There are a number of sensitive issues in the debate about how to interpret cost estimates generated by different models, including assumptions about tax recycling, target setting, and international co-operative mechanisms.

7.6.6.1 Tax Recycling

Tax recycling issues revolve around two critical points concerning the interactions between existing tax systems and a tax system that integrates carbon taxes:

• Assumptions on the structure of the tax system in the baseline and mitigation cases, which include assumptions on tax substitution generated by the recycled revenue of carbon taxes. These baseline assumptions have to be projected into the future for a considerable period if the revenue recycling is to be calculated correctly.
  
• The total impact of the policy scenario that includes the recycling of carbon taxes, in terms of both distribution and compensation.

The net cost of climate policy depends on (1) the structure of the tax system prior to the introduction of the mitigation policy and (2) the nature of the mitigation policy (e.g., which sectors are covered, what tax instruments are employed, and the way that revenues are recycled). Estimates of the size of the effect are discussed in Chapter 8. This is closely related to the double-dividend literature, which is discussed in Section 7.3.3.1. As noted there, the welfare loss (or burden) of a given climate policy depends on the structure of existing taxes. The more distorted the pre-existing tax the higher the welfare loss. This means that a carbon tax can result in either a totally increased burden (welfare loss of the whole tax system) or a double dividend (in which the total welfare loss of the tax system is lower because the carbon tax substitutes other “burdensome” taxes). In general, however, a larger benefit from a carbon tax is found in comparison with other instruments that meet the Kyoto Protocol targets (e.g., permits issued gratis) than is found in comparison between different methods of recycling.

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