When Can Carbon Abatement Policies Increase Welfare? The Fundamental Role of Distorted Factor Markets

This paper employs analytical and numerical models to assess the welfare effects of a revenue-neutral carbon tax and (nonauctioned) carbon emissions permits, taking into account preexisting tax distortions in factor markets. The presence of preexisting taxes significantly raises the general equilibrium costs of both policies. This cost increase is much greater under emissions permits, since this policy does not generate revenues to reduce distortionary taxes. Under our central estimates emissions permits cannot increase welfare unless environmental damages exceed about $18 per ton of carbon. In contrast, an appropriately scaled carbon tax is welfare-improving so long as environmental damages are positive.