Carbon Tax, or Carbon Rights?

A taste from the 2014 tax extenders—these are only some extenders, not the baseline!

• The tax credits for residential energy-efficiency improvement; second-generation biofuel production; electricity produced using Indian coal facilities placed in service before 2009; electricity produced using wind, biomass, geothermal, landfill gas, trash, hydropower, and marine and hydrokinetic renewable-energy facilities; and energy-efficient new homes
• The income and excise tax credits for biodiesel and renewable-diesel fuel mixtures and the excise tax credit for alternative fuels and fuels involving liquefied hydrogen
• The special depreciation allowance for second-generation biofuel plant property
• The tax deduction for energy-efficient commercial buildings
• The tax deferral rules for sales or dispositions of qualified electric utilities

If you accept a carbon tax, the proposal should be, we will permanently dismantle all of this. Yes, this means dismantling much of the US Department of Energy and the Environmental Protection Agency.

We could also stop subsidizing energy use first, including zoning laws that force a lot of needless driving, housing policies that encourage too-large houses, and so forth.

Why are some economists still skeptical about carbon-price proposals? I think that many are rightly wary that the carbon tax will just be added on top of this rot, and worse, that the proceeds of the carbon tax will be used to funnel more money to crony energy boondoggles. At a minimum, that is a strong reason to offer a revenue-neutral tax rather than to bundle it with plans to spend the revenues on “infrastructure.” Let infrastructure live on cost-benefit analysis not a dedicated stream.

I’d like to hear proponents loudly offer this deal in order to get a carbon tax, in a way that skeptics will perceive as enforceable.

A tax must be uniform

Summers touches on an important issue that will pollute the debate: on the other side of the ledger, there has always been the concern that raising carbon taxes would place an unfair burden on some middle- and low-income consumers. Those who drive long distances to work, say, or who have homes that are expensive to heat would be disproportionately burdened.

Economists understand that a tax like this is all about incentives and substitution, not about transferring income. The public and political systems see taxes as all about transferring income and tend to forget incentives. This will be a big problem.

The natural political life of any “tax,” including the carbon tax, will lard the tax up with exemptions. People who “need” to “drive long distances to work,” and “can't afford” new energy-efficient cars—farmers, small businesses, people who live in cold climates (we already have a home-heating-oil subsidy), high-energy industries (aluminum, concrete), and so on and so forth—will all clamor for exemptions. And will get them.

But this tax, of all taxes, must be uniform at the margin, with no exemptions. Its purpose is incentives, not revenue raising or redistribution. The planet doesn’t regard the worthiness of the carbon-emitter. People who drive a long way to work should move to smaller, more expensive houses closer to work. That’s the point of a carbon tax. Or shift to smaller cars, or carpool, or make other unpleasant substitutions. That’s the point of a carbon tax. Farmers should find less-carbon-intensive ways to plow and plant crops. People who live in cold places in the winter or warm places in the summer should move, and use less energy. Businesses that have to use a lot of carbon should contract. Those on the margin will close. That’s the point of a carbon tax. If this pain is not felt, the change in behavior won’t happen.

People are hurt. And they can be helped, just not on the margin. People who are hurt can get lump-sum checks, or vouchers. If the overall distribution of income is substantially made worse by carbon pricing, let the regular tax system redistribute more. If you think about it, in fact, it’s pretty unlikely that carbon taxes will have a substantial effect on the overall income distribution. I don’t have numbers, but poor people may well use less carbon. Yes, they drive, but they don’t fly and especially not in private jets. And getting rid of crony boondoggles in my deal above would help a lot too.

Summers makes a good and revealing point about the nature of redistribution: if these groups have received a windfall from the drop in energy prices, it would be possible to impose substantial carbon taxes without them being burdened relative to where prices stood six months ago. As an example, the price of gas fell by more than $1 per gallon from October 2014 to January 2015. A $25-a-ton tax on carbon that would raise over $1 trillion during the next decade would lift gas prices by only about 25 cents.

That is a very interesting view of just how short lived this sense of our political system’s desire for insurance and redistribution is. If we bring you back to where you were last year, you won’t complain. It’s not about the overall distribution of income—it’s about middle-income people’s right to the gas price they paid last year.

But I’m dubious. Given how long a debate over something this big will take, and how many people will dislike a carbon tax, I’m not persuaded Summers’s argument will be enough. The demand for “transition assistance” and help to pay the carbon tax will likely not be silenced by, “Well, it just brings gas to what you were paying in 2013.”

Furthermore, it’s a good bet that the same forces that will undermine my first caveat will be at work on the second one. If I install solar panels on my roof, can’t I get a break on the carbon tax?

In sum, I think the carbon-tax proposal needs a second deal to be offered. The carbon tax will be a uniform tax. Everyone pays the same rate on the margin; the tax does not get riddled with loopholes and exemptions.

I’d like to hear proponents loudly offer this deal in order to get a carbon tax, in a way that skeptics will perceive as enforceable.

It’s not that unrealistic. Gas taxes and tobacco taxes are administered pretty uniformly.

Taxes versus rights

The economic point is a carbon price. There are lots of ways to implement it. Instead of a tax, one can have carbon rights. The cap-and-trade schemes are the natural alternative, based on the latter idea. They don’t seem to be catching on, for reasons that I won’t go in to here.

Instead of the current business focus of cap and trade, suppose that every citizen has a right to emit x tons of carbon per year. In order to emit carbon (methane, etc.), or to sell fuel or electricity that emits carbon, a business must purchase those rights. (You buy gas and the gas company buys rights. We don’t charge carbon rights at the pump.) You can receive your rights with your annual tax filing, and sell them on electronic exchanges. A market will spring up quickly, offering citizens cash for their pollution rights.

It strikes me that this system obviates many of the political problems with carbon taxes.

It’s by construction revenue neutral, and the flows of money can’t go into boondoggles. All the money paid in carbon taxes goes into the pockets of citizens.

It’s by construction greatly progressive. Everyone gets the same right. Private-jet fliers and McMansion heaters/coolers will be lining the pockets of poor people who don't travel much and live in small homes. Progressives who bemoan the loss of energy policy at least can console themselves with this grand redistribution.

Environmentalists and those in pursuit of “climate justice” should like it. Everyone gets rights to a clean planet.

If you really don’t like carbon, you can choose not to sell. Or buy up other’s carbon rights and burn them. (Sorry, compost them.)

Every voter will have a strong incentive not to let anyone off the requirements to buy carbon rights. If favored industries come by and complain how much the carbon rights are costing and want a tax break, every voter knows that money is coming straight out of his or her pocket.

Every voter now is an enemy of command-and-control energy regulation, which lowers the demand for his or her carbon rights.

The last two forces are imperfect; and, it will still be important to pair this system with at least a formal promise to use the carbon (methane, etc.) price as the only instrument of energy policy, and with a formal promise to apply the requirement to purchase carbon rights uniformly. But the concentrated interest of voters will help.

This is no panacea, to be sure. Enforcing that businesses buy rights takes much the same bureaucracy as enforcing tax payments. Whether our political system would do a rights scheme better than a tax scheme takes a bit of a conjecture.

But take one look at the US tax system. What started on the academic blackboard as the sensible idea—“Hey, we can all chip in some fraction of our income to pay for the federal government?”—has turned in to the monster we see before us. A carbon “tax” also seems nice on the academic blackboard. But I worry that it will suffer the same fate.

John H. Cochrane is AQR Capital Management Distinguished Service Professor of Finance at Chicago Booth.