Using Carbon Tax Revenue to Grow the Economy

Federal Tax

The Biden administration has made climate change one of the core challenges it plans to address over the next four years. One climate policy lawmakers have debated—and will likely continue to do—is a carbon tax. At the same time, the new Administration will have to tackle the severe, and likely continuing, economic fallout of the COVID-19 crisis. Policies to spur economic growth will be necessary.

One way to combine the policy goals of carbon reduction and economic growth would be to enact a carbon tax and use the newly generated tax revenue to make the Tax Cuts and Jobs Act’s (TCJA) individual income tax provisions—which are set to expire at the end of 2025—permanent.

There are several ways to use carbon tax revenues to support pro-growth policies. A carbon tax is a broad-based tax on the carbon content of fossil fuels, essentially putting a price on carbon emissions to encourage consumers, businesses, and governments to produce less of them. Due to its broad tax base, a carbon tax can raise significant amounts of tax revenue, which can be used to 1) lower other types of taxes; 2) reduce the federal deficit; 3) fund public investments; or 4) be returned to taxpayers in the form of lump-sum rebates. Each of these revenue recycling options has different effects on economic growth.

At the end of 2025, most individual income tax provisions enacted by the TCJA will expire. More specifically, individual income tax rates will revert to their higher pre-2018 levels, the standard deduction will be cut in half, and several tax credits, exemptions, and deductions will return to their pre-TCJA form. On net, the expiration of these TCJA provisions will increase individual income taxes on most taxpayers. However, making these provisions permanent would not only avoid tax increases on most taxpayers but also positively impact economic growth.

According to our analysis, a carbon tax of $60 per metric ton of carbon dioxide equivalent, growing at 5 percent annually, would raise sufficient federal tax revenues to cover the cost of making the TCJA’s individual provisions permanent in the long run. In isolation, making the individual provisions permanent would increase the long-run size of the U.S. economy by 1.4 percent, while a carbon tax would reduce long-run economic growth by 0.4 percent. Combining these estimates implies that enacting a carbon tax to pay for permanent individual provisions is not only revenue-neutral but also increases the long-run size of the economy by 1 percent, making it a sustainable pro-growth option.

The main reason for this pro-growth effect is that each type of tax impacts the economy differently. Carbon taxes—which can be categorized as consumption taxes—pose comparably little economic harm, as they have relatively less adverse influence on the decisions of households and firms to work and invest. Individual income taxes, on the other hand, can reduce work incentives and thus negatively impact economic growth. In other words, a dollar in tax revenue raised through consumption taxes is economically less harmful than a dollar raised in individual income taxes.

The economy and climate change are two challenges the Biden administration has identified as priorities. One way to address both issues at the same time is to enact a carbon tax to discourage carbon emissions, and to use the resulting carbon tax revenue to lower—or in the case of the TCJA’s individual provisions, avoid increases of—other, more distortive, types of taxes. This would not only address the challenges of climate change but also support the economy.

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