Consulting by RPM || Free Advice Blog

Carbon “Tax Swap” Deals: A Review and Critique

In case you’re wondering what I mean when I talk about my “day job” stuff, here’s a good example: Today IER is releasing my new study [.pdf] with the above title. Here are excerpts from the Executive Summary:

A growing number of academics and policymakers have recommended a revenue-neutral carbon “tax swap” deal, under which the revenues from a new carbon tax would be used to reduce pre-existing taxes, dollar for dollar. Conservative proponents argue that such a proposal would not only mitigate potential environmental damage down the road, but would provide immediate relief to Americans by reducing the inefficiency of the tax code. By “taxing bads not goods,” these conservatives believe, a revenue-neutral carbon tax swap would lead to more economic growth immediately, and would reduce future climate change damages as a bonus. Unfortunately, there are many problems with this conservative claim, including both technical and pragmatic flaws in the position.

Technical Flaws

Even taking the standard textbook framework of the economics of climate change on its own terms, there are four technical problems with the conservative case for a revenue-neutral carbon tax swap:

==> The best literature on the topic actually argues that a revenue-neutral carbon tax swap would make the tax code more inefficient and would hinder (conventional) economic growth, because a carbon tax has a narrower base than a conventional income tax. Indeed, some empirical estimates suggest that this “tax interaction effect” is so powerful that, even if carbon emissions caused $50/ton in environmental damages, the “optimal” carbon tax would be $0 if the revenues were distributed lump-sum back to citizens, and would be only $27/ton even if the carbon tax revenues were used dollar-for-dollar to reduce other taxes. This is an initially surprising result, but it is standard in the environmental economics literature and shows that the intuition behind a carbon “tax swap” deal may have things backwards. A carbon tax will likely distort economic behavior more than an income tax raising the same amount of revenue, meaning that even on purely technical grounds a carbon “tax swap” deal is less desirable than the standard textbook treatment would suggest.

==> The “social cost of carbon” is not the proper benchmark to use when calibrating a carbon tax implemented unilaterally by the U.S. government because of the problem of “leakage.”…William Nordhaus’s respected computer model estimated (in 2007) that if only half of the world’s governments implement the “optimal carbon tax,” then the economic cost of achieving a desired environmental objective will increase by 250 percent.

==> Federal and state governments already have in place many policies that discourage carbon-intensive activities and encourage alternatives. Some of these policies are: gasoline taxes, CAFE standards, special tax advantages and loan guarantees to promote renewable energy use, ethanol mandates, and renewable portfolio standards. Because these government policies already discourage carbon emissions, a new carbon tax should be smaller than proponents typically suggest.

==> The fourth and final technical objection is that an overly aggressive carbon tax can be a cure worse than the disease. For example, in the 2007 runs of William Nordhaus’s “DICE” (Dynamic Integrated Climate-Economy) model, he estimated that a theoretically perfect carbon tax, implemented by all governments around the world and for many decades into the future, would provide net benefits of $3 trillion. In contrast, Nordhaus estimated that had world leaders heeded the recommendations of the famous 2007 Stern Review by implementing a much steeper carbon tax, then the world would be $14 trillion poorer compared to the baseline case under which governments did nothing to halt climate change.

Practical Flaws

In addition to the above technical objections, there are four practical objections, showing that it is dangerous to rely on the academic framework used by the advocates of a carbon tax:

==> The promises of “revenue neutrality” are quite hollow, given U.S. history. The best historical precedent is the introduction of the federal income tax in 1913, which was supposed to promote tax efficiency and help poorer Americans by replacing the tariff structure. Yet just five years after implementation, the top income tax rate had gone from 7 percent in 1913 to 77 percent in 1918. Furthermore, the Smoot-Hawley Act in 1930 jacked up tariff rates so significantly that many economists cite it as a major explanation for the severity of the Great Depression…

==> The regressive nature of a carbon tax will make it very difficult politically to dedicate its revenues to income or other tax reductions. Conservative proponents of a revenue-neutral “tax swap” deal must realize that they are asking to make the U.S. federal tax code far more regressive—tax rates on wealthy individuals would go down, while electricity and gasoline prices would go up for poor households….

==> Any deal using a new carbon tax to offset existing payroll taxes would surely break down quickly, because the two taxes have specific and incompatible purposes. The textbook theory of a carbon tax argues that it should reflect the social cost of carbon, rising steadily over time with atmospheric concentrations of greenhouse gases. In contrast, to fulfill its official purpose, the payroll tax should reflect the changing demographics of Social Security and other social insurance programs. Whatever relationship initially existed between the new carbon tax and the correspondingly reduced payroll tax would soon break down as these underlying factors evolved.
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In light of these technical and practical objections, it is clear that the case for a carbon “tax swap” deal is very weak indeed. Conservatives, who normally have a healthy distrust of new initiatives and tax schemes, should be very wary of any such proposal.