Should we raise environmental taxes? This question has been asked increasingly in the face of widespread environmental problems including global warming, air and water pollution, and a host of other environmental problems that we face today. A “textbook” answer to this question would be yes, we certainly should raise taxes to the point where the tax equals the marginal social damage from pollution. Unfortunately the real world is more complicated than a textbook world. Measurement problems abound: how do we measure marginal social damages? Concerns about economic efficiency intrude given the widespread prevalence of other taxes. Finally, distributional concerns come into play. Environmental taxes tend to be regressive: poor people pay a disproportionate share of their income in these taxes relative to rich people.
This paper addresses how one could design an environmental tax reform such that it reduces or even eliminates the regressive nature of the reform. It considers reforms that combine environmental taxes with reductions in other taxes such that the increased regressivity of the environmental taxes is offset by increased progressivity resulting from reductions in other taxes. Using data from the 1994 Consumer Expenditure Survey and other sources, I show that a modest tax reform in which environmental taxes equal to 10 percent of federal receipts are collected has a negligible impact on the income distribution when the funds are rebated to households through reductions in the payroll tax and personal income tax. The degree of income shifting can be adjusted with changes in how the revenues are returned to households and it is possible to increase the progressivity of the tax system with an environmental tax reform.