Comments on Senate Finance Committee Proposal for Energy Tax

Thank you for the opportunity to comment on the Energy Tax Reform Discussion Draft of the U.S. Senate Committee on Finance (the Committee), dated December 18, 2013. I am a Fellow and the Policy Director for the Climate and Energy Economics Project at the Brookings Institution. My research focuses on the economic and environmental outcomes of climate and energy policies.

I congratulate the Committee on taking up the important issue of the design of fiscal policies to encourage clean energy. I agree that current incentives are unnecessarily complex and far less effective than they could be. I will focus on aspects of the proposal that directly pertain to my research.

Tax Subsidies for Clean Energy vs. Discouraging Energy Production that is Not Clean

It is hard to design a tax credit that rewards only those activities that would occur in the absence of the credit. Indeed, many of the questions raised in your draft relate directly to this challenge. In contrast, it is relatively easy to impose a simple excise tax on the carbon content of fuels and other identifiable sources of greenhouse gases (GHGs) such that all emitters have the same incremental incentive to reduce each ton of emissions.

As you know, economists have been advocating efficient price signals on carbon since we first heard the science of climatic disruption. Just as there is nearly universal agreement among scientists about human-induced climatic change, there is nearly universal agreement among economists that a price on carbon, such as through a carbon tax, is the most economically efficient policy to reduce GHG emissions. Here’s why:

1. First, an excise tax approach is market-based, it’s flexible, it accommodates existing fuel mixes and the “remaining useful life” of equipment, and it doesn’t undermine electricity reliability, while at the same time it provides an incentive to reduce use of fossil fuels in exact proportion to each fuel’s damage to the climate.
2. An excise tax creates abatement incentives on the margin at every level of emissions, even beyond the point at which any particular technical performance standard or benchmark is achieved. The policy always binds and always incentivizes abatement. An excise tax also helps drive a market for new technologies, which subsidies and standards based on existing technologies may not do.
3. An excise tax, without any ancillary measures, creates incentives to abate through the entire supply chain of energy. It incentivizes energy efficiency and a transition to lower-carbon fuels by electricity generating units and vehicles, and it induces offsite actions to reduce or avoid emissions. Moreover, an excise tax incentivizes abatement through all means, including those about which Congress and the EPA have no information.
4. An excise tax would be the easiest, fastest, possible implementation of climate policy. Some states and the federal government already have excise taxes on fuels, including motor fuels, most coal, and natural gas. It would be straightforward to revise these excise taxes to reflect the GHG content of the fuels in a way that equalizes the incentives for abatement across all sectors.
5. An excise tax would be easier to initiate and administer than other approaches to incentivize emissions reductions, including a cap-and-trade system, tradable performance standards, and tax credits. No agency would have to devise an initial allocation of allowances (such as auctions), create a registry or market, monitor allowance trades, or enforce a price floor. The government would not have to measure electricity generation, transmission, or consumption, or compute the “cleanliness” of various energy sources relative to an arbitrary benchmark. Tax authorities would just monitor the carbon in fossil fuels at a chokepoint in their supply chain and collect the money.
6. Excise taxes can be easier for regulated firms than regulatory standards because firms would not have to worry about allowance price volatility, fluctuating stringency, protracted litigation of the Clean Air Act rules, uncertainty about standards EPA might set, or macroeconomic gyrations that would affect emissions allowance markets. The compliance price and its trajectory would be fixed, thus fostering the long term investments that are key to decarbonizing the economy.
7. If the federal government instead subsidizes clean energy, then taxpayers may be paying for deployment of technologies that are already required by state renewable energy standards.  This problem does not occur with an excise tax.
8. The federal government could use the revenue from a carbon excise tax to lower the net burdens of the tax system. The economic literature, including studies by us, shows that the most cost effective climate policy would use revenue generated from a carbon tax for a “tax swap.”[1] The federal government has some revenue instruments, notably capital income taxes, which are likely to be more distortionary than a carbon tax, so the possibility of an efficiency-enhancing tax swap raises the prospect of net social benefits without even counting the environmental benefits. Alternatively, the revenue could be used to lower the federal budget deficit, or to rebate the revenue to poor households, or for other purposes.
9. An excise tax bounds the cost of abatement because firms can always pay the tax rather than abate emissions. In contrast, tax subsidies can produce arbitrarily high costs of abatement. For example, CBO estimates that the cost to taxpayers of CO2 emissions reduced by the tax credit for electric cars is between $230 and $4,400 per metric ton.
10. A carbon tax has strong diplomatic advantages over tax subsidies for clean energy and EPA regulation of GHGs with an emissions performance standard. A specific price path on carbon is far more transparent in its implementation and consequences than a subsidy to reduce emissions or stipulating that electricity generators must attain an emissions performance standard of no more than X pounds of CO₂ per kWh generated. Other countries keenly want to know the economic level of US ambition, and anything other than a price on carbon is hard for them to assess.

On Avoiding Harm to Energy-Intensive Trade Exposed Industries

My proposal for a carbon tax includes five approaches that would mitigate any competitive effects of a U.S. carbon tax on energy-intensive trade-exposed (EITE) industries and the U.S. economy generally.[2]

1. The carbon tax I propose starts modestly (at $16 per ton of CO₂) and ramps up slowly (at 4% over inflation). This gives affected industries time to lower emissions and otherwise anticipate and adjust to higher relative prices of polluting inputs.
2. The tax revenue reduces the marginal statutory corporate income tax rate from 35% to 28%. This will help offset some of the burden of the carbon excise tax on affected industries and help make other industries more competitive than they are now.
3. A carefully crafted border carbon adjustment would tax select imports of EITE goods from countries with less ambitious climate policy goals.
4. To the extent that a carbon tax substitutes for more costly and less effective climate policy, it makes the overall U.S. economy more efficient and competitive.
5. My proposal includes a vigorous diplomatic complement to the carbon tax. The goal would be to leverage U.S. action to encourage other countries to adopt analogous emissions control measures.  This is the best possible way to reduce competitiveness effects of differential climate policy around the world.

Energy Efficiency Tax Credits vs. Carbon Tax

The summary of the staff discussion draft notes concerns about the abuse of energy efficiency tax credits for residential home improvements. I recommend that you also consider the evidence around the incremental environmental effectiveness of these credits, particularly in light of increasing energy efficiency standards.

My research shows that the tax credits are significantly environmentally inferior to taxing carbon. My colleagues Warwick McKibbin and Pete Wilcoxen and I did a modeling study that compared a carbon tax with a tax credit for energy efficient household capital (e.g. appliances and cars). We modeled both policies to have about the same sized fiscal footprint but of opposite signs. We concluded:

“[A] carbon tax would be far more effective at reducing U.S. emissions than an investment tax credit for energy efficient household capital. By 2040, a carbon tax reduces emissions by 60 percent while the reduction due to an investment tax credit for energy-efficient capital would be about 1.5 percent.”[3]

A carbon tax is more environmentally effective than tax credits for several reasons.  First, a tax incentivizes cleaner generation of electricity, which the household tax credit doesn’t do. Second, a carbon tax affects the characteristics of new equipment (like the tax credit), but it also affects the use of existing equipment. Finally, the subsidy for more efficient technologies produces household energy cost savings that are in part used on consumption of energy (directly or indirectly), a kind of rebound effect.

Thank you again for this opportunity to provide recommendations for the Committee. I would be happy to discuss any of these ideas with you in more detail.

[1] McKibbin, Warwick, Adele Morris, and Peter Wilcoxen, “The Potential Role of a Carbon Tax in U.S. Fiscal Reform,” with Warwick McKibbin and Peter Wilcoxen, Policy Brief: Brookings, July 24, 2012.

[2] “The Many Benefits of a Carbon Tax,” The Hamilton Project, Brookings, February 26, 2013.

[3] McKibbin, Warwick, Adele Morris, and Peter Wilcoxen “Subsidizing Energy Efficient Household Capital: How Does It Compare to a Carbon Tax?”, The Energy Journal, Special Issue. Strategies for Mitigating Climate Change Through Energy Efficiency: A Multi-Model Perspective, 2011, pages 111-127.