For given greenhouse gas reduction targets, the most critical issue in containing the costs of a domestic emissions control program is to raise revenue from the policy and recycle that revenue back to the economy in ways that improve economic efficiency. The problem with the Waxman-Markey bill is that the allowances in the proposed cap-and-trade system are largely given away to firms and households for free, which dramatically increases the costs of the policy to the economy. From a cost-containment perspective, the allowances should be auctioned off by the government, and the revenue used to reduce taxes that distort labor supply, savings, investment, and other behavior by households and firms.
According to studies by researchers at Resources for the Future and elsewhere, the economic efficiency benefits of those tax reductions would offset around two-thirds or more of the economic costs of the cap-and-trade program (see for example When Can Carbon Abatement Policies Increase Welfare? The Fundamental Role of Distorted Factor Markets and Tax Deductions, Environmental Policy, and the Double Dividend Hypothesis). If there really is little prospect for auctioning the allowances, it would be better to abandon cap-and-trade altogether in favor of a carbon tax, with legislation requiring automatic recycling of the revenue in lower income taxes.
Imposing a CO2 tax of say $20 per ton on CO2 emissions would raise annual revenues in the order of $100 billion in the near term. Ideally, this revenue would be recycled back to the economy in the form of cuts in the marginal rates of personal income taxes for inpiduals and corporate income taxes for firms. This would benefit the broader economy through encouraging more work effort, investment, and savings. And it would also reduce distortions from tax preferences that encourage excessive spending on employer-provided medical insurance, home ownership, and so on.
RFF research suggests the economic efficiency gains from recycling $100 billion of emission tax revenues from a CO2 tax would be very substantial, perhaps in the order of $40 billion a year (see Tax Deductions and the Marginal Welfare Cost of Taxation). There is an offsetting effect as higher energy prices drive up production costs and (slightly) contract overall economic activity, which tends to exacerbate the distorting effects of taxes on work effort, investment, and savings. Nonetheless, if exploited the revenue recycling benefit would reduce, quite substantially, the overall costs to the economy of carbon abatement policies.
Under Waxman-Markey, the revenue-recycling benefit is largely forgone as the huge bulk, some 85 percent, of the permits will be given away for free to firms and households (or to the extent that permits are sold the revenue is typically earmarked for spending projects). This means that the overall cost of the policy (for a comparable reduction in emissions) is dramatically larger than under a (revenue-neutral) CO2 tax. Work by RFF researchers suggest that the emissions reductions under Waxman-Markey, which rise to about 25 percent below baseline levels by 2020, could impose costs on the economy that are at least two or three times as large as those under equivalently-scaled emissions taxes (see: When Can Carbon Abatement Policies Increase Welfare? The Fundamental Role of Distorted Factor Markets and Tax Deductions, Environmental Policy, and the Double Dividend Hypothesis).
Obviously there is no guarantee that revenues from a pure emissions tax would be used productively. More often than not in the past governments have used new revenue windfalls to increase spending rather than reduce other taxes. To the extent extra spending is driven by pressure from lobby groups (as opposed funding socially desirable projects) it may produce little, if any, benefit to the overall economy. The case for an emissions tax therefore depends critically on accompanying legislation requiring automatic reductions in other distortionary taxes.
Of course policymakers might be concerned about the distributional incidence of emissions taxes, given that low-income families tend to spend a greater share of their budget on electricity and other energy goods. However, in my view the central goal of climate policy should be to establish a credible price on greenhouse gas emissions that rises progressively over time. Distributional issues are better addressed through the broader tax and benefit system, rather than introducing provisions to compensate households with preferences for relatively energy-intensive goods.
Unfortunately, to put it mildly, the prospects for a revenue-neutral CO2 tax in the United States do not look promising at present. Nonetheless, it still behooves economists to compare existing proposals with their least-cost counterparts, so policymakers are at least aware of the, often striking, trade-offs between apparent practical feasibility and broader societal costs.
For more read: When Can Carbon Abatement Policies Increase Welfare? The Fundamental Role of Distorted Factor Markets, Tax Deductions, Environmental Policy, and the Double Dividend Hypothesis, Tax Deductions and the Marginal Welfare Cost of Taxation, and Should the Obama Administration Implement a CO2 Tax?
