Options for Returning the Value of CO2 Emissions Allowances to Households

Abstract

This paper examines alternative ways that the value of CO2 emissions allowances created under cap-and-trade policy could be returned to households. One approach (based on principles of economic efficiency) is effectively a "tax shift" that would use revenues from an auction of CO2 emissions allowances to reduce preexisting distortionary taxes. A second approach (based on principles of property rights for common-pool resources), known as cap-and-dividend, would refund allowance value as equal lump-sum cash transfers to households. Economic theory suggests (with some caveats) that a tax shift would be considerably less costly to the overall economy. In contrast, cap-and-dividend provides ample compensation for low-income households, though it appears to be more costly than other approaches, including perhaps well-designed regulatory policies. A dividend approach might be combined with other policies to provide incentives for households to invest in energy-efficient technologies and thereby lower the costs of the carbon policy.

Keywords: cap-and-trade, auction tax shift, revenue recycling, tax interaction, dividends

JEL Classification: H23, Q54, Q58