A Proposal for a U.S. Carbon Tax Swap: An Equitable Tax Reform to Address Global Climate Change Gilbert E. Metcalf Department of Economics Tufts University February 9, 2008

A Classic Externality Non-spatial externality Efficient solution: price CO 2 emissions at their marginal damages What’s the right price? –Estimates are very imprecise: range from $3 to $95 per ton CO 2 e –Weitzman uncertainty Given long lags in GHG dispersion, prudence dictates starting now and refining policy as more information becomes available

Policy Options Cap and trade bills –Lieberman-Warner (S.2191) –Paltsev et al. (2007) analyze a number of bills Carbon tax –Metcalf (2007) discusses advantages of carbon tax approach Hybrid approaches –Bingaman-Specter (S. 1766) –Stavins (2007)

Carbon Tax Bills Dingell Draft Stark-McDermott (HR 2069) Larson (HR 3416)

Dingell Plan $50/ton C ($13.64/ton CO 2 ) $0.50/gallon gasoline Rate fixed in real terms Fossil fuel CO 2 only Revenue linked to various spending programs and Highway Trust Fund Phase out of mortgage interest deduction on large homes Converting from prices in tons C to tons CO 2 : Multiply by 12/44

Stark Bill $10/ton C ($2.73/ton CO 2 ) rising $10 annually until emissions fall to 80% below 1990 levels Fossil fuel CO 2 only Credits for sequestration activities Use of funds unspecified

Larson Bill $15/ton CO 2 growing at 10 percent real Fossil fuel CO 2 only Credits for sequestration activities Bulk of funds for income tax relief designed to be distributionally neutral

All prices in year 2005 dollars Tax Rates

Cap & Trade vs. Tax: Important Issues Revenue Allocation Efficiency Price Volatility Induced Innovation

Revenue Revenue obscured under a cap & trade system –$80 billion annually with a $15 per ton CO 2 price –Order of magnitude larger than Acid Rain Program Including the revenue in the budget process explicitly instills some budgetary discipline –Revenue from cap & trade only included in federal budget if auctioned –Free permits are a hidden transfer

Allocation Permits are valuable assets –Big incentive for rent seeking activity Current focus on allocation has perverse distributional results –Emphasis should be on compensating affected parties, not regulated sectors –Carbon Tax Swap addresses this problem

Efficiency Pure cap & trade fixes quantity but not price Pure tax fixes price but not quantity Economic modeling consistently shows that tax more efficient to achieve given expected GHG reductions under abatement cost uncertainty

Price Volatility EU-ETS prices highly volatile Makes planning by firms difficult Need for complex schemes (e.g. Carbon Market Efficiency Board) Safety valve mechanisms address upside risk –But if binding, converts system to a tax

Induced Innovation Downside risk also a concern with cap & trade –Phase I ETS prices traded for less than €5 throughout 2007 –Concern in RGGI that initial permit allocation may be too high Low permit prices deter induced innovation

No Guarantee Of Emission Reductions with Carbon Tax Committing to specific emission reductions regardless of the cost cannot be justified by any model of social welfare We should balance reductions against the economic cost as represented by the marginal cost of abatement Moreover, no guarantee of specific emission reductions with cap and trade

Differences can be overstated Hybrid schemes mix attributes of both approaches –Safety Valve –Cap & Trade and Carbon Fee Either approach preferred to a partial regulatory approach International harmonization possible with either approach Carbon Tax or Cap & Trade?

Important Design Features Comprehensive sectoral coverage Upstream implementation Multi-gas implementation Long-term commitment –Domestic planning –Credibility an issue to ensure global participation

Carbon Tax Swap Proposal A tax on emissions at an initial rate of $15 per metric ton of CO2 equivalent and gradually increasing over time A refundable tax credit for sequestered GHGs and other approved sequestration activities Border tax adjustment for fossil fuels An environmental earned income tax credit in the personal income tax equal to the employer and employee payroll taxes on initial earnings up to a limit. –For 2003 emissions and earnings, the credit would offset payroll taxes paid on the first $3,660 of earnings per worker up to a maximum credit of $560 per covered worker.

Burden of Carbon Pricing Cap & trade or tax prices carbon Cost predominantly shifted forward into higher consumer prices –Carbon price is regressive like most energy taxes

Burden of Carbon Tax Source: Metcalf (2007)

Rebate Distribution Source: Metcalf (2007)

Net Burden Overstates regressivity: Social Security benefits indexed Source: Metcalf (2007)

Distributional Impact of Grandfathering Grandfathering precludes the opportunity for distributional offsets Source: Metcalf (2007)

Summary Carbon tax has a number of advantages over cap & trade –Except for political expediency –But public opinion is shifting: Any form of carbon pricing strictly preferred to a regulatory approach Hybrid cap & trade blurs some of the distinction between permits and taxes

Summary Important difference is distribution Carbon pricing is regressive Regressivity can be undone through well-designed rebate of carbon revenue Precedents suggest that many if not all permits will be given away –And given to the wrong groups –Giving $80 billion annually to special interest groups to purchase their support is bad public policy If cap & trade is chosen instrument, distributional and revenue neutrality with full auctioning should be a guiding principle

Source: Metcalf et al. (2008)