Optimal carbon taxation under oligopoly: An application to commercial aviation

Diego S. Cardoso. Job Market Paper

Abstract Corrective environmental taxes typically equal 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 an 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 US domestic aviation by combining a theoretical framework of optimal environmental taxation and structural econometric methods for the study of oligopolies. Based on estimated model parameters and sufficient statistics for marginal welfare changes, I (i) estimate marginal and total costs of emission abatement via carbon taxation, (ii) calculate the optimal carbon tax in the presence of non-carbon distortions, and (iii) examine the extent to which existing taxes are substitutes for a carbon tax. I find that the marginal cost of abatement with carbon taxation starts at \$208/ton CO2. Thus, if the social cost of carbon (SCC) is smaller than this value, any positive carbon tax would decrease social welfare in the short run. Under a higher SCC of \$230/ton CO2, the optimal carbon tax would be \$40/ton CO2, much lower than the Pigouvian tax level. Lastly, I find that current taxes on air travel correspond to a carbon tax of approximately \$52/ton CO2. Implementing a revenue-neutral carbon tax to replace current taxes would lead to substantial welfare gains. The lack of scalable abatement technologies and sizable market imperfections lead to high carbon abatement costs, highlighting a key challenge for climate policy in aviation.