Taxing Externalities: Revenue versus Welfare Gains with an Application to US Carbon Taxes

This article illustrates how the ratio of welfare gains to tax revenue plays a central role in framing political-economy and efficiency issues in the use of Pigouvian taxes to correct externalities. To date, the comparison of welfare and revenue has played virtually no role when economists recommend such taxes. This article presents a conceptual framework and then shows that the ratio of welfare gains to tax revenue is increasing in relation to both the marginal external costs and the market responsiveness to the tax in equilibrium. Further, the article illustrates the wide range of potential results with carbon taxes applied to different fossil fuels in the United States. For example, assuming a social cost of carbon and a carbon tax equal to $50 per ton, the central estimates imply ratios of the welfare gain to tax revenue of 12.1 for coal, 0.36 for natural gas, and very close to 1 for diesel and gasoline. When all four fuels are combined, the ratios range between 0.9 and 1.8. The article concludes with a general appeal for economists to pay more attention to the relative magnitudes of efficiency gains and tax revenue when analyzing and advocating for externality-correcting taxes.