Moving U.S. Climate Policy Forward: Are Carbon Taxes the Only Good Alternative?

This paper estimates the welfare costs of the main medium-term options for significantly reducing U.S. energy-related carbon dioxide (CO2) emissions, including carbon taxes and cap-and-trade systems applied economy-wide and to the power sector only, and an emissions rate standard for power generation. The key theme is that welfare costs depend importantly on how policies interact with distortions in the economy created by the broader fiscal system. If allowance rent is not used to increase economic efficiency, economy-wide cap-and-trade systems perform the worst on cost-effectiveness grounds. In contrast, if revenues are used to substitute for distortionary income taxes (either directly, or indirectly through deficit reduction), economy-wide carbon taxes (or auctioned allowance systems) may have (slightly) negative costs. The bottom line is that revenues or rents created under economy-wide, market-based carbon policies must be used to increase economic efficiency to ensure that these instruments are more cost-effective than regulatory or sectoral approaches.