Economics of Carbon Taxes

The idea of enacting a carbon tax to address climate change and fiscal woes may be as plausible as relying on new leadership to steer the Chicago Cubs to their first world championship in over a century.

But now that another baseball season has come and gone with no changes on the North Side of Chicago, national fiscal season emerges with yet another return to the question of imposing some form of tax on some forms of fossil fuel. In this case, could such a tax be part of a fiscal cliff deal?

The carbon tax idea has been around for a long time, backed by an extensive and ideologically diverse set of economists. This includes prominent economic advisors going back to every presidential administration since that of Richard Nixon, though their public embrace of the idea tends to increase markedly after departure from public office. Even diverse think tanks are getting back into the act, reflected in yesterday’s “economics of carbon taxes” summit at the American Enterprise Institute.

Indeed, that illustrates the main rap against carbon taxes: Good economics, awful politics, public policy non-starter. Why take a risk on the best available policy option when the political costs are likely to be severe? And why not revert to third- or fourth-best policy options that obscure the costs and thereby curry greater favor? The avalanche of state and local climate initiatives over the past decade largely reflect this pattern, with carbon tax aficionados most likely to note much earlier experience from the Nordic countries as their models.

But that is not the entire story. Indeed, perhaps the most prominent example of a carbon tax in the past decade involves one Canadian province. Like the United States, Canada produces a very high rate of per capita greenhouse gas emissions. Like the United States, it has struggled mightily to formulate any federal policy on climate change. But Canada is a very decentralized federal system and some provinces have operated outside the conventional policy box, just like some states under American federalism.

Enter British Columbia. If this province seceded from Canada and joined the United States, it would clearly be a blue coastal state, somewhat akin to neighboring Oregon and Washington. But this is hardly a case in which environmental advocates seized power and imposed their will. Key design elements and features follow:

Center-right Political Push. The push for a tax that would steadily ramp up to $30 per ton of carbon dioxide over a four-year period came from the Liberal Party, the center-right governing party. It faced stiff opposition from the left-center New Democratic Party, which endorsed virtually every climate policy option except a tax. This was approved in 2008, the Liberal Party won subsequent re-election, and continues to hold power despite a change in its premier. The tax reached its peak of $30 in January 2012, roughly equivalent to 27 cents per gallon on gasoline and also applied to other fossil fuels. (See Shi-Ling Hsu’s The Case for a Carbon Tax for a fuller discussion)

Targeted Revenue Use. Most of the focus on carbon taxes has emerged from the economics community, looking at competing designs and likely economic consequences. Far less attention has been paid to how revenue might be allocated—and whether or not that makes a political difference. British Columbia systematically linked cost-imposition (the tax) with public benefits. This began with a small rebate check to all citizens but followed with a revenue-neutral approach that involved a commensurate reduction in other provincial taxes. There is ample precedent in the United States for linking new energy taxes to demonstrable benefits, ranging from Dwight Eisenhower’s use of gasoline excise revenues to Sarah Palin’s allocation of funds from her oil windfall profits tax overhaul in Alaska.

Rapid Implementation. Imposition of the first wave of the tax was almost immediate, building on established tax platforms and necessitating virtually no staff expansion. Indeed, the overseeing minister faced a 15 percent salary penalty if key implementation requirements were missed. This is greatly at odds with many other climate policies, such as California which is about to enter its seventh year of deliberation on how to implement its cap-and-trade program and how to use any revenues generated via auction.

Measurable Impacts. The best analysis to date suggests that the tax has had a demonstrable impact on reducing fossil fuel use and emissions. In turn, the province has experienced higher GDP growth than the average rate among provinces during this period, confirming the Nordic experience that a unilateral energy tax can coincide with economic growth.

No other province or state has rushed in to replicate the British Columbia model and it may remain a single-case fluke in North America. But if carbon taxes ever shift from the agenda of former public officials to current ones (including newly-elected ones facing a fiscal cliff), it offers numerous lessons on political feasibility. These might prove particularly useful for newly-elected officials eager to avoid a fiscal cliff. Even the Chicago Cubs need to get ready for next year, just in case.