Optimal environmental taxes under relative consumption effects

This paper explores the interactions between carbon dioxide emissions taxes and a pre-existing income tax in a numerically calibrated model of climate change and the world economy. Based on evidence from the recent empirical literature, the model allows for the presence of relative consumption effects in the specification of preferences. In the absence of relative consumption effects, optimal emissions taxes would rise from US$44 to US$229 per tonne of carbon (in year 2000 dollars) over the course of the next century. These tax rates, which arise when emissions tax revenues are used to reduce taxes on personal income, are slightly above the present value marginal benefits of emissions control. Given realistic assumptions concerning the empirical magnitude of relative consumption effects, the optimal emissions tax rises from US$63 per tonne in 2005 and US$384 per tonne in 2105. Accounting for relative consumption effects reduces the perceived social benefits of consumption, thus increasing social willingness to pay for environmental quality while reducing both the costs of tax interaction effects and the benefits of efficient revenue recycling. Taken together, these factors support the implementation of comparatively high environmental taxes in the face of relative consumption effects.