Optimal carbon tax in oligopolies: An application to commercial aviation

Diego S. Cardoso. (Job Market Paper)

Abstract Taxes to correct environmental externalities are typically designed to match the value of marginal damages. This approach maximizes social welfare when an environmental externality is the only market imperfection. When multiple imperfections exist, however, estimates of marginal damage are not sufficient to set the optimal tax: it is also necessary to understand the market structure and estimate the effect of imperfections, such as market power and distortionary taxes. This paper estimates the optimal carbon tax for the US domestic aviation, a sector with mounting evidence of market power and subject to non-environmental, distortionary taxes. To do so, I combine a theoretical framework of optimal environmental taxation and econometric methods for the study of oligopolies. Based on estimated model parameters and sufficient statistics for marginal welfare changes, I (i) calculate the optimal carbon tax in the presence of non-carbon distortions, (ii) estimate total and marginal welfare costs of emission abatement via carbon taxation, and (iii) examine the extent to which existing taxes are substitutes to a carbon tax. I find that any positive carbon tax would decrease social welfare in the short run, based on a social cost of carbon (SCC) of \$50/ton CO2. If a carbon tax of \$50/ton CO2 were implemented, it would reduce emissions by 14% but result in a net loss of \$4.5 billion per year in social welfare (about 5% of the sector’s yearly aggregate revenue). Assuming a higher SCC of \$230/ton CO2, the optimal carbon tax would be \$40/ton CO2, thus much lower than the standard Pigouvian taxation suggests. Furthermore, if emission reductions are achieved exclusively through lowering demand, the marginal abatement cost (in loss of aggregate private surplus) corresponds to $208/ton CO2. Lastly, I find that current taxes correspond to carbon tax of approximately \$52/ton CO2; however, implementing a revenue-neutral carbon tax to replace current taxes would have little effect on emissions and welfare. These findings highlight one of the main challenges for climate policy in the aviation: the abatement cost of carbon emissions is high, at least with limited abatement technologies available in the short run.