For decades carbon taxes – charging those who produce carbon dioxide to incentivize lower emissions – have failed to gain traction among those countries who contribute the most to climate change. Nam Nguyen, Alejandro Rivera, and Harold H. Zhang consider the arguments that existing carbon taxes are regressive and propose combining capital gain taxes and transfers with existing carbon taxes in a revenue-neutral scheme. Such a scheme, they write, would expand policymakers’ toolkits by avoiding regressive carbon pricing, discouraging investment in higher emitting firms, and subsidizing green firms. 

As the signatory nations strive to reach their Paris Agreement goals, a quick, efficient transition to a greener economy is crucial. Since US economist William Nordhaus published Managing the Global Commons in 1994, economists have coalesced around the need for carbon taxes – which are a tax levied on emitters – to address the negative externalities of greenhouse gas emissions on temperatures.

But here’s the thing: according to the International Monetary Fund, the current global average price of carbon is only $6 per ton, far below the range of $50-$100 determined to be needed by 2030 to achieve the objectives of the Paris Agreement. Why the disparity? It’s simple: too many legislative bodies around the world have failed to enact a meaningful carbon price. In the US, a unified carbon tax, which has been debated for years but has faced strong political opposition, appears to be out of reach.

Where does the burden of carbon taxes fall?

A credible argument against carbon taxes is that they are too regressive — they strain lower-income households more than higher-income ones. According to a study by the Congressional Budget Office, a $28 tax per ton of carbon dioxide emitted would cost households in the lowest income quintile around 2.5 percent of their after-tax income, vs. just 0.75 percent for those in the highest quintile.

Remember the “gilets jaunes” (yellow vest) demonstrations in France? In 2018, long-simmering discontent boiled over into nationwide protests after the Macron government abolished a long-standing tax advantage for diesel fuel. Blaming Macron for rising fuel costs may have been irrational, but in France it’s clear the burden would fall too heavily on the poor, rural communities, and blue-collar workers.

Clearly, carbon pricing alone is not a panacea for ensuring that decarbonization happens at the pace and on the scale required to reach the Paris goal of “well below 2°C.” At least not without harming those least able to shoulder our shared burden.

We think it is both unsound and impractical to rely solely on carbon pricing. According to the Carbon Pricing Leadership Coalition’s Report of the High-Level Commission on Carbon Prices: “Well-designed complementary policies may be needed to tackle other market failures or manage distributional outcomes. Other policies can influence investment and purchase decisions.”

Carbon taxes combined with capital gain taxes and transfers

We believe a revenue-neutral regime of differential capital gain taxes that incentivizes investors to reallocate capital from firms that have a negative environmental impact (known as ‘brown’ firms) to green ones — coupled with targeted transfers — should be implemented together with the existing carbon tax to tackle the contribution emitters make to climate-change. Our proposed tax scheme would also be more politically palatable than a carbon tax alone because it avoids the regressivity of carbon pricing. This plan would thus expand the toolkit available for policymakers and environmental activists alike.

The rationale for a revenue-neutral carbon tax scheme is to encourage capital reallocation, discourage investments made by carbon-intensive firms, and recycle the revenues to subsidize green projects. In equilibrium, the cost uptick induced by carbon taxes renders brown firms’ investments less fruitful, thereby forcing those firms to reduce capital spendings. Meanwhile, a subsidy for green firms generated from the carbon-tax revenue boosts their returns on investments, and hence their capital expenditures. Consequently, carbon taxes affect firms’ total capital stock, output, and emissions.

Nonetheless, carbon-intensive firms may dodge this new scheme by passing their higher costs on to end consumers instead of bearing it themselves. “A tax of, say, $35 a ton on CO2 emissions in 2030 would typically increase prices for coal, electricity, and gasoline by about 100, 25, and 10 percent, respectively,” according to the IMF. Lower-income households typically have a higher expenditure share of carbon-intensive consumption; for them, the relative fallout would be more burdensome.

“Climate Strike 2019 12 – No Going Backwa” (CC BY 2.0) by Amaury Laporte

What’s clear is that prices of brown firms’ output move in tandem with carbon taxes, so even though carbon taxes improve overall social welfare, thanks to fewer emissions and climate disasters, citizens at the lower part of the income distribution become worse off.

Incentivizing investors and alleviating the burden on low-income households

So here’s where we are today: The carbon budget once available to limit the temperature rise below 1.5°C is depleting fast, carbon taxes are facing political and socioeconomic backlash, and still, US policymakers struggle to find a solution to the carbon-pricing dilemma. Our proposed solution consists of a revenue-neutral scheme of differential capital gain taxes, coupled with rebates and the existing carbon tax, that is as effective as carbon taxes alone in achieving the optimal decarbonization path while remaining progressive:

First, much like traditional capital gain taxes — which are differential, in other words, lower on dividends and long-term capital gains and higher on nonqualified dividends and short-term gains — investors could be taxed differentially, based on the eco-friendliness of their investment assets. Taxing brown stocks more and their green counterparts less will take care of the needed resource reallocation through the cost-of-capital channel. That is, because investors in brown firms will demand a higher pretax return to compensate for the tax increase, the values of brown firms will necessarily decrease due to the discount-rate channel. Lower valuations will in turn induce brown firms to shrink their capital spendings. At the same time, general equilibrium effects will induce green firms to invest more.

Second, to alleviate the burden on low-income households from the rise in prices of carbon-intensive goods by virtue of scarcer supply, the tax proceeds should be redistributed to them as a subsidy to risk-free assets such as checking and savings accounts. Since stock market participation is higher among wealthier households on the intensive and extensive margins, the above transfer genuinely targets low-income earners, who do not hold risky assets but concentrate their wealth in risk-free ones. Thus, our suggested self-contained tax scheme not only improves social welfare by curbing emissions and slowing climate change but also helps to mitigate social unrest arising from regressive taxation.

We see three other reasons why this proposed tax scheme could gather majority political support:

• Our proposed plan can be jointly implemented with carbon taxes. Hence, policymakers would be able to choose from a broader menu of options, mixing and matching carbon and capital gain taxes. They could then fine-tune the agenda to find a sweet spot that is infeasible with carbon pricing alone.
• Because the capital gain tax would fall on dispersed investors, rather than on companies’ bottom line, this tax scheme could potentially circumvent brown firms’ fierce opposition to carbon taxes.
• Our proposed solution can be conveniently integrated into the existing tax codes; no separate administrative system is needed.

Our proposed tax plan would mitigate the risk of climate disaster while reducing economic inequality along the decarbonization pathway. The resulting enhanced policy toolkit will enable policymakers, regulators, and environmental activists to address climate change more effectively, more fairly, and sooner. 

• This article is based on the paper, ‘Incentivizing Investors for a Greener Economy’, forthcoming in the Journal of Financial and Quantitative Analysis.
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• Note: This article gives the views of the author, and not the position of USAPP – American Politics and Policy, nor the London School of Economics. 
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