What Welfare State Objectives can governments pursue with Carbon Price revenues? Implication of Political Support across EU countries

Jules Linden - Luxembourg Institute of Socioeconomic Research

Carbon pricing is central to the EU’s climate strategy but raises important equity concerns. Using carbon tax revenues to compensate households for increased living costs through income transfer is popular among academics and policymakers, but produces winners and losers and challenges the EU’s commitment to ‘leave no one behind’. Who wins and loses from carbon pricing and compensation measures primarily depends on how tax revenues are used. The choice of compensation measures is likely guided by their distributional impact and the size of the losing group. This paper simulates a carbon tax and eight compensation measures in six EU countries. Our analysis yields two insights. First, the distributional impact of compensation measures differs substantially across countries, complicating policy learning. Second, governments in all countries face a trade-off between the level of redistribution achieved and the share of losers created by compensation measures. In many countries, a Universal Basic Income - UBI - and a Food VAT reduction offer the best balance between redistribution and the share of reform losers, but do not directly support a transition to low-carbon societies. Consequently, households may remain locked in unsustainable consumption patterns for longer than desirable. This points to a potential trade-off between securing political support for carbon pricing today and generating broader support for future climate action.