efficiency effects. The same is true for the case of indirect taxes. The greater the investment tax credit and the less the value added tax the better the efficiency effects and the more the welfare loss although also with an increased level of progressivity. So less ITC and more VAT lead to lower aggregate welfare outcomes which are nevertheless more regressive outcomes. From this it also follows the interest in considering a case with

reductions in the personal income tax to help with positive welfare effects and progressivity and investment tax credits to help with efficiency.

Let’s consider first the PIT/CIT grid. The reduction in energy demand and in CO2 emissions increases in the share of the CO2 revenues allocated towards reductions in the PIT, relative to the CIT.

This however comes at the cost of less desirable economic effects on output and employment. The macroeconomic effects on GDP become positive around the 50/50 mixed case. Finally, greater welfare gains and more progressive outcomes are possible with a greater allocation of the revenues from the carbon tax to reductions in the PIT, relative to the CIT. All things considered, an equal allocation of revenues to reductions in the PIT rate and the CIT rate, the 50/50 case, seems to be a good compromise.

Table 6.7 Long Run [2050] Energy and Environmental Effects

(Percent change relative to the reference scenario)

PIT/CIT Shares GDP Consumption Investment Employment Public Debt

Table 6.9 Long Run [2050] Distributional Effects – Equivalent Variations

Second, we consider the VAT/ITC grid. In this case, a greater reduction in energy demand is associated with a larger share of revenues allocated to reductions in the VAT rate and a smaller allocation to financing for an increase in the ITC. CO2 emissions reductions, however, reach a maximum around a balanced allocation in which half of the revenues are directed towards reductions in the VAT rate and half

Table 6.10 Long Run [2050] Energy and Environmental Effects

(Percent change relative to the reference scenario)

are directed towards an increase in the ITC, the 50/50 case. In addition, we observe more desirable macroeconomic effects on output and employment with a larger share of the revenues allocated towards financing an increase in investment tax credits, with positive GDP effects observed around the 50/50 mixed case. Finally, we observe greater welfare gains with a larger allocation of revenues to reductions in the VAT although the effects are regressive. These effects highlight a trade-off suggested that we are faced with a choice between positive welfare effects that are regressive and negative welfare effects which are progressive. Again the choice of the 50/50 mixed case is a good compromise.

Table 6.11 Long Run [2050] Macroeconomic Effects

(Percent change relative to the reference scenario)

VAT/ITC

Shares GDP Consumption Investment Employment Public Debt

Table 6.12 Long Run [2050] Distributional Effects – Equivalent Variations

(Percent change relative to the reference scenario)

Third, and finally, we consider the PIT/ITC grid, which explores the desirable distributional effects of reductions in the PIT and the desirable economic effects of the increase in ITC. A larger reduction in energy demand and in CO2 is possible with a greater allocation of revenues to reductions in the PIT rate. At the same time, this leads to less desirable economic effects on output and employment.

Again, the macroeconomic GDP effects become positive around the 50/50 allocation. Finally, greater and more progressive welfare gains are possible with a larger allocation of the revenues from the carbon tax to

Table 6.13 Long Run [2050] Energy and Environmental Effects

(Percent change relative to the reference scenario)

Shares GDP Consumption Investment Employment Public Debt

Table 6.15 Long Run [2050] Distributional Effects – Equivalent Variations

reductions in the PIT. Once again, 50/50 is a good compromise: It yields substantive economic gains and progressive welfare effects with positive outcomes for households in the lowest income group while the largest welfare losses, accruing to households in the highest income group, are less than half of what those associated with a simple tax on carbon.