Essay About Carbon Tax Scam

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  • Key Takeaways
  • Implement a carbon tax
  • Significantly reduce emissions
  • Create better market incentives for energy conservation
  • Use carbon tax revenue to reduce other taxes or pay down the debt
  • Supplant other clean-air regulations

By William Gale

Major tax policy changes have frequently occurred in a president’s first year in office. Ronald Reagan, Bill Clinton, and George W. Bush all achieved significant tax reform in their first years. While a president may ultimately have more than one bite at the tax apple, it is clear that a new chief executive gets a pretty big bite in the first year. 

Much determines exactly what and how much a president can accomplish. Perhaps the greatest two determinants are the party composition of each house of Congress and whether the president chooses to make tax reform a priority, particularly during the campaign. But regardless of party–and even of the makeup of Congress–the next president has an opportunity to do something truly dramatic: Implement a carbon tax. 

While this seems counterintuitive, given that most Republican candidates have not shown interest in the greenhouse gas policies often associated with a carbon tax, doing so makes good economic and political sense and has the support of a great number of economists, both liberal and conservative. A carbon tax would charge for carbon pollution, thus raising revenue and allowing for a combination of long-term debt reduction and cuts to taxes on personal income and corporate profits. 

Tax Reform – Past and Present

The first year of a new presidential administration has proven to be an auspicious time for changes in tax policy. Prospects are raised if the newly-elected president campaigned on a specific tax reform agenda or has the benefit of a unified Congress of his or her own party. But there is nothing automatic. Some presidents have not achieved or even pursued first-year reforms.  Some tax changes have occurred after the first year, in the second term, or with a divided Congress. 

If the next president faces a Congress in which the opposition party holds one or both houses, it may be hard to see how major tax reform will occur in 2017. The political atmosphere seems too toxic to generate the good faith and trust needed to go into such discussions, or to generate the compromises needed to come out of such discussions with a significant reform proposal that could have majority support. If one party were to hold all of the reins of power, it seems more plausible, but still not necessarily likely, that a major reform could go through. 

Then again, looking back, previous presidents have implemented tax reform—and two of the most noteworthy examples did so even though they did not control both houses of Congress.

Ronald Reagan, Bill Clinton, George W. Bush, and Barack Obama each pushed through major tax changes in his first year in office. For Reagan and Bush, the first-year tax reforms were direct extensions or applications of their campaign platforms. Reagan campaigned on a proposal to cut taxes substantially.  In 1981, he saw the Congress enact his tax measures, cutting the top personal income tax rate from 70 to 50 percent, creating a slew of saving and investment incentives, and indexing income tax brackets for inflation. Two decades later, George W. Bush made tax cuts a centerpiece of his campaign, and in 2001, Congress enacted his proposals virtually intact (and added a set retirement saving incentives). The new law provided immediate taxpayer rebates, cut income tax rates, created other subsidies, and cut estate taxes. The changes were phased in over time and all were originally scheduled to expire in 2010. 

For Clinton and Obama, the first-year story is a little more complex. After entering office, Clinton abandoned the middle-class tax cut proposal of his campaign and endorsed a deficit-reduction package that raised taxes on high-income households. Obama campaigned under rapidly deteriorating economic circumstances as the financial crisis and Great Recession took hold in 2008. The landmark 2009 stimulus package was certainly related to, and consistent with, his campaign themes, but the details had to be ironed out after inauguration. 

Clinton and Obama were able to bring about tax changes with the benefit of a unified government, with the White House and both houses of Congress held by Democrats. Reagan and Bush faced divided Congresses, but were able to enact their tax programs anyway. Notably, none of the presidents in the four first-year examples above had to deal with a situation where both legislative chambers were controlled by the opposing political party. 

Of course, major tax policy can be enacted after a president’s first year.  In response to the 1981 tax cuts’ effect on the budget, Reagan endorsed the major tax increases of 1982.  The once-in-a-generation Tax Reform Act of 1986 occurred during Reagan’s second term and closed dozens of loopholes and cut tax rates, with the top rate falling to 28 percent–all in a revenue-neutral and distributionally-neutral manner.  The tax cuts in 1997 (the first year of President Clinton’s second term) were essentially a reward to both parties as the economy and budget improved after 15 years of grueling fiscal restraint and political compromise that followed the deficits generated by Reagan’s 1981 tax cuts and defense spending increases. In 2003, at President Bush’s urging, Congress–with Republican majorities in each house–accelerated the phase-ins from the 2001 legislation, provided new rebates, and cut tax rates on capital gains and dividends. The tax changes at the end of 2012 occurred at the end of the first Obama Administration. 

Still, it is remarkable how many major tax policy changes have occurred in a president’s first year in office. 

Looking Ahead 

A safe prediction is that there will continue to be complaints about the tax system, including in particular the personal and corporate income taxes. Still, to cut taxes for those areas without driving budget deficits deeper poses a problem. If the president wanted to alleviate the direct burden on earners–individual and corporate–he or she could offset the revenue loss by creating a carbon tax.

The discovery and exploitation of natural resources by humans gave rise to the advanced civilization in which we live today. Coal, petroleum, and natural gas fueled industrialization, raising living standards and life expectancy for most. Energy use continues to fuel economic growth and development today. But along with the benefits of energy consumption come substantial societal costs—including those associated with air and water pollution, road congestion, and climate change. Many of these costs are not directly borne by the businesses and individuals that use fossil fuels, and are thus ignored when energy production and consumption choices are made. As a result, there is too much consumption and production of fossil fuels.

“…along with the benefits of energy consumption come substantial societal costs…”

Greenhouse gas emissions create a series of problems for the economy and the environment. The Intergovernmental Panel on Climate Change (2014) explains that emissions, if left unchecked, would increase “the likelihood of severe, pervasive, and irreversible impacts for people and ecosystems.”

Economists have long recommended specific taxes on fossil-fuel energy sources as a way to address these problems. The basic rationale for a carbon tax is that it makes good economic sense: Unlike most taxes, carbon taxation can correct a market failure and make the economy more efficient. Greg Mankiw (2013), Harvard economist and former chair of the Council of Economic Advisers under George W. Bush, says that “among economists, the issue is largely a no-brainer.”

To be clear, a “carbon tax” should address all greenhouse emissions to the extent that they are attributable to an identifiable party. Carbon dioxide accounts for the vast share of emissions in the United States, but other emissions of other gases – for example, methane and nitrous oxide – are more potent and would need to be taxed under separate schedules.

Carbon taxes would contribute to a cleaner, healthier environment and better environmental and energy policy by providing price signals to those who pollute. Not surprisingly, most analyses find that a carbon tax could indeed significantly reduce emissions. Gilbert Metcalf of Tufts University estimates that a $15 per ton tax on CO2 emissions that rises over time would reduce greenhouse gas emissions by 14 percent, while Jenny Sumner, Lori Bird, and Hillary Smith of the National Renewable Energy Laboratory estimate that the European countries’ carbon taxes have had a significant effect on emissions reductions, attributing reductions of up to 15 percent to a carbon tax. Furthermore, the University of Ottawa found that the carbon tax implemented in British Columbia led to a 10 percent reduction in greenhouse gas emissions in the province, compared to less than 5 percent for the rest of Canada, where comprehensive carbon taxes were not applied.

A carbon tax would also create better market incentives for energy conservation, the use of renewable energy sources, and the development of energy-efficient and low-carbon goods. The permanent change in price signals from enacting a carbon tax would stimulate new private sector research and innovation to develop new ways of harnessing renewable energy and energy-saving technologies. The implementation of a carbon tax also offers opportunities to reform and simplify other climate-related policies that affect the transportation sector. The tax would also reduce the U.S. economy’s dependence on foreign sources of energy, with potentially positive political connotations. 

A carbon tax could help the budget as well. A carbon tax set at $25 per metric ton on most greenhouse gas emissions measured in carbon dioxide equivalents (e.g. the amount of carbon dioxide that would result in an equivalent level of warming), growing 2 percentage points faster than inflation, could raise gross revenues equal to about 0.7 percent of GDP from 2016-2025 (around $160 billion per year), or net revenues of about 0.5 percent of GDP, after taking account of how other taxes would change, according to Tax Policy Center and Congressional Budget Office (CBO) estimates. For comparison purposes, note that CBO (2013) estimates that a $20 per ton carbon tax would increase the price of gasoline by about 20 cents per gallon.

“A carbon tax could help the budget as well.”

The revenue could be used to reduce other taxes and improve other economic incentives, bolster spending programs, or pay down the debt.

Although a carbon tax would be a new policy for the U.S. government, such a tax has been implemented in several other countries. Thus, problems of administration can be handled by following the procedures used by other countries, piggybacking off of existing U.S. fuel taxes or developing new options. 

There are several potential problems with a carbon tax, but each can be addressed. First, while it receives high marks on efficiency criteria when looking at the United States in isolation, a carbon tax could hurt the country if other nations do not adopt similar measures. Robert Stavins of Harvard notes that the largest efficiency gains would come in the form of internationally harmonized climate policies.  While the United States is one of the largest per capita emitters of carbon dioxide, China is the largest overall emitter, and the European Union makes a significant contribution as well. Therefore, enacting a program that would lead to better cooperation with other countries and reduce emissions across the world would more effectively deal with the well-known problems brought about by climate change, such as rising sea levels and higher frequency of extreme temperatures. In addition, there are ways to deal with competitiveness issues, including border carbon adjustments, the reduction of other regulations that could accompany a carbon tax, or lower corporate tax rates.

Second, the tax can have a negative impact on low-income households that use most of their income for consumption. Nevertheless, this regressivity could be offset in a number of ways, including refundable income or payroll tax credits. 

The politics of the carbon tax are not easy. Conservative opposition to a climate-related tax, or any new tax, should not be understated. More than 160 members of Congress have signed the “No Climate Tax” pledge, opposing carbon tax increases that are not fully offset by other tax cuts. In addition, it would be necessary to provide adjustment assistance for communities and workers affected by the decline in coal consumption that would occur due to higher (after-carbon-tax) prices of coal. There are precedents for this type of assistance, for example, with respect to the tobacco settlement, so it is a feasible proposition.

“Conservative opposition to a climate-related tax, or any new tax, should not be understated.”

Moreover, one should not underestimate how difficult it will be for a new president and Congress to thread the political needle, ingeniously bringing an end to an era of partisanship and gridlock. Still, there are rays of hope. The liberal case for a carbon tax is fairly straightforward and hinges on giving incentives to clean up the environment and address climate change. But there is also a conservative case, focusing on the role of public policy to provide insurance against adverse outcomes, to get market incentives right, and to obviate more costly approaches, such as regulations, subsidies, and mandates. The carbon tax could supplant at least some regulation of greenhouse gases under the Clean Air Act, which the EPA has begun to implement and which most conservatives oppose.

Conservative leaders like George Shultz and Harvard economist Greg Mankiw have favored a carbon tax. John McCain proposed a cap-and-trade system, which can have similar economic effects to a carbon tax, more than a decade ago, and has spoken eloquently on the dangers of climate change. Some of the revenues from a carbon tax could be used to reduce corporate taxes, a proposal that may help garner conservative support.

Conclusion 

The first year in office may well provide the best opportunity for the incoming president to influence tax policy. But history suggests that even a first-year program is not easy to enact unless the chief executive has campaigned on tax reform, and thus can claim a mandate on that issue, or has the benefit of having both houses of Congress held by his or her own party. There will continue to be disputes about the income and corporate tax well beyond 2017. In the meantime, the new president should seize the opportunity to lead the country to a carbon tax. 

In my last article, I explained that two years ago the Manhattan Institute’s Senior Fellow Oren Cass wrote a masterful critique of the typical arguments for a U.S. carbon tax. His essay, “The Carbon Tax Shell Game,” is so good that I decided to spend two posts here at IER amplifying some of his strongest points. As I’ve been illustrating over the years with my own work (e.g., here and here), the case for a carbon tax falls apart once you start picking at it.

In the previous post, I focused on Cass’s claim that the carbon tax in U.S. politics is a “shell game,” because its proponents promise contradictory things to different groups. In this post, I’ll focus on Cass’s sophisticated critique of superficial justifications for a U.S. carbon tax based on the concept of a “negative externality.”

Assumptions About the “Discount Rate” Drive the Analysis

Cass reviews the standard economic argument for a carbon tax: Because greenhouse gas emissions could cause significant damage in the form of climate change, they constitute “negative externalities.” In the tradition of economist A.C. Pigou, a textbook response to negative externalities is a so-called Pigovian tax, in order to make actors in the marketplace—both businesses and consumers—take into account the full social cost of their activities.

Although this is very straightforward in theory, when we try to implement a carbon tax in practice things get much more dubious. (I have written exhaustively on these issues: see here and here for example.) There are many stumbling blocks in the path of acknowledging the possibility of manmade climate change damage, and setting an “optimal” carbon tax.

In this post, I’ll just review one of the issues, which we at IER have covered extensively: namely, the discount rate used to convert future damages into present dollars.

Because so much of the damage (which is simulated in computer models) from greenhouse gas emissions doesn’t occur until decades or even centuries in the future—the Obama administration’s team ran their computer simulations through the year 2300—it matters a very great deal how we translate, say, $100 billion worth of damage from climate change in the year 2210, into 2017 dollars. After all, if we set a carbon tax at $40 per ton today, that will cause people today to rearrange their activities to reduce emissions. On standard Pigovian terms, this $40 per ton is optimal only if the marginal ton of CO2 that would otherwise be emitted, would cause a total of $40 worth of damage—measured in 2017 dollars—over the next few centuries. In order to calculate that, we have to know how to compare 2017 dollars with (say) 2210 dollars.

(For an analogy, if we wanted to set a carbon tax in euros, even though our damage estimates were all expressed in dollars, then we would obviously need to know the exchange rate between euros and dollars. Likewise, since we are setting a carbon tax in today’s dollars, while our damage estimates in the computer simulations occur in various years through 2300, we need an “exchange rate” or “discount rate” to make them the same units.)

In case the reader wonders why I’ve spent so many paragraphs hammering home this point, it’s because the discount rate we plug into the formula drives the entire result. In other words, we don’t need to have a big argument about how sensitive the earth’s temperature is to a doubling of CO2 concentrations, and we don’t need to have a big argument over how much damage to human welfare a given amount of warming will cause. Even if we stipulate all of those conditions for the sake of argument, nonetheless I can derive an “optimal” carbon tax either close to $0, or on the other hand above $100 per ton, if you just let me adjust the dial of the discount rate.

Here’s how Oren Cass expressed the situation:

Consider the federal government’s official effort to develop [a social cost of carbon] assessment. The marginal cost of one ton of CO2, even after averaging out the range of hypothetical climate behaviors, varies from $0 to $129. (Marginal-cost estimates for the full range of modeling between the fifth and 95th percentiles vary from -$12 to $515.)

The choice of discount rate, meaning the relative importance of future costs versus current costs, overwhelms all other model attributes. Outputs generated with a 3% discount rate (the heaviest weighting typically used in regulatory analyses) are generally at least three times higher than comparable outputs for a 5% discount rate (a moderate weighting); one could more closely approximate the costs implied by a 5% rate with a tax of $0 than with a tax derived using the 3% rate. An assumption about how society values costs 100 years from now swings the result by more than an assumption about whether climate change exists at all. [Bold added.]

This is one of the main reasons we at IER have argued that the “social cost of carbon” is an inappropriate tool for regulatory analysis. The public and even policymakers are led to believe that there are scientists in white lab coats using fancy equipment in order to go out and measure “the social cost of carbon,” the way they might measure the charge on an electron or estimate the temperature of the sun’s surface.

Yet in contrast, an economic or even philosophical decision about how to treat the welfare of our great-great-grandchildren, relative to our own welfare, is what really drives the so-called “social cost of carbon,” and hence the size of an “optimal carbon tax” if we base it on such as estimate.

A Subtle Flaw With the “Double Dividend” Logic

Cass makes many sophisticated observations about the typical case for a carbon tax, and I would encourage even professional economists to read his essay. He makes many points that economists too often miss in their glib endorsement of “taxing bads, not goods” in the climate change policy debate.

For now, let me end by highlighting just one of Cass’s points. This is something I have not seen anyone else bring up. In context, Cass is addressing the claim that if we refund the revenues from a carbon tax in order to reduce other distortionary taxes, that we can (a) reduce emissions and hence reap an environmental benefit but also (b) boost the conventional economy, because those pre-existing taxes are so destructive of economic growth.

But there’s something missing from this typical analysis. It’s obvious once you think about it, but I confess I hadn’t even thought of this wrinkle until Cass brought it up—and I’ve spent years thinking about the problems with carbon taxes! Here he explains his insight:

Nor does describing a carbon tax as “revenue neutral” do anything to improve its appeal. Promising to use the revenue for tax cuts or a rebate does not guarantee its best use or a net positive economic impact, nor does it make the policy somehow free. To the contrary, a revenue-neutral tax is guaranteed to be costly precisely because it holds government revenue constant while also increasing costs to private actors by driving them toward higher-cost energy technologies. The effect is most obvious in a world where the tax has driven emissions to zero, and government revenue comes from all of its pre-tax sources, except consumers also find themselves motivated by the tax’s existence to pay the full cost of electric vehicles and solar panels. In this respect, the tax operates much like the minimum wage; it imposes large and plainly government-created costs in the form of “off-budget” spending for which the government is never held accountable. [Bold added.]

To repeat, the part I’ve put in bold is an amazing insight from Cass, which I haven’t seen discussed elsewhere in this entire debate.

To reiterate, Cass is here pushing back against the simplistic claims made by some—especially those pitching a carbon tax to conservatives and libertarians—that so long as the revenues are used to cut taxes on capital and labor, then the actual pain of a carbon tax will be minimized or even flipped negative. “After all,” so the reasoning goes, “we want to discourage people from emitting carbon dioxide, and we want to encourage them to work and save, so how could it possibly be a bad thing to levy a tax on emissions in order to fund cuts in the payroll tax and corporate income tax?”

Yet the block quotation from Cass above shows that this glib reasoning is leaving something out. Suppose that the U.S. government implemented an outrageously high carbon tax—something like $2,000 per ton—and enforced it vigorously. The price of conventional gasoline would skyrocket some $16 per gallon, while electricity prices would soar because coal- and natural gas-fired power plants would suddenly have outrageous taxes to pay.

In this regime, the amount of U.S. carbon dioxide emissions would fall drastically, so that even with the very high rate of carbon tax, it’s possible that within a decade very little revenue would be coming in. (Remember, total carbon tax receipts per year are annualtons of emissions multiplied by carbon tax per ton.) In this scenario, the tax rates on labor and capital would have to be basically what they were before the new, draconian carbon tax, because of the assumption of “revenue neutrality.” In other words, if the draconian carbon tax isn’t bringing in much revenue since the carbon base gets driven to basically zero, then there isn’t much in the kitty to offset the pre-existing taxes.

So what can we say about the state of the conventional economy? It clearly isn’t benefiting from any “pro-growth” kick emanating from “Pigovian tax reform.” No, in this extreme scenario, the pre-existing distortionary taxes haven’t been cut at all.

However, the situation isn’t simply a wash. Even though it’s not bringing in new revenue, the massive $2,000 per ton carbon tax is definitely forcing Americans to alter their behavior. Nobody would be driving gasoline-powered vehicles, and all coal- and natural gas-fired power plants would be shuttered. Americans’ standard of living would have collapsed, as transportation and energy had become outrageously expensive.

Now to be sure, there would be a drop in estimated future damages from human-caused climate change, since (by assumption) U.S. emissions would quickly fall to near zero. But the point is, the typical carbon tax advocates have been telling Americans that they could get a “win-win” when carbon tax receipts are devoted to “pro-growth tax reform.” Advocates have been telling Americans that they would get a healthier environment and faster economic growth.

Yet as this exaggerated example illustrates, the advocates need to do more homework. The numbers matter. The higher the carbon tax rate, the more it drives down the size of the carbon tax base. And even as the total amount of carbon tax receipts declines, the presence of an ever-higher carbon tax rate is altering behavior in ways that stifle conventional economic growth.

It’s not enough just to observe, “Greenhouse gas emissions are a negative externality while we want to encourage work and saving.” The numbers matter. Even if “taxing bads, not goods” leads to a “win-win” upfront, it’s possible that the numbers move and cause the flipside to occur in a decade or two.

Let me make sure the reader understands the point of my exaggerated example. I picked a ridiculously high carbon tax of $2,000 per ton to make Cass’s point crystal clear. But even at a more moderate level, we still have to take into account the subtle mechanism at work: The more successful a carbon tax is at inducing people to alter their behavior, then the less revenue it raises. The impact of a carbon tax on the conventional economy is not necessarily directly proportional to the amount of revenue it raises, and so in general we can’t rely on catchy slogans like “tax bads, not goods.” To assess the economic cost of complying with a carbon tax—which could be compared to the ostensible benefits of avoided future climate change damages—we need to look at specifics. A very low carbon tax rate won’t raise much revenue, and so won’t allow for much tax reduction elsewhere, but on the other hand a very high carbon tax rate might not raise much revenue either.

Oren Cass wasn’t picking one particular fiscal projection over another, but he was underscoring the huge leaps of faith in the typical case for a U.S. carbon tax when it comes to discussions of “revenue neutrality.” To repeat, the numbers matter. Anyone trying to sell the idea of a carbon tax just using basic principles and textbook intuition has not really considered the issue in depth.

Conclusion

Oren Cass’s essay on the politics and economics of a carbon tax was first released two years ago, but it is still very relevant for today’s policy debate. Cass picks apart the various (and contradictory) arguments for a carbon tax so beautifully that this is one of the single best pieces in the genre.

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