Household heterogeneity, aggregation, and the distributional impacts of environmental taxes

• Environmental tax incidence is affected by the household aggregation bias.
• We theoretically study how household heterogeneity qualitatively affects incidence.
• We quantitatively show that the aggregation bias matters for carbon tax incidence.
• The aggregation bias mainly affects the returns to factors of production.
• Our findings are robust to a number of model extensions.

This paper examines how the general equilibrium incidence of an environmental tax depends on the effect of different incomes and preferences of heterogeneous households on aggregate outcomes. We develop a Harberger-type model with general forms of preferences and substitution between capital, labor, and pollution in production that captures the impact of household heterogeneity and interactions with production characteristics on the general equilibrium. We theoretically show that failing to incorporate household heterogeneity can qualitatively affect incidence. We quantitatively illustrate that this aggregation bias can be important for assessing the incidence of a carbon tax, mainly by affecting the returns to factors of production. Our findings are robust to a number of extensions including alternative revenue recycling schemes, pre-existing taxes, non-separable utility in pollution, labor–leisure choice, and multiple commodities.