Question

The Government has imposed a Carbon Tax. Using General Equilibrium theory what are some of the effects on the economy as a whole. The more obscure the better

Answer 1

In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an overall general equilibrium.

How Would a Carbon Tax Directly Affect the Economy?

By raising the cost of using fossil fuels, a carbon tax would tend to increase the cost of producing goods and services—especially things, such as electricity or transportation, that involve relatively large amounts of CO2 emissions. Those cost increases would

provide an incentive for companies to manufacture their products in ways that resulted in fewer CO2 emissions. Higher production costs would also lead to higher prices for emission-intensive goods and services, which would encourage households to use less of them and more of other goods and services.Without accounting for how the revenues from a carbon tax would be used, such a tax would have a negative effect on the economy. The higher prices it caused would diminish the purchasing power of people’s earnings, effectively reducing their real (inflation-adjusted) wages. Lower real wages would have the net effect of reducing the amount that people worked, thus decreasing the overall supply of labor. Investment would also decline, further reducing the economy’s total output.

The costs of a carbon tax would not be evenly distributed among U.S. households. For example, the additional costs from higher prices would consume a greater share of income for low-income households than for higher-income households, because low income households generally spend a larger percentage of their income on emission intensive goods. Similarly, workers and investors in emission-intensive industries, who would see the largest decrease in demand for their products, would be likely to bear relatively large burdens as the economy adjusted to the tax. Finally, areas of the country where electricity is produced from coal—the most emission-intensive fossil fuel per unit of energy generated—would tend to experience larger increases in electricity prices than other areas would.

Additional information

How Would Various Uses of the Revenues
From a Carbon Tax Alter Its Economic Effects?
Lawmakers’ choices about how to use the revenues from a carbon tax would help
determine the tax’s ultimate impact on the economy. Some uses of those revenues
could substantially offset the total economic costs resulting from the tax itself, whereas
other uses would not.

1. Using the Revenues to Reduce Deficits Would Decrease the Tax’s Total Costs to the Economy.

At least part of the negative economic effect of a carbon tax would be offset if the tax
revenues were used for deficit reduction. Federal budget deficits tend to result in lower economic output over the long run than would otherwise be the case, by crowding out private-sector investment. Thus, policies that reduce deficits generally have a positive
effect on the economy in the long run (although they can have a negative effect in the
short term when the economy is weak).

2. Using the Revenues to Cut Marginal Tax Rates Would Also Decrease Total Costs.

Lawmakers could also offset some of the negative economic effects of a carbon tax by using the
revenues to reduce the existing marginal rates of income or payroll taxes—a policy
known as a tax swap. Existing taxes on individual and corporate income decrease
people’s incentives to work and invest by lowering the after-tax returns they receive
from those activities. Consequently, reducing those marginal tax rates would have
positive effects on the economy.

3.Using the Revenues to Reduce Adverse Effects on Selected Groups Would Not Decrease Total
Costs.

Targeting revenues toward people who would be likely to bear a disproportionate
burden under a carbon tax would provide them with relief, but such a policy would tend
not to reduce the total economic costs of the tax. Thus, lawmakers would face a trade-
off between the goals of helping those households most hurt by the tax and helping the
economy in general. Lawmakers could use the revenues in more than one way to try to
balance those goals.