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Jan Schmitz, Kai Menzel and Fabian Dittrich

Economists agree that a tax on externalities is one of the most efficient means to internalize the social cost of environmental pollution. However, the political reality in democracies has revealed complications in the rate-setting exercise. Without the willingness of voters to bear their full individual share of the social costs through taxation, rates are nearly always too low to fully internalize even the lowest estimates of the social costs of environmental damage and climate change. Furthermore, in its currently applied versions, such a tax acts as a regressive form of taxation, since energy expenses relative to disposable income are higher for low-income households than for higher-income households. The solution we propose to these two problems is straightforward: the entire revenue of energy taxation shall be given back to voters. Doing so on a per capita basis, reimbursing to each household the average amount of the energy tax paid, leaves the incentive structure of the taxation setting intact. Under such a setting, the payable energy tax is higher the more energy is consumed, while after reimbursement the average household bears no tax burden at all. Only households with above average energy consumption pay net energy taxes, low energy households would receive a net transfer. Energy savings continue to pay off individually, because the individual household can save energy (and lower tax payments) with the reimbursement remaining untouched. In the political realm, this should allow for much higher energy tax rates.