Just about every public discussion of carbon tax swaps implicitly assumes that the distortions emanating from the tax code must decrease if the government begins taxing a negative externality (carbon emissions) and uses the revenue to reduce tax rates on productive activity. However, the analysis of the tax interaction effect shows that this assumption may be wrong.

This is from the just-released Econlib Feature Article for October, “Carbon Taxes and the Tax Interaction Effect.”

In the piece, Robert Murphy lays out the results of work by A. Lans Bovenberg and Lawrence H. Goulder. Bovenberg is an economist in the Netherlands who was awarded the Spinoza Prize in 2003. Goulder is Shuzo Nishihara Professor of Environmental and Resource Economics in the Economics Department of Stanford University. Although their work appeared in the most-prestigious economics journal in the world, the American Economic Review, in 1996, it has received little attention.

Until now. Murphy does an excellent job of walking the reader through the steps in the argument. The bottom line is that even if global warming is a problem and even if the optimal tax on carbon in a simple framework is $50 per ton of carbon, that result does not hold up in the real world in which we have other distorting taxes. Taking account of how the carbon tax can interact with other distorting taxes, Murphy points out that the optimal tax will be lower than $50 per ton and could be as low as zero.