Climate Change: Caps vs. Taxes

This essay is available here as an Adobe Acrobat PDF.

No. 2, June 2007

As the Kyoto Protocol's 2012 expiration date draws near, a general theme dominates the global conversation: leadership and participation by the United States are critical to the success of whatever climate policy regime succeeds the Kyoto Protocol. Two general policy approaches stand out in the current discussion. The first is national and international greenhouse gas (GHG) emissions trading, often referred to as "cap-and-trade." Cap-and-trade is the most popular idea at present, with several bills circulating in Congress to begin a cap-and-trade program of some kind. The second idea is a program of carbon-centered tax reform--for example, the imposition of an excise tax based on the carbon emissions of energy sources (such as coal, oil, and gasoline), offset by reductions in other taxes. In this paper we will address the strengths and weaknesses of both ideas and the framework by which legislators should evaluate them.

The framing of a global climate regime presents a classic chicken-and-egg problem: the United States does not wish to enter into a regime of economically costly emission caps or taxes that would have the effect of driving industry and jobs to nations such as China and India that do not participate in such caps. China and India, however, are unlikely to enter into a restrictive regime unless the United States goes first, and even then, only so long as the policy regime does not threaten serious constriction of their economies. It is often assumed that if the United States goes first, developing nations will eventually follow, but this is by no means assured. Both China and India have repeatedly declared that they are not prepared to make even a delayed commitment at this time.

Given these policy uncertainties--and other uncertainties about the eventual impacts of climate change in terms of severity, distribution, and timing--there are two guideposts policymakers should keep in mind. The first is that the United States can only effectively impose a national regulatory regime (though such a regime could eventually be harmonized with international efforts). The second is that, given the current uncertainty, policy should conform as much as possible to a "no regrets" principle by which actions undertaken can be justified separately from their GHG emissions effects in the fullness of time, such that nonparticipation by developing nations will disadvantage the United States in the global marketplace as little as possible.

While the United States may wish to join with other nations in setting a post-Kyoto emissions goal, it should be wary of joining an international emissions-trading or other regulatory regime. One of the less-remarked-upon aspects of the Kyoto Protocol, and any prospective successor treaty on that same model, is that it represents an unprecedented kind of treaty obligation for the United States. Most treaties involve direct actions and policies of governments themselves, such as trade treaties that bind nations' tariff levels and affect the private sector of the economy only indirectly. Kyoto and its kin go beyond government policy to affect the private sector directly or require the government to control the private sector and the investment decisions of the private sector to an unprecedented degree. It is not governments that emit GHGs, after all. Between the asymmetries of legal and regulatory regimes across nations, the United States should think hard about the dilution of sovereignty that a binding GHG treaty represents, even if the United States agrees with the basic objective of reducing carbon emissions.

Problems with Emissions Trading for GHG

Some economists favor the idea of emissions trading for its elegance in achieving least-cost emissions reductions while avoiding the manifold difficulties of prescriptive "command-and-control" regulation from a centralized bureaucracy. But this is something of a false choice, as such regulation is a deeply troubled policy option. While trading may be superior to command-and-control, it is not necessarily superior to other alternatives, such as carbon-centered tax reform.

There are a number of emissions-trading success stories that, upon inspection, suggest significant limitations to the applicability of emissions trading for GHG emissions. Enthusiasts for cap-and-trade point first to our sulfur dioxide (SO2) trading experience under the 1990 Clean Air Act Amendments. It is claimed that the costs of SO2 abatement through trading turned out to be dramatically lower than economists had forecast for a prescriptive regime, wherein the Environmental Protection Agency (EPA) would have mandated control technologies on individual coal-fired power plants. But a closer look shows this success to have been uneven. There has been significant volatility in emission permit prices, ranging from a low of $66 per ton in 1997 to $860 per ton in 2006, as the overall emissions cap has been tightened, with the price moving up and down as much as 43 percent in a year.[1] Over the last three years, SO2 permit prices have risen 80 percent a year, despite the EPA's authority to auction additional permits as a "safety valve" to smooth out this severe price volatility.

Several other aspects of the SO2-trading program are of doubtful applicability to GHGs. First, SO2 trading was only applied to a single sector: initially, only 110 coal-fired power plants were included in the system, but it subsequently expanded to 445 plants. While coal-fired power plants account for roughly one third of U.S. carbon dioxide (CO2) emissions and will therefore be central to a GHG cap-and-trade program, a comprehensive GHG emissions-trading program will have to apply across many sectors beyond electric utilities, vastly complicating a trading system.

Second, SO2 and CO2 are not comparable targets for emissions reduction. Reducing SO2 emissions did not require any constraint on end-use energy production or consumption. Coal-fired power plants had many low-cost options to reduce SO2 emissions without reducing electricity production. Some switched to low-sulfur coal (abetted in large part by railroad deregulation in the 1980s, which made transport of Western low-sulfur coal more economical than previously). The cost of "scrubbers"--industrial devices which capture SO2 and sequester it--turned out to be lower than predicted. Other utilities emphasized more use of natural gas. The impact on ratepayers and consumers was modest.

CO2 is different: it is the product of complete fuel combustion. There is no "low-CO2 coal," and the equivalent of SO2 scrubbers does not yet exist in economical form.[2] At the margin there is some opportunity for GHG emissions reductions through substitution--increased use of natural gas (which emits less CO2 per unit of energy than coal) and possibly nuclear power--but the inescapable fact is that any serious reduction in CO2 emissions will require a suppression of fuel combustion. This is going to mean lower energy consumption and higher prices, at least in the intermediate term.

Even though confined to a segment of a single sector of energy use, the SO2 emissions-trading regime was far from simple. There were complicated allocation formulas to distribute the initial emissions permits. Despite the best efforts to create objective criteria, at the end of the day, the allocation of emission permits involves some arbitrary discretion. For political reasons there were special subsidies and extra allowances for the benefit of high-sulfur coal interests. Most trading in the early years took place between power plants within the same company.

Establishing allowances and accounting systems for GHG emissions across industries is going to be vastly more difficult and highly politicized. The forest products industry, for example, will reasonably want credits for creating carbon sinks in the trees it plants and harvests, but the manufacturing sector that uses these wood products as a raw material will want credit for sequestering carbon. The difference will have to be split in some arbitrary manner that will surely introduce economic distortions in the marketplace. The auto industry will want credits for GHG innovations, while industries and businesses of all kinds will lobby for credits for reducing mobile source emissions from changes to their auto and truck fleets. There are going to be winners and losers in this allocation process. Multiply this problem across sectors and industries and it becomes evident that a GHG emissions-trading system is going to be highly complex and unwieldy, and too susceptible to rent-seeking influence in Washington. The problem of politically adjusting competing interests will be compounded on the international scale. The long-running diplomatic conflicts that can be observed over purported subsidies for aircraft (i.e., Boeing versus Airbus) and the European Union's agricultural subsidies and trade barriers are examples of the kinds of conflicts that will be endemic to any international emissions-trading scheme.

The favored solution to these problems is to over-allocate the number of initial permits both to ease the cost and to encourage the rapid start-up of a market for trades. This was the course the European Union took with its Emissions Trading System (ETS), and it has very nearly led to the collapse of the system. Because emissions permits were over-allocated, the price of emissions permits plummeted, and little--if any--emissions reductions have taken place because of the ETS. The over-allocation of initial permits merely postpones both emissions cuts and the economic pain involved. Economist Robert J. Shapiro notes:

As a result of all of these factors and deficiencies, the ETS is failing to reduce European CO2 emissions. . . . [T]he European Environmental Agency has projected that the EU is likely to achieve no more than one-quarter of its Kyoto-targeted reductions by 2012, and much of those "reductions" will simply reflect credits purchased from Russia or non-Annex-I countries [developing countries], with no net environmental benefits.[3]

As economist William Nordhaus observes:

We have preliminary indications that European trading prices for CO2 are highly volatile, fluctuating in a band and [changing] +/- 50 percent over the last year. More extensive evidence comes from the history of the U.S. sulfur-emissions trading program. SO2 trading prices have varied from a low of $70 per ton in 1996 to $1500 per ton in late 2005. SO2 allowances have a monthly volatility of 10 percent and an annual volatility of 43 percent over the last decade.[4]

Nordhaus points out the ramifications of such volatility, observing that "[s]uch rapid fluctuations would be extremely undesirable, particularly for an input (carbon) whose aggregate costs might be as great as petroleum in the coming decades," and that "experience suggests that a regime of strict quantity limits might become extremely unpopular with market participants and economic policymakers if carbon price variability caused significant changes in inflation rates, energy prices, and import and export values."[5]

Nordhaus is not alone in this concern about price volatility. Shapiro similarly observes:

Under a cap-and-trade program strict enough to affect climate change, this increased volatility in all energy prices will affect business investment and consumption, especially in major CO2 producing economies such as the United States, Germany, Britain, China and other major developing countries.[6]

Additional pitfalls and dilemmas of emissions trading can be seen through a review of the spectacular trading failure of the RECLAIM (Regional Clean Air Incentives Market) emissions-trading program in Southern California. Launched in 1994 after three years of development, RECLAIM set in motion an emissions-trading program targeting SO2 and nitrogen oxides (NOx) emissions, and eventually hoped to expand to include volatile organic compound (VOC) emissions. All three types of emissions are important precursors to ozone formation in the greater Los Angeles air basin. RECLAIM, for the first time, offered swaps between stationary and mobile sources: stationary sources such as oil refineries could help reach their emissions reduction targets by purchasing old, high-polluting automobiles and trucks and taking them off the road--a cost-effective measure in a voluntary demonstration program. The South Coast Air Quality Management District (SCAQMD) estimated that SO2 and NOx would be reduced by fourteen and eighty tons per day, respectively, by the year 2003, at half the cost of the usual prescriptive method of regulation.[7] There was great public support and enthusiasm for the program at the outset.

RECLAIM never came close to operating as predicted, and was substantially abandoned in 2001. Between 1994 and 1999, NOx levels fell only 3 percent, compared to a 13 percent reduction in the five-year period before RECLAIM. There was extreme price volatility aggravated by California's electricity crisis of 2000. NOx permit prices ranged from $1,000 to $4,000 per ton between 1994 and 1999, but soared to an average price of $45,000 per ton in 2000, with some individual trades over $100,000 per ton. Such high prices were not sustainable, and SCAQMD removed electric utilities from RECLAIM in 2001. SCAQMD also dropped its plan to expand RECLAIM to VOCs. Despite the hope that RECLAIM would be simple and transparent, there were serious allegations of fraud and market manipulation, followed by the inevitable lawsuits and criminal investigations.

One particular problem with RECLAIM that is likely to plague any international GHG emissions-trading regime is the lack of definite property rights to the emissions allowances the program creates. A cliché of the moment is that industry would like some clarity and certainty about any prospective GHG regulatory regime. A cap-and-trade program, however, cannot provide certainty precisely because emissions allowances are not accorded real property rights by law.[8] The government can change the rules at any time, making emissions allowances worthless. This is exactly what happened to electric utilities in Los Angeles: their allowances were terminated, and the utilities were subsequently required to install specified emissions-control technologies and to pay fines for excess emissions. In effect, some Los Angeles firms had to pay three times over for emissions reductions.

A GHG emissions-trading scheme on an international level will be even more vulnerable to these kinds of unpredictable outcomes. To the extent that a GHG emissions-trading program results in international cross-subsidization of the economies of trading partners, it is going to be politically unsustainable in the long run. An international emissions-trading program is also unlikely to survive noncompliance by some of its members.

There are two final, overriding reasons to be doubtful about global emissions trading. It is possible that the defects of previous emissions-trading programs could be overcome with more careful design and extended to an international level, though this would require an extraordinary feat of diplomacy and substantial refinements of international law. Even if such improvement could be accomplished, it would not provide assurance against the prospect that the cost of such a system might erode the competitiveness of the U.S. economy against developing nations that do not join the system.

The second reason for skepticism about global emissions trading is that it fails the "no regrets" test. It is considered bad form nowadays to express doubt or skepticism about the scientific case for rapid and dangerous global warming in the twenty-first century. If warming is either less pronounced than some current forecasts predict or if emissions reductions have limited effect in moderating future temperature rise, however, a severe global emissions-reduction policy through emissions trading (on the order of a minimum 50 percent cut by 2050) could turn out to be the costliest public policy mistake in human history, with the costs vastly exceeding the benefits.

Could instituting a tax on the carbon emissions released by fuel use, as part of a revenue-neutral tax reform package, pass these two tests? We believe it could.

Advantages of a Revenue-Neutral, Carbon-Centered Tax Reform

Most economists believe a carbon tax (a tax on the quantity of CO2 emitted when using energy) would be a superior policy alternative to an emissions-trading regime. In fact, the irony is that there is a broad consensus in favor of a carbon tax everywhere except on Capitol Hill, where the "T word" is anathema. Former vice president Al Gore supports the concept, as does James Connaughton, head of the White House Council on Environmental Quality during the George W. Bush administration. Lester Brown of the Earth Policy Institute supports such an initiative, but so does Paul Anderson, the CEO of Duke Energy. Crossing the two disciplines most relevant to the discussion of climate policy--science and economics--both NASA scientist James Hansen and Harvard University economist N. Gregory Mankiw give the thumbs up to a carbon tax swap.[9]

There are many reasons for preferring a revenue-neutral carbon tax regime (in which taxes are placed on the carbon emissions of fuel use, with revenues used to reduce other taxes) to emissions trading. Among them are:

  • Effectiveness and Efficiency. A revenue-neutral carbon tax shift is almost certain to reduce GHG emissions efficiently. As economist William Pizer observes, "Specifically, a carbon tax equal to the damage per ton of CO2 will lead to exactly the right balance between the cost of reducing emissions and the resulting benefits of less global warming."[10] Despite the popular assumption that a cap-and-trade regime is more certain because it is a quantity control rather than a price control, such a scheme only works in very limited circumstances that do not apply to GHG control. The great potential for fraud attendant on such a system creates significant doubt about its effectiveness, as experience has shown in both theory and practice in the gyrations of the European ETS.

The likelihood of effectiveness also cannot be said for regulations such as increased vehicle fuel economy standards. In fact, such regulations can have perverse effects that actually lead to increased emissions. By making vehicles more efficient, one reduces the cost of a unit of fuel, which would actually stimulate more driving, and, combined with increasing traffic congestion, could lead to an increase in GHG emissions rather than a decrease.

As Harvard researchers Louis Kaplow and Steven Shavell point out, "The traditional view of economists has been that corrective taxes are superior to direct regulation of harmful externalities when the state's information about control costs is incomplete," which, in the case of carbon emissions reductions, it most definitely is.[11] And when it comes to quantity controls (as a cap-and-trade system would impose), Pizer found that

My own analysis of the two approaches [carbon taxes vs. emission trading] indicates that price-based greenhouse gas (GHG) controls are much more desirable than quantity targets, taking into account both the potential long-term damages of climate change, and the costs of GHG control. This can be argued on the basis of both theory and numerical simulations.

Pizer found, in fact, that a carbon-pricing mechanism would produce expected net gains five times higher than even the best-designed quantity control (i.e., cap-and-trade) regime.[12]

  • Incentive Creation. Putting a price on the carbon emissions attendant on fuel use would create numerous incentives to reduce the use of carbon-intensive energy. The increased costs of energy would flow through the economy, ultimately giving consumers incentives to reduce their use of electricity, transportation fuels, home heating oil, and so forth. Consumers, motivated by the tax, would have incentives to buy more efficient appliances, to buy and drive more efficient cars, and to better insulate their homes or construct them with more attention to energy conservation. A carbon tax would also create incentives for consumers to demand lower-carbon power sources from their local utilities. A carbon tax, as its cost flowed down the chains of production into consumer products, would lead manufacturers to become more efficient and consumers to economize in consumption. At all levels in the economy, a carbon tax would create a profit niche for environmental entrepreneurs to find ways to deliver lower-carbon energy at competitive prices. Finally, a carbon tax would also serve to level (somewhat) the playing field among solar power, wind power, nuclear power, and carbon-based fuels by internalizing the cost of carbon emission into the price of the various forms of energy.
  • Less Corruption. Unlike carbon cap-and-trade initiatives, a carbon tax would create little incentive or opportunity for rent-seeking or cheating. As William Nordhaus explains:

A price approach gives less room for corruption because it does not create artificial scarcities, monopolies, or rents. There are no permits transferred to countries or leaders of countries, so they cannot be sold abroad for wine or guns. . . . In fact, a carbon tax would add absolutely nothing to the instruments that countries have today.[13]

Without the profit potential of amassing tradable carbon permits, industry groups would have less incentive to try to get credits for their favored but non-competitive energy sources. That is not to say that tax-based approaches are immune from corruption, for they certainly are not. If set too far down the chain of production or set unevenly among energy sources, carbon taxes could well lead to rent-seeking, political favoritism, economic distortions, and so on. Foreign governments might have an incentive to undermine a trading scheme by offering incentives to allow their manufacturers to avoid the cost of carbon trading. A tax on fuels proportionate to their carbon content, levied at the point of first sale, should be less susceptible to corruption, and by delivering revenue to the government rather than to private entities, should create incentives more aligned with the government's objective.

  • Elimination of Superfluous Regulations. Because a carbon tax would cause carbon emissions to be reduced efficiently across the entire market, other measures that are less efficient--and sometimes even perverse in their impacts--could be eliminated. With the proper federal carbon tax in place, there would be no need for corporate average fuel economy standards, for example. California's emissions-trading scheme, likewise, would be superfluous, and its retention only harmful to the Golden State. As regulations impose significant costs and distort markets, the potential to displace a fairly broad swath of environmental regulations with a carbon tax offers benefits beyond GHG reductions.
  • Price-Stabilization. As the experiences of the European ETS and California's RECLAIM show us, pollution-trading schemes can be easily gamed, resulting in significant price volatility for permits. Imagine one's energy bill jumping around as permits become more or less available due to small changes in economic conditions. A carbon tax would be predictable, and by raising the overall price of energy to include the tax, the portion of energy cost per unit that stems from fluctuation in market rates for fossil fuels shrinks as a percentage of the whole. That shrinkage makes the price of a given form of energy less susceptible to volatility every time there is a movement in the underlying production costs.
  • Adjustability and Certainty. A carbon tax, if found to be too stringent, could be relaxed relatively easily over a timeframe, allowing for markets to react with certainty. If found too low to produce results, a carbon tax could easily be increased. In either event, such changes could be phased in over time, creating predictability and allowing an ongoing reassessment of effectiveness via observations about changes in the consumption of various forms of energy. A cap-and-trade system, by contrast, is more difficult to adjust because permits, whether one is the seller or the buyer, reflect significant monetary value. Permit traders would demand--and rightly so--compensation if what they purchased in good faith has been devalued by a governmental deflation of the new "carbon currency." In addition, sudden changes in economic conditions could lead to significant price volatility in a cap-and-trade program that would be less likely under a carbon-tax regime.
  • Preexisting Collection Mechanisms. Whether at local, state, or federal levels, carbon taxes could be levied and collected through existing institutions with extensive experience in enforcing compliance, and through ready-made statutes to back up their actions. The same cannot be said for emissions-trading schemes that require the creation of new trading markets, complete with new regulations and institutions to define and enforce the value of credits.
  • Keeping Revenue In-Country. Unlike an international cap-and-trade regime, carbon taxes--whether done domestically or as an internationally agreed-upon value--have the advantage of keeping tax payments within individual countries. This could strongly reduce the opposition to international action that has, until this point, had a strong implication of wealth redistribution overlaid on the policy discussion.

This dynamic leads to a second reason why a carbon tax is a better fit for U.S. climate policy: it offers an international analogue to our federalist approach to public policy innovation within the United States. As we have seen, there is reason to doubt the long-run effectiveness and sustainability of the EU's emissions-trading program. If the United States adopts a carbon tax approach, we will be able to compare the effectiveness of tax versus emissions trading in short order.

  • Mitigation of General Economic Damages. As energy is one of the three most important variable inputs to economic production (along with labor and capital), raising the cost of energy would undoubtedly result in significant economic harm. Using the revenues generated from a carbon tax to reduce other taxes on productivity (taxes on labor or capital) could mitigate the economic damage that would be produced by raising energy prices. The most likely candidates for a carbon tax tradeoff would be the corporate income tax (the U.S. rate is currently among the highest in the industrialized world) and payroll taxes, the latter of which would lower the cost of employment and help offset the possibly regressive effects of higher energy prices on lower-income households. But across-the-board income tax rate cuts and further cuts in the capital gains tax could also be considered.

Few other approaches offer this potential. Regulatory approaches such as increasing vehicle efficiency standards do not because they mandate more expensive technologies and allow the costs to be passed on to consumers without offsets (unless they are subsidized), in which case it is the general taxpayer whose wallet shrinks. Emissions-trading would allow for this if one auctioned all initial permits and used the revenue to offset other taxes. The vast majority of trading systems, however, begin with the governing entity distributing free emission credits to companies based on historical emission patterns rather than having an open auction for permits that would produce such revenue streams. Without an auction, the revenues in a trading scheme accrue only to private companies that trade in carbon permits, while the companies buying permits would pass the cost on to consumers. International emissions-trading approaches such as Kyoto's clean development mechanism are worse still: the beneficiaries of the scheme are likely to be foreign governments or private entities that can reduce (or pretend to reduce) carbon emissions more efficiently, leaving Americans with higher energy prices and no revenue stream to offset the negative impacts on productivity.

Exploring the Parameters of Carbon-Centered Tax Reform

Published estimates of an initial optimal carbon tax on fuels are in the range of $10 to $20 per ton of CO2 emitted (in 2005 dollars). Nordhaus, for example, estimates the optimal rate for a tax implemented in 2010 to be $16 per ton of carbon and rapidly rising over time.[14] We will focus primarily on a tax rate of $15 per ton of CO2, while also providing enough information to allow a reader to consider the likely impact of a range of possible taxes.

  • Background on Emissions. According to the U.S. Energy Information Administration, emissions of CO2 in the United States in 2005 equaled 6,009 million metric tons (MMT) of CO2, an increase of twenty MMT over 2004.[15] Emissions have grown at an annual rate of 1.2 percent between 1990 and 2005. Recently, the rate has slowed, with the average annual rate between 2000 and 2005 equaling 0.5 percent.
  • Price Impacts. Table 1 shows the price impacts of a $15 per ton CO2 tax under the assumption that the tax is fully passed forward. The price shown for gasoline is not in addition to that on crude oil (i.e., it is not a double-tax). It is included to show how the price levied on crude oil would change the price of the refined product.[16] This provides a rough guide to the excise tax equivalent price impacts of a tax on CO2. We can scale the tax rates to evaluate different carbon taxes. For example, a $10 per ton tax on CO2 would raise the price of coal by $28.55 x 0.66 = $18.84.

Table 1

A $15 CO2 tax would raise the price of gasoline by 14¢ per gallon. A similar calculation can be made for coal-fired electricity. Using the most recent data from EPA's Emissions & Generation Resource Integrated Database (eGRID), we calculate that the average emission rate for coal-fired power plants is 2,395 pounds of CO2 per megawatt-hour (MWh) of electricity. A $15 per ton CO2 tax would raise the price of coal-fired electricity by 1.63¢ per kilowatt-hour (kWh), or 20 per-cent at an average electricity price of 8.3¢ per kWh.

Table 2 shows the impact of a $15 per ton carbon tax on the price of major fuels used in electricity generation. Fuel prices are prices at which the carbon tax would likely be applied.[17] Not surprisingly, coal is most heavily impacted by a carbon tax, with coal's price rising by more than three-quarters with a tax of this magnitude.

Table 2

  • Behavioral Responses and Revenue. The higher energy prices in table 2 should bring about a reduction in the demand for carbon-intensive fuels. A full analysis of equilibrium changes in carbon emissions requires a Computational General Equilibrium (CGE) model, an exercise that is beyond the scope of this paper. We can, however, make a rough calculation using previously published results from CGE models. Here, we extrapolate results from the analysis of Bovenberg and Goulder of a $25 per ton tax on carbon.[18] Table 3 presents the price and output changes for fossil fuels following the imposition of the carbon tax in Bovenberg and Goulder's study. We compute the arc elasticity as the ratio of the percentage output change to price change.

Table 3

These response elasticities are not price elasticities in the usual sense, since they are the outcome of the entire general equilibrium response to the tax. These responses, for example, include a shift in electricity production away from coal toward natural gas and oil.[19] They are also relatively short-run responses, on the order of three to five years following the phased-in introduction (over three years) of the carbon tax.

The elasticities from table 3 combined with the price increases in table 2 imply the reductions in fuel use and carbon emissions seen in table 4.

Table 4

As table 4 shows, CO2 emissions are reduced by 663 million metric tons, a decline of 11 percent. Most of the reduction in emissions comes from reduced coal use. A static estimate of CO2 tax revenue (ignoring the behavioral response) suggests that a $15 tax would raise $90.1 billion per year in the near term.[20] Allowing for the emissions reductions calculated in table 4, the tax would raise $80.2 billion per year. Clearly, the tax would raise less money in future years as greater reductions in carbon emissions occurred through improvements in efficiency, fuel switching, or new technologies like carbon capture and sequestration.[21] The revenue estimate, however, does not factor in growth in demand for electricity nor the baseline growth in carbon emissions that would result in the absence of any carbon policy.

Applying this approach to different carbon tax rates gives the results for emissions reductions and tax revenues seen in table 5.

Table 5

While these results are useful for providing a ballpark estimate of the impact of a carbon tax, more detailed modeling will be required to refine them further. Our estimates are broadly consistent with results from more detailed CGE modeling of U.S. carbon policies.[22]

  • Potential Uses of Revenue. Carbon tax revenues could be used for a number of purposes, such as lowering payroll and corporate income taxes, funding tax relief to low-income earners most affected by increased energy prices, or a combination of these. Table 6 reports the carbon tax revenue from table 5 as a percentage of various tax collections in 2005, as reported in the most recent administration budget submission.

Table 6

A $15 per ton CO2 tax raises enough revenue to reduce the corporate income tax by over one-quarter and income or payroll taxes by roughly 10 percent. In a policy brief for the Brookings Institution and the World Resources Institute, economist Gilbert Metcalf estimated that a rebate of the employer and employee payroll tax contribution on the first $3,660 of earnings per worker in 2003 would be sufficient to make the carbon tax both revenue- and distributionally neutral.[23]

Distributional neutrality may well impact the desirability and political feasibility of a carbon tax, but there are efficiency considerations as well. There is substantial literature on the "double dividend" that examines the economic conditions under which a carbon tax can be paired with a reduction in other taxes in a manner that improves the overall efficiency of the economy. Where such a double dividend is available, a carbon tax swap would be desirable, even if the environmental benefit of reduced carbon emissions failed to be realized.

The concept of the double dividend stems from the observation that a tax on an environmental externality not only helps curb the externality (dividend 1), but also provides revenue with which other distorting taxes can be reduced, thereby providing efficiency gains (dividend 2).[24]

The double dividend comes in different levels.[25] The "weak" double dividend states that if one has an economically distorting tax, using environmental tax proceeds to lower it provides greater efficiency gains than returning the proceeds lump sum to those who pay the environmental tax. An intermediate form of the double dividend hypothesis is that there exists a distortionary tax, such that using environmental tax proceeds to lower this tax will improve welfare, setting aside environmental benefits.[26] A strong form claims that a welfare gain will occur when environmental proceeds replace those of the typical distorting tax.

The weak double dividend is uncontroversial,[27] while the strong double dividend is somewhat more controversial.[28] Criticisms notwithstanding, logic suggests that the pursuit of a strong double dividend is desirable as a matter of public policy. To that end, it would seem much more desirable in terms of efficiency to pursue capital tax reduction as a revenue feedback than other choices, as the current treatment of capital in the tax code is quite far from the optimal tax of zero, and the efficiency gains from a reduction in a payroll tax would likely be minimal if labor is, as is generally accepted, supplied relatively inelastically.

It should be noted that cap-and-trade systems and carbon-tax systems can be designed so they are quite similar. If, for example, emissions are capped and permits are auctioned off, then one could, after observing the auction price, set a carbon tax that leads to a similar emissions and revenue outcome. Cap-and-trade systems, however, generally have been pursued as an alternative to revenue-raising taxes, and often allocate the permits according to some formula rather than through an auction. For the purposes of exposition, we compared a carbon tax to this latter form of the cap-and-trade system. One should remember that cap-and-trade proposals can be adjusted to raise revenues, and the revenues could then be used to pursue the double dividend. In that case, the relative merits of a carbon tax would be diminished.

Achieving a More Efficient System

A cap-and-trade approach to controlling GHG emissions would be highly problematic. A lack of international binding authority would render enforcement nearly impossible, while the incentives for cheating would be extremely high. The upfront costs of creating institutions to administer trading are significant and likely to produce entrenched bureaucracies that clamor for ever-tighter controls on carbon emissions. Permit holders will see value in further tightening of caps, but will resist efforts outside the cap-and-trade system that might devalue their new carbon currency. Higher energy costs resulting from trading would lead to economic slowdown, but as revenues would flow into for-profit coffers (domestically or internationally), revenues would be unavailable for offsetting either the economic slowdown or the impacts of higher energy prices on low-income earners.

A program of carbon-centered tax reform, by contrast, lacks most of the negative attributes of cap-and-trade, and could convey significant benefits unrelated to GHG reductions or avoidance of potential climate harms, making this a no-regrets policy. A tax swap would create economy-wide incentives for energy efficiency and lower-carbon energy, and by raising the price of energy would also reduce energy use. At the same time, revenues generated would allow the mitigation of the economic impact of higher energy prices, both on the general economy and on the lower-income earners who might be disproportionately affected by such a change. Carbon taxes would be more difficult to avoid, and existing institutions quite adept at tax collection could step up immediately. Revenues would remain in-country, removing international incentives for cheating or insincere participation in carbon-reduction programs. Most of these effects would remain beneficial even if science should determine that reducing GHG emissions has only a negligible effect on mitigating global warming.

A modest carbon tax of $15 per ton of CO2 emitted would result in an 11 percent decline in CO2 emissions, while raising non-coal-based energy forms modestly. Coal-based energy prices would be affected more strongly, which is to be expected in any plan genuinely intended to reduce GHG emissions. A number of pos-sible mechanisms are available to refund the revenues raised by this tax. On net, these tools could significantly reduce the economic costs of the tax and quite possibly provide economic benefits.

For these reasons, we conclude that if aggressive actions are to be taken to control GHG emissions, carbon-centered tax reform--not GHG emission trading--is the superior policy option.

Kenneth P. Green is a resident scholar, Steven F. Hayward is the F. K. Weyerhaeuser Fellow, and Kevin A. Hassett is a senior fellow and director of economic policy studies at AEI.

AEI editorial associate Nicole Passan worked with Messrs. Green, Hayward, and Hassett to edit and produce this Environmental Policy Outlook.

This essay is available here as an Adobe Acrobat PDF.

Notes

1. United States Environmental Protection Agency (EPA), "Progress Reports," available at www.epa.gov/airmarkets/progress/progress-reports.html.

2. Sequestration projects currently appear to be not only very expensive, but they also reduce net power generation by as much as 20 percent, further aggravating the cost that will be passed along to consumers and rate payers.

3. Robert J. Shapiro, "Addressing the Risks of Climate Change: The Environmental Effectiveness and Economic Efficiency of Emissions Caps and Tradable Permits, Compared to Carbon Taxes," February 2007, 22, available at www.theamericanconsumer.org/Shapiro.pdf.

4. William Nordhaus, "Life after Kyoto: Alternative Approaches to Global Warming Policies" (NBER working paper no. W11889, December 2005), 15.

5. Ibid., 22.

6. Robert J. Shapiro, "Addressing the Risks of Climate Change: The Environmental Effectiveness and Economic Efficiency of Emissions Caps and Tradable Permits, Compared to Carbon Taxes."

7. RECLAIM covered 390 stationary sources of NOx and fourteen stationary sources of SO2, which represented only 17 percent of total basin-wide NOx emissions and 31 percent of basin-side SO2 emissions.

8. The Clean Air Act forbids it, in fact. SCAQMD's RECLAIM regulations read: "An RTC [RECLAIM Trading Credit] shall not constitute a security or other form of property." Section 4 of the RECLAIM regulations reiterated this point: "Nothing in District rules shall be construed to limit the District's authority to condition, limit, suspend, or terminate any RTCs or the authorization to emit which is represented by a Facility Permit." (Cited in James L. Johnston, "Pollution Trading in La-La Land," Regulation [Fall 1991], available at www.cato.org/pubs/regulation/reg17n3-johnston.html.)

9. Carbon Tax Center, "Who Supports," available at http://carbontax.wrkng.net/who-supports/.

10. William Pizer, "Choosing Price or Quantity Controls for Greenhouse Gases," Resources for the Future Climate Issues Brief 17 (July 1999).

11. Louis Kaplow and Steven Shavell, "On the Superiority of Corrective Taxes to Quantity Regulation," American Law and Economics Review 4, no. 1 (2002).

12. William Pizer, "Choosing Price or Quantity Controls for Greenhouse Gases."

13. William Nordhaus, "Life after Kyoto: Alternative Approaches to Global Warming Policies," 15.

14. Ibid.

15. U.S. Department of Energy (DOE), Energy Information Administration (EIA), Emissions of Greenhouse Gases in the United States 2005, DOE/EIA-0573(2005), Washington, DC: DOE, 2006. Total GHG emissions equaled 7,147 million metric tons CO2 equivalent using hundred-year global warming potentials. Note that a simple conversion of other GHGs (i.e., methane, nitrous oxides, HFCs, and PFCs) does not exist. The global warming potential depends on the time horizon. We focus on CO2 only in this study, though, ideally, a carbon tax would also tax these non-CO2 emissions.

16. This is a standard assumption borne out by CGE modeling. See, for example, A. Lans Bovenberg and Lawrence Goulder, "Neutralizing the Adverse Industry Impacts of CO2 Abatement Policies: What Does It Cost?" in Distributional and Behavioral Effects of Environmental Policy, eds. Carlo Carraro and Gilbert. E. Metcalf (Chicago: University of Chicago Press, 2000), 45-85.

17. We assume the tax on coal would be applied for electric utilities and major industrial coal users. Note that 91 percent of domestic and imported coal is consumed by electric utilities. (DOE, EIA, Emissions of Greenhouse Gases in the United States 2005.) The tax on crude oil is levied at refineries, and the tax on natural gas at the city gate.

18. A. Lans Bovenberg and Lawrence Goulder, "Neutralizing the Adverse Industry Impacts of CO2 Abatement Policies: What Does It Cost?"

19. Increased coal prices could also lead to increased demand for imported oil, an important policy consideration outside the scope of this paper.

20. Carbon taxes can be reported in either units of carbon or CO2. To convert a tax rate per unit of carbon dioxide to a rate per unit of carbon, multiply the CO2 rate by 44/12 (the mass difference between carbon and CO2). Thus, a tax of $10 per ton of CO2 is equivalent to a tax of $36.67 per ton of carbon.

21. The recent coal study by researchers at the Massachusetts Institute of Technology suggests that carbon capture and sequestration is cost competitive at a carbon price of $30 per ton of CO2. See John Deutch and Ernest Moniz, The Future of Coal (Massachusetts Institute of Technology, 2007), available at http://web.mit.edu/coal/.

22. Sergey Paltsev et al., Assessment of U.S. Cap-and-Trade Proposals, report 146 (Cambridge, MA: MIT Joint Program on the Science and Policy of Global Change, 2007), available through http://mit.edu/globalchange/www/abstracts.html#top.

23. Gilbert Metcalf, A Green Employment Tax Swap: Using a Carbon Tax to Finance Payroll Tax Relief (Washington, DC: Brookings Institution-World Resources Institution, 2007).

24. Don Fullerton and Gilbert E. Metcalf, "Environmental Taxes and the Double Dividend Hypothesis: Did You Really Expect Something for Nothing?" Chicago-Kent Law Review 73, no. 1 (1998): 221-56.

25. See Lawrence H. Goulder, "Environmental Taxation and the ‘Double Dividend': A Reader's Guide," International Tax and Public Finance 2 (1995): 157-83, for a thorough taxonomy of the various double dividends. Also see A. Lans Bovenberg and Lawrence Goulder, "Neutralizing the Adverse Industry Impacts of CO2 Abatement Policies: What Does It Cost?"

26. The terminology of intermediate and strong double dividends is due to Goulder, "Environmental Taxation and the 'Double Dividend': A Reader's Guide."

27. Mustafa Babiker, Gilbert E. Metcalf, and John Reilly, "Tax Distortions and Global Climate Policy," Journal of Environmental Economics and Management 46 (2003): 269-87. Babiker et al. show that it is possible, however, to find taxes such that lump-sum replacement dominates, lowering a distortionary tax.

28. A. Lans Bovenberg and Ruud de Mooij, "Environmental Levies and Distortionary Taxation," American Economic Review 84, no. 4 (1994): 1085-89. See also Lawrence H. Goulder, "Environmental Taxation and the ‘Double Dividend': A Reader's Guide."

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  • Steven F. Hayward was previously the F.K. Weyerhaeuser Fellow at AEI. He is the author of the Almanac of Environmental Trends, and the author of many books on environmental topics. He has written biographies of Presidents Jimmy Carter and Ronald Reagan and of Winston Churchill, and the upcoming book, The Politically Incorrect Guide to the Presidents. He contributed to AEI's Energy and Environment Outlook series. 

 

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