During his visit to the U.S. last week, Pope Francis brought renewed focus to the issue of climate change and the need to help those in poverty. His encyclical on the environment expresses doubt about the ability of tradeable carbon-emission credits to bring about “radical change”. Hopefully, this skepticism does not extend to other market-based instruments such as a carbon tax. Existing research suggests that a carbon tax is likely the most efficient policy to fight global greenhouse emissions. An argument often used against a carbon tax is that it will impose costs on firms and eventually on households, particularly low income households, as prices of taxed items rise. However, it is important to remember that existing Environmental Policy Agency regulations on carbon emissions are also costly. As per a report by NERA consulting, the cost of the EPA regulating emissions through the Clean Power Plan could be as high as $479 billion between 2017 and 2031. Separate calculations, including those of the U.S. Chamber of Commerce, produce similar estimates. The EPA projects the cost to be between $4.2 to $7.4 billion in 2020. When analyzing the possibility of a carbon tax, the core question is whether a carbon tax is likely to be less costly and more efficient than existing command and control policies. Viewed from this perspective, much of the opposition to the tax seems less defensible.
A Tax Is the Most Efficient Instrument to Regulate Emissions
There are essentially three ways in which we can control the emissions of greenhouse gases: regulation, as is currently being done by the EPA; cap-and-trade, as has been proposed earlier in Congress; the carbon tax. As most economists would agree, a tax is the most cost-effective means for regulating emissions. A tax sets a clear price on carbon emissions that allows firms to internalize resulting costs in their production processes. By setting the tax high enough, the desired level of emissions could be reached. From an administrative standpoint, it would be relatively easy to implement a new tax as a functional tax system already exists. A cap-and-trade system sets the quantity of emissions and subsequently allocates or auctions permits up until the preset emission level. In principle, the quantity and price from a carbon tax and cap-and-trade system should be similar in equilibrium. However, cap-and-trade is often associated with volatility in prices. In addition, should a government decide to allocate rather than auction permits, it will not yield revenues which a carbon tax would guarantee. The least preferred option is regulation since it tends to be administratively costly, produces no revenues and creates uncertainty for firms. Rules and regulations tend to vary over time, across geographic regions and according to types of emitters.
Of course, there are legitimate concerns with a carbon tax. A large literature shows that a carbon tax is regressive. When a tax is imposed, it increases the costs of production for almost all types of goods in the economy, especially energy goods. The production cost increase results in higher prices for everyday items, particularly electricity. As energy goods are a larger share of income for lower income households, the carbon tax impacts those households proportionately more than higher income households.
Addressing Concerns With a Carbon Tax
A developing literature over the course of the last few years suggests several ways in which these concerns could be mitigated. A lot of importance is placed on the proper use of revenues.
Lumpsum Rebates
First, money can be returned to households through a lumpsum rebate. In a recent paper, Adele Morris and I calculated that if 11 percent of the revenues were returned to the bottom 20 percent of the income distribution, then on average those households would not be worse off than before the tax. Another policy paper from the Center on Budget and Policy Priorities shows that revenues could be used to help low-income households through provisions of refundable tax credits or through expansions of SNAP benefits for low-income households. In another paper, Roberton Williams et al. show that a lumpsum rebate to all households would be progressive as low-income households would be made better off. The driving force behind these studies is that it is possible to design a carbon tax policy in such a manner that it does not conflict with helping those in poverty.
Tax Swap
A second policy possibility involves a tax swap. In this case, the revenues from a carbon tax are used to lower other distortionary taxes in the economy, such as corporate income taxes or personal income taxes. While all tax swaps offset some of the burden of a tax and improve efficiency, new research shows that a corporate income tax swap would be the most efficient, least costly policy because corporate income taxes are the most distortionary taxes. But, a corporate tax cut favors higher income households more than lower income households, and so it is still a regressive policy.
In general, the trade-off in the use of revenues is between efficiency and distributional concerns. The most efficient use of revenues (corporate tax swap) is regressive, and the most progressive policies that aim to help low-income households are perhaps the least efficient. Policymakers need to understand and be willing to make these trade-offs in order to develop a politically feasible carbon tax proposal.
As we debate energy policies and climate change, it is important to keep in mind that both regulations and carbon taxes impose costs on the economy, and these costs impose burdens on households. The only difference is that with regulations, these costs are likely to be higher, more burdensome and less transparent than with a tax. The fact that we understand better the burden of a carbon tax and how to offset it for low income households, should make us more likely to adopt this policy, not less so.
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