The Case for (and Against) a Carbon Tax

by Reihan Salam

Yoram Bauman and Shi-Ling Hsu are convinced that a “carbon tax swap,” in which revenue from a carbon tax is used to reduce taxes on individuals and firms, is an excellent idea:

Economic theory suggests that putting a price on pollution reduces emissions more affordably and more effectively than any other measure. This conclusion is supported by empirical evidence from previous market-based policies, like those in the 1990 amendments to the Clean Air Act that targeted sulfur dioxide emissions. British Columbia’s carbon tax is only four years old, but preliminary data show that greenhouse gas emissions are down 4.5 percent even as population and gross domestic product have been growing. Sales of motor gasoline have fallen by 2 percent since 2007, compared with a 5 percent increase for Canada as a whole.

What would a British Columbia-style carbon tax look like in the United States? According to our calculations, a British Columbia-style $30 carbon tax would generate about $145 billion a year in the United States. That could be used to reduce individual and corporate income taxes by 10 percent, and afterward there would still be $35 billion left over. If recent budget deals are any guide, Congress might choose to set aside half of that remainder to reduce estate taxes (to please Republicans) and the other half to offset the impacts of higher fuel and electricity prices resulting from the carbon tax on low-income households through refundable tax credits or a targeted reduction in payroll taxes (to please Democrats).

Revenue from a carbon tax would most likely decline over time as Americans reduce their carbon emissions, but for many years to come it could pay for big reductions in existing taxes. It would also promote energy conservation and steer investment into clean technology and other productive economic activities.

Part of me wishes that Bauman and Hsu had read Monica Prasad’s 2008 op-ed on carbon taxes. She explained how Denmark’s experience suggests that a “swap” is exactly the wrong way to approach carbon pricing:

What did Denmark do right? There are many elements to its success, but taken together, the insight they provide is that if reducing emissions is the goal, then a carbon tax is a tax you want to impose but never collect.

This is a hard lesson to learn. The very thought of new tax revenue has a way of changing the priorities of the most hard-headed politicians — even Genghis Khan learned to be peaceful, the story goes, when he saw how much more rewarding it was to tax peasants than to kill them. But if we want lower emissions, the goal of a carbon tax is to prompt producers to change their behavior, not to allow them to continue polluting while handing over cash to the government.

How do you get them to change? First, you prevent policy makers from turning the tax into a cash cow. Carbon tax discussions always seem to devolve into gleeful suggestions for ways to spend the revenue. Reduce the income tax? Give the money to low-income consumers? Use it to pay for health care? Everyone seems to forget that the amount of revenue is directly tied to the amount of pollution that is still going on.

Denmark avoids the temptation to maximize the tax revenue by giving the proceeds back to industry, earmarking much of it to subsidize environmental innovation. Danish firms are pushed away from carbon and pulled into environmental innovation, and the country’s economy isn’t put at a competitive disadvantage. So this is lesson No. 1 from Denmark.

But Prasad is nevertheless a proponent of taxing industrial emissions of carbon — she just thinks the revenue needs to be earmarked for investment in green energy technology.

Jim Manzi has offered an insightful discussion of the real-world pitfalls facing a carbon tax. An approach that works in British Columbia or Denmark might not work in the United States:

First, a carbon tax would be highly regressive, so you’d have to institute some kind of offset, probably an income tax credit. This is especially tricky, since you have to make sure that the marginal deadweight loss (excluding the potential AGW-related benefits) of the carbon tax is no more than the marginal deadweight loss of the offset tax, or you will create a real incremental social cost. Second, if you only taxed carbon, you’d create all kinds of perverse incentives to convert some existing production to processes that create non-CO2 greenhouse gases, so you’d actually have to make this a multi-substance GHG tax (I’ll continue to refer to it as a “carbon tax” since this is the common terminology). Third, unless you make the dubious assumption that the major developing economies enact and enforce a harmonized international tax regime, a carbon tax would lead firms to conduct some GHG-producing activities offshore, typically in countries with less efficient production facilities, thereby increasing total GHG production for the offshored activities. I attended a climate change policy conference a couple of weeks ago in which a senior EPA economist gave a rough estimate that about 20% of GHG production subject to a tax in the US would leak in this manner. None of this complexity is insurmountable, but consider that the idea of “let’s tax each person a given percentage of annual income” sounds pretty simple too, but annual income tax compliance costs on the US are currently estimated to be as high as $100 billion. Assuming we do not actually do away with some other major class of taxation, imposing a carbon tax means imposing significant incremental compliance costs.

Jim goes on to observe, among other things, that we don’t have a very good sense of how to set an appropriate price for carbon, in part because we know very little about climate sensitivity. I recommend checking out all three pieces.