The Tax That Could Save the World

Whatever it is determined to be, it could be added to the cost of oil when it’s purchased by the barrelful, natural gas when it’s fed into a pipeline, or coal when it’s mined. “The insight economists have is that the most efficient way of doing this is through the pricing of carbon emissions, or the pricing of all climate-forcing emissions,” says University of Gothenburg’s Thomas Sterner. “And one of the reasons is that such pricing will catch new sources of emissions. Otherwise, we tend to focus a lot on the ones we know, such as from airlines, meat, cars, etc. If you just take these on one by one, some other sector is going to find new ways of using oil and coal—like through heating outdoor pools, as it’s lovely to have a heated pool outdoors in the Arctic region, where I live. So the only method that will catch all of these, and in a reasonably efficient manner, is through pricing carbon.”

It sounds easy, but uncertainty over the true cost of carbon is one barrier. Use too high an estimate, cautions Chicago Booth’s Robert H. Topel, and a tax can do more harm than good. Moreover, passing the cost on in this way, regardless of how governments choose to apply or structure it, is essentially a tax on consumption. That is one source of pushback, because unless offset by other credits, a carbon tax can be regressive if poorer consumers spend a greater percentage of their income on things such as fuel and electricity.

Tax reform is tricky. Late last year, French president Emmanuel Macron sought to implement high fuel taxes in France specifically to target carbon emissions—hiking the gas tax while reducing wealth taxes for the rich. This resulted in violent riots throughout Paris. Protesters scrawled graffiti on the Arc de Triomphe, calling Macron “President of the Rich” and warning that “we cut off heads for less than this.” On December 4, 2018, French prime minister Édouard Philippe announced that the government would bow to the protesters and that the planned diesel-fuel tax hikes would be suspended. “No tax deserves to endanger the unity of the nation,” he said in a television address to the country.

A proxy for politics in general

While the politics of pricing carbon are difficult locally, global political schisms are another obstacle to implementing any plan to reduce carbon emissions. The planet is divided into 195 countries that share a single atmosphere, and the atmosphere doesn’t much care where emissions come from, as the impact on climate is the same. Meanwhile, no country or state wants to hurt its economic competitiveness. “A region or nation that moves ahead of its neighbors on climate policy can potentially put its own carbon-intensive firms at a disadvantage. This is a major policy concern,” write Stanford’s Lawrence H. Goulder and Andrew R. Schein in a 2013 paper. While the US, the European Union, and China have the heft to lead the world in a greener direction, all must contend with the demands of their local politics.

Still, were opposition to carbon taxes limited to only pocketbook matters such as prices at the pump, governments might be able to sway opinion with offsetting incentives, including lower taxes on food and clothing or health care. But there might be deeper forces at play, particularly in the US, according to Topel. In “Some Dismal Economics of Climate Policy,” a May 2018 talk he gave at the University of Chicago’s Becker Friedman Institute, he offers an alternative explanation for why the carbon tax has not been implemented—which boils down to the role of government.

Putting aside the political toxicity in the US of taxes in general, and the issue of whether people believe or deny scientific consensus about global warming, Topel focuses on what he sees as a more fundamental schism between the political Left and Right. The Left, he says, is happy to expand the size of government, while the Right doesn’t want to. A carbon tax could massively increase government revenues.

Topel assumes a rate of $41 per ton of spent carbon. Current consumers paying freight for the cost of carbon would pay a tax of $41 per ton, adjusted alongside either inflation or the cost of capital (another fierce point of debate) over time. “The textbook solution is to set a tax on carbon equal to the social cost of carbon and be done with it,” says Topel.

By making carbon more expensive, the measure would theoretically dissuade people from using it—but also grow government. Topel estimates a carbon tax would raise $280 billion to $300 billion in revenues, the equivalent of about 10 percent of current annual federal spending. The political Left would support this, but the political Right would not—and therefore right-leaning carbon-tax opponents have a rational basis for their stance.

Moreover, would this government growth be worthwhile? The point of a carbon tax is to pressure businesses and consumers into curbing the consumption of oil, electricity, or whatever else is creating harmful emissions. But a $41-per-ton tax translates to about 35 cents per gallon of gas, which might not be enough of an incentive to greatly shift driving habits—at least in the short run—in any consequential way, he says. If either the demand for or the supply of oil, or any other carbon-based good, is highly inelastic, the government could collect billions of dollars in tax revenue for a pretty small environmental payoff.

Topel calculates that when it comes to oil, a carbon tax generates $100–$400 of government revenue for every $1 of avoided climate harm. “Waste avoided is less than 1 percent of taxes collected,” he says. If one’s view is that more than 1 percent of government spending is wasteful, he argues, the tax ultimately increases waste and reduces welfare—and like it or not, the opinion that the government is wasteful is widespread.

This gives carbon-tax opponents even more ammunition. Anyone who thinks the government is at least slightly more wasteful than the private sector can make a case that the tax would make the world worse, not better.

What about a revenue-neutral tax?

But what if the tax could be made revenue neutral, so that any funds that flow to the government as a result of the tax would be reinjected into the economy, holding the size of government (as well as government waste) constant? On the surface, this would seem to reassure critics.

Former Secretaries of State George P. Shultz (a onetime Chicago Booth dean) and James A. Baker III, alongside former Senate majority leader Trent Lott (Republican of Mississippi) and former Senator John Breaux (Democrat of Louisiana), formed a political action committee in 2018 called Americans for Carbon Dividends. With support from the energy industry, they have pushed for a revenue-neutral carbon-tax plan that they paint as palatable to conservatives and government skeptics. They promote a path to revenue neutrality that involves what they call carbon dividends and Topel describes as the “parachute drop”: any funds the government raises through a carbon tax would be transferred back to the public as a lump-sum payment. Other regulations on emissions would be dropped, because prices would be optimal.

Politically, this may be the best option. In the Wall Street Journal, the statement by prominent economists holds that a carbon tax should “be revenue neutral to avoid debates over the size of government.” The parachute-drop plan “kind of sways them a little bit,” Topel says of carbon-tax skeptics, channeling them when he says, “‘Oh, you’re going to give the money back, and the government’s not going to grow, maybe I’m going to get some of that back.’” The parachute drop could involve notable trade-offs. Exxon, for example, gave $1 million to Americans for Carbon Dividends and supports a revenue-neutral carbon tax—but in exchange for limited liability protection against lawsuits that emerge from carbon-related damage claims. This doesn’t factor into Topel’s analysis. In Canada, Trudeau’s government this past October announced a carbon tax that would return most of the revenue, in the form of “Climate Action Incentive payments,” to residents of some provinces.

Regardless, this kind of approach “doesn’t actually work,” according to Topel, who says that the parachute-drop approach ignores the interplay between a carbon tax and existing taxes. The US government already taxes carbon in direct and indirect ways that exceed the social cost of carbon, he says. These include the federal income tax, since consumers buy carbon-based products with posttax money, as well as sales taxes, including on gasoline. Unless the social cost of carbon is greater than the existing tax wedges—and at $40 per ton, it isn’t—the “tax and give it back” strategy is likely to reduce welfare. Returning revenue raised by a tax “sounds like a really easy solution, but it doesn’t work if you’re not reducing distortions somewhere else” in the tax system, Topel says. “They’re saying ‘just stick money in an envelope and send it back,’ but that is unlikely to reduce distortions or improve welfare in a world where taxes are already high.”

But can economists design a policy accordingly to come up with an optimal tax? Topel says a different path to revenue neutrality would yield welfare gains: offsetting carbon-tax revenue by reducing income or other taxes by an equivalent amount, which he says would prevent the government from growing while reducing distortions in economic incentives. Other versions of this idea might return revenue in the form of payroll taxes, or by eliminating regulations and taxes on industries that rely less on fossil fuels and have a smaller carbon footprint. British Columbia’s carbon tax is accompanied by personal income tax cuts and a low-income tax credit.

The only problem? Topel doesn’t think the US voting public would trust elected officials to follow through on that proposal—as many people have different ideas about what to do with revenue raised from a tax, and the government cannot commit to maintaining lower taxes. Consider the National Resources Defense Council’s view of a carbon tax. “While a carbon tax can be an important part of a comprehensive program to cut our carbon footprint and to hold polluters accountable, it must be accompanied by strong limits on carbon emissions, including those under existing authority granted by the Clean Air Act and all other existing legal tools,” says a spokesperson in a statement. Topel sees this as evidence of groups not trusting that markets, even if armed with better-balanced incentives, would solve the problem of climate change. They would still push for more government involvement in the market in the form of regulation, and perhaps also subsidies and investment in green-energy research.

“Just about all of us agree a carbon tax can’t stand alone; it has to be part of a suite of policies,” explains the Carbon Tax Center’s Charles Komanoff, an environmental activist who says US carbon-tax advocates including him are focusing in 2019 on persuading members of Congress to include a carbon tax in any Green New Deal they propose. “A carbon tax is going to be passed only when there is a strong Democratic majority in Congress and a Democratic president. And the Democratic majority is going to insist on investing some of the carbon tax revenues to transition to a lower-carbon economy. The window has closed on an era when we might have been able to pass a pure carbon tax. I don’t see that window opening again for a long time.”

The only hope for securing voter support for a carbon tax may be to focus on the almighty dollar, says University of Chicago’s David A. Weisbach. People should be attracted to the amount of revenue a carbon tax could raise over the course of a decade, not just climate-change benefits. If the tax raises $1 trillion, that would both move the economy in a more environmentally responsible direction and fund any number of value-improving projects.

“You can do good stuff with that money,” he says. Topel counters: “To many, that’s the problem.”

Alternative 1: Cap and trade

Voters, even in the US, may yet come around to supporting carbon taxes. Among the surveys suggesting that Americans have an appetite for confronting climate change, one conducted in November 2018 finds that 70 percent of Americans believe climate change is happening. Moreover, 49 percent of respondents said they would support a carbon tax if the revenues were rebated to households, and 67 percent said they would support a carbon tax if revenues were put toward environmental restoration. “These findings appear to run counter to the conventional wisdom about the most politically appealing version of a carbon tax and to recent efforts by the federal government to step back from environmental protection,” said University of Chicago’s Michael Greenstone, director of its Energy Policy Institute, when the results were released in January. The survey was conducted by the Associated Press-NORC Center for Public Affairs, with funding from the Energy Policy Institute.

But political polarization still makes a carbon tax an unlikely prospect in the US, at least in the short and medium run. “There is very low to no chance that a carbon tax would be implemented by the federal government in the near future,” Weisbach says.

So what are the alternatives? Emissions trading, also known as cap and trade, is the most prominent. Both taxes and cap-and-trade systems can raise revenues, through either taxes or emissions permits. While a tax establishes a price for carbon and lets the market set the amount of emissions, a cap-and-trade system works in reverse, establishing a cap for emissions and letting the market set a price for carbon. Typically, the government produces and either hands out or auctions off a limited number of pollution permits, creating a market for permits and establishing a market-based cost. The US used such a system to reduce the pollutants that cause acid rain. An attempt to set up a nationwide cap-and-trade system was proposed but failed to become law during the Obama presidency.

“The problem with such cap-and-trade programs is that they, in essence, give the revenue from a Pigovian tax lump sum to a regulated entity. Why should an electric utility, for example, be given a valuable resource simply because it has for years polluted the environment? That does not strike me as equitable,” wrote Harvard’s N. Gregory Mankiw in 2009. He says he still supports that position, seeing cap and trade as less desirable. “Of course, cap-and-trade systems are better than heavy-handed regulatory systems. But they are not as desirable, in my view, as Pigovian taxes coupled with reductions in other taxes.”

But, if properly designed, either cap-and-trade or a carbon tax could work well, although the outcomes depend greatly on details, write Goulder and Schein. “The performance of the two approaches depends critically on specifics of design. Indeed, the design of the instrument may be as important as the choice between the two instruments.” They also suggest countries could pursue a hybrid policy that combines the cap-and-trade approach with a price floor, price ceiling, or both, to reduce volatility.

Richard L. Sandor, CEO of Environmental Financial Products, which helps set up cap-and-trade systems worldwide, says that while academic economists can prove the superiority of either method, he sees emissions trading as the preferred way to proceed. “I just don’t get it because sulfur dioxide proved the case,” he says, adding that the program to reduce S0₂ cost $2 billion at most to implement and has led to $120 billion in benefits, including reduced medical expenses associated with lung disease. “The program reduced emissions by 90 percent below 1990 levels. In my experience, as a practitioner, that’s a far superior result compared to a tax. I believe that cap and trade allows for the achievement of reductions at the lowest possible cost.”

Cap-and-trade programs are running in California, the northeastern and mid-Atlantic US, the EU, and, most recently, China. The EU’s cap-and-trade program for carbon has seen significant variability in terms of permit prices, and the rollout of its second trading period coincided with the 2008–09 financial crisis, which helped depress emissions and prices. If permit prices are low, some see it as an indication that emissions caps were too lax, less stringent than what most cost-benefit analyses would recommend. However, says Goulder, the low prices reveal both a weakness and a strength of the EU system, the strength being “it shows that the [emissions] cap could be met at relatively low cost.” Also, a tax establishes a more-certain price signal for households or companies making long-term decisions—but cap and trade creates more-predictable emissions reductions.

China in 2017 launched a carbon market that is expected to become the world’s largest carbon-trading program. Unlike the EU’s cap-and-trade system, which starts with the premise of capping emissions on the basis of historical levels, China’s system is “rate-based” and so will allocate emissions allowances according to a variety of benchmark emission-output ratios. In a 2018 paper, Goulder and Richard D. Morgenstern, of the nonprofit research institution Resources for the Future, called China’s adoption of a carbon-trading system “a major step for climate change policy” that “could encourage carbon pricing policies elsewhere.” However, they write that the success of the program in reducing emissions will depend fundamentally on the details of how the Chinese government calculates allowable emissions. “Internationally, much is riding on this program,” they write. “If successful, it could serve as a positive model and encourage other nations’ climate policy efforts. Failure could impede the adoption of emissions trading programs in many parts of the world.”

Alternative 2: Green technology

If neither a tax nor a trading system succeeds, it could mean the climate future depends largely on fossil-fuel alternatives and new technologies becoming cheaper to use and more competitive. This is happening—somewhat.

The cost of solar panels dropped 85 percent between 2010 and 2018, as China’s manufacturers entered into (and flooded) the market, reports solar photovoltaic research company PVInsights, while the cost of battery storage has dropped 82 percent, according to Bloomberg New Energy Finance.

Thanks to falling battery prices, electric-vehicle adoption worldwide will increase substantially between 2025 and 2030, Jeffrey Osborne, an analyst at Cowen Inc., has predicted. A 2017 report from Cowen says battery cost declines and carbon-dioxide restrictions will make internal combustion engines more expensive. “Government plays an important role in funding advanced R&D in partnership with the private sector as well as creating the regulatory framework and parameters to encourage competition, allowing the market to separate winners from losers rather than mandating a certain technology,” Osborne writes in the report. Add to this list advances in agriculture, urban planning with networked “smart” technologies, and more-efficient robots.