U.S. Climate Policy: Desperately Seeking Revenue

Editor’s Note: Ted Gayer, co-director of the Economic Studies program, delivered the following remarks at the Tax Policy Center’s “Desperately Seeking Revenue” event on March 2, 2010.

Thank you for inviting me to speak today. I was asked to talk about whether revenues from a climate policy – either cap-and-trade or carbon tax – could help close the fiscal gap. But first I wanted to commend the authors [Rosanne Altshuler, Katherine Lim and Roberton Williams] on their paper, which convincingly demonstrates the difficulty of closing the 10-year cumulative deficit through increases in the existing income tax, especially if one only considers changes to the top two tax brackets. The tables that show the required increases in marginal tax rates are indeed sobering. The $11 trillion expected 10-year shortfall is simply too much to close through our already inefficient income tax structure.    

And this is just to narrow the 10-year cumulative deficit. Things get much worse over the longer-term, as rising health care costs and the aging population exacerbate our fiscal problems. According to Alan Auerbach and Bill Gale, the infinite horizon 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. Even under CBO’s very conservative – and unrealistic – current law scenario, the debt-to-GDP ratio increases to about 80 percent in 2035 and about 280 percent in 2080. CBO’s more realistic alternative scenario shows the debt-to-GDP ratio exploding to about 715 percent in 2080! 

Any time I am presented with the facts about our dire fiscal situation, I am left wondering about two things. The first is what is meant by “politically feasible.” The authors understandably note that it would be politically infeasible to close the 10-year cumulative deficit using our current income tax system. But I think the more appropriate standard is what is economically feasible. It seems that every serious idea of reducing our substantial debt burden is deemed as politically infeasible by someone. The list of politically infeasible measures at times includes a consumption tax, raising the eligibility age for Social Security and Medicare, means testing all entitlements, and eliminating tax expenditures such as the mortgage interest deduction or the tax exclusion of employer-provided health insurance. I suspect the phrase “politically feasible” is similar to the word “want” in that they are both meaningless without a discussion of prices. If the price of foregoing a given policy increases, then the policy will become more politically feasible.

Which leads to my second question, which is why isn’t our dire fiscal situation being priced into the bond market? Even with a 10-year cumulative deficit of about $11 trillion, the 10-year Treasury yield is well under 4 percent.  There seems to be a mis-match between the underlying fiscal fundamentals and the market price for US borrowing. I don’t mean to suggest that we should assume there is no fiscal problem as reflected in the bond market. If we’ve learned anything these past few years, it is that prices don’t always accurately reflect the underlying risk, and indeed prices can change abruptly. A sharp jump in Treasury rates would quickly worsen our fiscal situation, which would in turn suddenly change what we consider our set of “politically feasible” options. Of course, it would be much better if we got our fiscal house in order before a severe prompting of the bond market.

My final comment on the general fiscal situation concerns debt maturity. Right now, about a third of our debt is maturing within a year, and over half of it is maturing within three years. If we think that current Treasury borrowing rates are low given the fundamentals of our fiscal situation, shouldn’t we consider shifting more of our debt into locking into the relatively low longer-term rates?

Now on to the possibility of closing the fiscal gap through climate revenues. The economic justification for a carbon tax or cap-and-trade is that the price of any carbon-intensive activity should include the environmental cost imposed by the activity. As much as we need deficit reduction, the goal of a carbon tax or a cap-and-trade program should not be to maximize tax revenue. Nonetheless, an optimal carbon tax or cap-and-trade program would yield substantial revenue that could be targeted for deficit reduction.

There is an economic case for using carbon revenues to offset existing distortionary taxes or to reduce the deficit. A carbon tax or cap-and-trade program increases the price of energy and transportation, which in effect lowers real wages. This decrease in real wages magnifies 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.  The way to reduce these costs is by using the pollution tax revenue to offset economically harmful taxes or deficits. A recent study by Larry Goulder, Mark 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 just given away for free.

Sadly, our policy history is one in which revenues from a pollution tax or a cap-and-trade program are not used for tax or deficit reduction. Our existing sulfur dioxide cap-and-trade program gives away all of the allowance value. For climate, the bill that passed the House of Representatives calls for about 60 percent of the total allowances to be given away for free over the life of the program. The remaining 40 percent is to be auctioned by the government, but the auction revenue is not used for tax or deficit reduction. Of the total allowance value in 2016, only 0.2 percent is targeted for deficit reduction. The bulk of the value goes to such things as subsidizing electric utilities, helping trade-exposed industries, and transfers to low-income consumers. 

In the Senate, the bill proposed by Senators Kerry and Boxer gives away 77 percent of the allowances for free in 2012. Of the remaining 23 percent, only 43 percent is targeted for deficit reduction. The bill proposed by Senators Cantwell and Collins auctions all of the allowances, but then allocates 75 percent of the revenue evenly across all U.S. residents and allocates 25 percent to fund such things as transition assistance, carbon sequestering projects, and clean energy investments. Nothing is allocated for deficit reduction.

The administration’s original cap-and-trade proposal also called for all allowances to be auctioned. However, the administration did not target any of the auction revenue for deficit reduction, nor did it target reducing the most inefficient taxes. 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 track record for using pollution revenues for deficit reduction is not good. Indeed, the history of US environmental policy is one in which Congress is more willing to subsidize the good (such as clean energy) rather than to tax the bad (such as pollution). There is a clear economic argument for taxes over subsidies; but even ignoring this argument, one should recognize that a policy of subsidies or tax credits makes our fiscal situation worse, not better.  

Putting aside our poor track record, how much deficit reduction could we accomplish through a well-designed climate policy? According to the EPA’s analysis of the caps in the existing bills, we could raise about $60 to $80 billion annually in the early years, rising to about $100 billion per year in about 25 years, and then dropping to about $70 billion per year in later years. Over the ten-year window, this makes potential carbon revenue on par with our expected revenue from excise taxes, which amounts to about a half of percent of GDP. 

One final point: a carbon tax or cap-and-trade auction raises government revenue by allocating a property right for using the air. There are other opportunities for the government to charge for granting rights to common property.  For example, as reported in the NY Times this Sunday, auctioning radio spectrum could raise over $100 billion per year. 

Even though revenue from such things as carbon allowance or radio spectrum auctions won’t close the fiscal shortfall (especially over the longer-term), they will make reasonable dents. And given our current fiscal outlook, such opportunities should not be lost.  Thank you.