Fiscal Reform and Climate Protection: Considering a U.S. Carbon Tax

These comments were delivered on October 18, 2011 at “Fiscal Reform and Climate Protection: Considering a U.S. Carbon Tax,” an event hosted by Resources for the Future and the Peterson Institute of International Economics.

Thank you for inviting me to speak today. I was asked to help frame the issue of the carbon tax within the political economy of fiscal reform.

Putting aside for the moment the political considerations, I think the framing of the fiscal challenge is relatively straightforward. Even under CBO’s very conservative current law scenario (which assumes such things as a sharp reduction in Medicare payment rates to physicians, a cessation of the perennial patches of the Alternative Minimum Tax, and the expiration of the marginal tax rate reductions next year), the cumulative 10-year deficit is expected to be $3.5 trillion. According to work by Alan Auerbach and Bill Gale, the debt-to-GDP ratio under this scenario would increase to over 90 percent by 2035, which would be the largest federal debt burden since immediately after the end of World War II. Under a more realistic extended policy baseline, the debt-to-GDP ratio grows to about 170 percent by 2035, with continued and indefinite growth forecasted thereafter. Over the infinite horizon, the fiscal gap is about 9 percent of GDP — meaning that we would need an immediate and permanent increase in taxes or reduction in spending of this enormous magnitude to keep our debt-to-GDP ratio at the current level.

The key question for today’s event is what role a carbon tax can play in addressing this fiscal challenge. I believe a well-designed carbon tax can make for both good environmental policy and good fiscal policy. But I do approach today’s theme with some trepidation. The economic justification for a carbon tax is that the price of any carbon-intensive activity should include the environmental costs imposed on third parties by that activity. Thus, we need to keep in mind that the primary economic purpose of a carbon tax is to discourage emissions, not to raise revenue. While we need to address our fiscal shortfall, an efficient carbon tax is one set at the expected external cost of carbon emissions, not at the level that maximizes tax revenue.

Of course, once you’ve set a carbon tax, there is a clear economic case for using the revenues to offset existing inefficient taxes or to reduce the deficit. A carbon tax would increase the price of energy and transportation, which in effect would lower real wages. This decrease in real wages would magnify distortions from pre-existing taxes, such as the income tax. This is known as the tax-interaction effect, and it can mean that a tax on pollution can impose substantial economic costs, even in some cases leading to negative net benefits. The way to reduce these costs is by using the pollution tax revenue to offset economically harmful taxes or deficits. There are many studies of the implications of this. One study by Larry Goulder, Marc Hafstead, and Michael Dworsky, finds that using climate revenue to reduce marginal income taxes results in GDP costs that are about 33 percent lower than when these revenues are returned to the economy in a lump-sum fashion.

So efficient use of carbon tax revenues can substantially lower the cost of any climate policy. And while it can contribute meaningfully to deficit reduction, it only goes so far in closing our fiscal gap. A carbon tax of similar stringency to the cap-and-trade bill that passed the House in 2009 would raise about $60-$80 billion annually in the early years, rising to about $100 billion in about 25 years, before dropping again thereafter. This is a substantial amount of tax revenue, but it would only play a small part in closing our fiscal gap. If one focuses on just the 10-year window, annual carbon tax revenue would be on par with our expected revenue from excise taxes, which amounts to about half a percent of GDP annually. This is slightly smaller than the revenue loss due to the mortgage interest deduction. Over the longer-term, which is when we face our most pressing fiscal problems due to rising health care costs and the aging population, we could expect the carbon tax to contribute less to closing our fiscal shortfall, since emission reductions would be likely to outpace increases in the carbon tax.

Rather than help close the fiscal gap, a carbon tax could instead be part of a revenue-neutral means of reducing taxes on labor and saving. There are many ways to do this. Gib Metcalf’s 2007 proposal called for a carbon tax in which revenues were used for a tax credit to partially offset the employer and employee payroll taxes. Under this proposal, the carbon tax would generate about $80 billion per year and would allow for a tax credit to offset payroll taxes paid on the first $3,660 of earnings up to a maximum credit of $560. Tax credits are less economically efficient than marginal rate reductions, so we could instead use the revenues to reduce rates in something like the highly-inefficient corporate tax code. A rough calculation suggests the corporate tax rate could be reduced from 35 percent to 27 percent using carbon tax revenues.

But if the goal is to use pollution revenues for deficit reduction, unfortunately our policy track record here has not been good.  

Our existing sulfur dioxide cap-and-trade program—which is our most successful market-based program—gives away all of the cap allowance value to electric utilities. For climate policy, the bill that passed the House in 2009 called for about 60 percent of the total allowances to be given away over the life of the program. The remaining 40 percent was to be auctioned by the government, but the auction revenue for the most part was not to be used for deficit reduction. Of the total allowance value in 2016, less than one percent was targeted for deficit reduction. The bulk of the value went to such things as subsidizing electric utilities, helping trade-exposed industries, and transfers to low-income consumers. The bill also would have passed a large share of the value of emission allowances along to households in a way that would have blunted their incentives to conserve energy, thus increasing the carbon price necessary to achieve the environmental goals of the program.

In the Senate, the climate bill proposed by Senators Kerry and Boxer would have given away 77 percent of the allowances in 2012. Only about 10 percent was targeted for deficit reduction. The bill proposed by Senators Cantwell and Collins auctioned all of the allowances, but then would have allocated 75 percent of the revenue evenly across all U.S. residents and would have allocated 25 percent to fund such things as transition assistance, carbon sequestering projects, and clean energy investments. Nothing was allocated for deficit reduction.

The administration’s original cap-and-trade proposal did call for all allowances to be auctioned. However, the administration did not target any of the auction revenue for deficit reduction. Instead, about 80 percent of the revenue was to go to permanently extending the Making Work Pay tax credit, and the remainder was to go to subsidizing clean energy technology.

So our limited policy history and proposals with pollution revenue recycling is one in which the revenues are largely either given away to the regulated industry or are used to fund government programs or tax credits, not to fund deficit reduction or reductions in the most inefficient taxes.

But perhaps our pressing fiscal challenges present an opportunity for better policy now. This is where we turn to the current political economy framework. I suspect a political consensus is indeed achievable with respect to tax reform. Our current tax system is economically harmful, complex, unpredictable, and often unfair, which strikes me as thus creating a broad negotiating space for improvement.

But I do think the most likely route towards tax reform would entail changing our current tax code, by broadening the base through reducing tax expenditures while lowering marginal tax rates. Indeed, this was the general framework adopted by President Bush’s tax reform panel in 2005 and more recently by the Simpson-Bowles fiscal commission in 2010. Neither of these commissions proposed the adoption of new taxes, such as a carbon tax. I think it would be politically challenging — albeit not impossible — to expand the dimensions of tax reform to include new taxes, rather than focus on reforming the tax system we currently have.

Let me touch on another possible path towards a carbon tax, given that the political climate suggests that coupling a carbon tax with deficit reduction or even tax reduction might be challenging.

I think an underexplored opportunity exists to couple a carbon tax with broader environmental policy reform. It is true that one of the points previously used in favor of cap-and-trade was that it could substitute for the default policy, which stemming from the Massachusetts vs. EPA Supreme Court ruling is that the EPA will issue emission rules for greenhouse gases under the Clean Air Act. This Clean Air Act approach to climate policy is considerably less cost-effective than a modest, gradually increasing, and predictable price on carbon through a carbon tax or cap and trade.

But I would take this one step further. Not only could a carbon tax substitute for prospective carbon regulations under the Clean Air Act, it could also substitute for other existing environmental and energy regulations. For example, fuel economy standards and energy efficiency standards are largely redundant given a clear and predictable price on carbon. And carbon reductions should yield co-benefit reductions in other conventional pollutants currently regulated by the EPA. I would be curious to see EPA model what would be the effects of a carbon tax or cap-and-trade on attainment of Clean Air Act standards for conventional pollutants.

If fiscal and tax reform proceeds without including a carbon tax, advocates for climate policy should consider making a carbon tax part of broader environmental policy reform, including reducing our reliance on less cost-effective existing regulations under the Clean Air Act. Thank you.