A Question of Balance: Finding the Optimal Carbon Tax Rate

Guest Post by James Handley

Economists are virtually unanimous: Raising the price to emit carbon is essential for reducing greenhouse gas emissions and staving off climate disaster. But how high should that price be set? And how steep a trajectory should be chosen to get there? Here, we look at what several leading economists have said about carbon tax rates, as well as their preferences for the use of carbon tax revenues.

One of the most forceful and respected advocates of carbon taxation is Yale economist William Nordhaus. In his new book, A Question of Balance, Weighing the Options on Global Warming Policies, Nordhaus employs a complex model of the U.S. economy to determine the "optimal" carbon tax rate – the rate that would cost the economy no more in reduced productivity than the climate damage it would prevent. He writes:

According to our estimates, efficient emissions reductions follow a "policy ramp" [with] modest rates of emissions reductions in the near term, followed by sharp reductions in the medium and long terms. Our estimate of the optimal emissions-reduction rate for CO2 relative to the baseline is 15 percent in the first policy period, increasing to 25 percent by 2050 and 45 percent by 2100. This path reduces CO2 concentrations, and the increase in global mean temperature relative to 1900 is reduced to 2.6°C for 2100 and 3.4°C for 2200." (p. 14)

Nordhaus assumes that, at least in the near term, Earth’s climate system will respond predictably to rising levels of greenhouse gases. He thus distances himself from the more aggressive stance of Al Gore and Sir Nicholas Stern who advocate steeper carbon pricing policies to avoid triggering irreversible "tipping points" in the climate system. Nordhaus also assumes a far higher "discount rate" than Stern, which leads to greater emphasis on present costs than distant benefits. With these assumptions, Nordhaus concludes that a carbon tax starting at $7.40/ton of CO2 is optimal, so long as it increases by 2-3% a year in real terms (after inflation) until 2050, with steeper increases after that.

recycle_color_logo.jpgNordhaus suggests revenues "be used to soften the economic impacts on lower-income households, to fund necessary research on low-carbon energy, and to help poor countries move away from high-carbon fuels." (p. 24) He calls internationally "harmonized" carbon prices the most efficient way to induce emissions reductions worldwide.

Another forceful advocate of carbon taxes is Gilbert Metcalf of Tufts University. In his paper, A Green Employment Tax Swap: Using A Carbon Tax to Finance Payroll Tax Relief, published jointly by the Brookings Institution and the World Resources Institute, Metcalf recommends a carbon tax just under $17/ton of CO2. This would nearly double coal’s price, reducing its use by 32%, while petroleum products would increase in price by nearly 13% and natural gas by just under 7%. Metcalf also advocates dedicating carbon tax revenues to eliminate the payroll tax on the first $3,660 earned by each worker. He calculates that this equates to an average 11% reduction in payroll taxes, with greater percentage reductions for the lowest-paid workers.

Metcalf’s rationale for reducing payroll taxes is simple:

"In general, taxes on labor supply discourage labor and create economic losses to workers over and above any taxes collected. Workers forego opportunities to work longer hours or engage in training that increases their productivity and wages. Moreover, workers may choose not to enter the labor force in response to taxes on wage income. Tax reductions can encourage additional labor supply either on the intensive margin (hours worked) or the extensive margin (the decision to enter the labor force). The Green Employment Tax Swap encourages additional labor supply on the extensive margin." (p. 2)

Greg Mankiw, Harvard economist and former economic advisor to President Bush, has written in the New York Times in support of Metcalf’s proposal.

A third prominent carbon tax advocate is Robert Shapiro, former undersecretary of Commerce in the Clinton Administration and now head of SonEcon a Washington, DC consulting firm, and co-chair of the U.S. Climate Task Force. In his recent report, Addressing Climate Change Without Impairing the U.S. Economy, Shapiro begins with the science:

"…a range of scientific studies has concluded that the world’s current climatic conditions can be sustained if atmospheric CO2 concentrations do not exceed a general range of 450 to 550 ppm over the long term. Stabilizing carbon dioxide concentrations at those levels will require sharp reductions in net global emissions of CO2 for the next several decades." (p. 2)

Shapiro’s optimal carbon tax would

reduce carbon emissions at the rate and levels required to move to a path that will stabilize future atmospheric concentrations of CO2, so they do not produce destructive climatic changes, and in ways that impose the least marginal social and economic costs. Because climate science is still developing, scientists cannot say with certainty what the marginal cost of CO2 emissions is today, and consequently at what precise point a carbon-based tax — or the cap in a cap-and-trade program — would achieve this goal.

Shapiro continues:

One of the most comprehensive surveys of these issues, conducted by a leading European expert, Dr. Richard S.J. Tol, assessed 103 published estimates of the marginal costs of CO2, including 43 studies published in peer-reviewed journals. Among these more rigorous analyses, the average or mean value of this measure was $50 per metric ton of carbon or $13.64 per metric ton of CO2." (p.15)

Shapiro accepts this figure and uses the U.S. Energy Department’s NEMS model to predict the effects of gradually increasing to that carbon tax level. He concludes:

… Americans’ use of the least carbon-intensive forms of energy, renewable fuels, would rise sharply (up 220 percent by 2030) while the use of coal, the most carbon intensive fuel, would fall correspondingly (down 54 percent by 2030). Much of this shift would occur in the fuels used to produce electrical power. By 2030, these shifts would drive down U.S. annual CO2 emissions by about 30 percent, compared to what they would be without a climate change program, or about 6 percent less than current emissions." (p. 18)

Shapiro recommends recycling 90% of the carbon tax revenue, with the balance dedicated to research and development of low-carbon energy:

This policy then would return to workers, businesses or households nearly $3.6 trillion of the $4 trillion collected by the tax. These recycled revenues would be sufficient to reduce, on average, the annual payroll tax rate for workers and businesses by two percentage points, or exempt from payroll tax the first $10,066 in a worker’s earnings (or exempt the first $5,033 from the payroll taxes paid by both workers and their employers), or provide every working person a rebate payment of $1,080 each. [Alternatively,] these revenues also could be returned as flat payments to every household averaging $1,275 per year, per household, from 2010 to 2030. These payments would more than offset the direct tax related costs for the majority of American households, since the $1,563 in direct costs applies to the "average-income" household. (p. 21)

The Carbon Tax Center advocates establishing a $10/ton CO2 tax and increasing it at that rate each year for at least a decade. Using a simple but transparent model, CTC estimates that this more aggressive approach would reduce U.S. CO2 emissions relative to their expected growth curve by a third, if ramped up for 10 years and then held constant, and by almost half if the incrementing is extended over a second decade. This would put the U.S. on a trajectory to meet the recommendations of the Fourth Assessment by the Intergovernmental Panel on Climate Change to reduce emissions by 80% from projected "business as usual" levels by 2050.  As for use of carbon tax revenues, CTC is agnostic between tax-shifting and pro-rata "dividends," provided the tax is kept revenue-neutral.

The table below summarizes the four sets of carbon tax recommendations:

 Source  Initial tax, $/tonCO2  Annual Tax Increment  Tax Rate in 10 yrs  Tax Rate in 20 yrs

Revenue treatment

 Nordhaus  $7.40  2 – 3%  $9 – 11  $11-13

offsets for poor, low-carbon energy R&D, assistance for LDCs

 Metcalf  $16.60  0  $16.6  16.6 payroll tax shift
 Shapiro  $15  $2  $35  $55 payroll tax shift
 Carbon Tax Center  $10  $10  $100  $100-200 payroll tax shift/dividend

All four sources propose starting with modest carbon taxes. CTC recommends predictable, step-wise increases to create clear expectations, while two others recommend gradual increases but concede that adjustments in carbon tax rates may be needed to meet emissions targets.

Two recommend that a fraction of carbon tax revenue be devoted to research and development of low-carbon energy. All recommend "recycling" most or all carbon tax revenue over targeted subsidies to energy industries, because price signals would more effectively spur individuals and firms to develop and implement conservation and alternative energy technologies. "Revenue recycling" would improve the overall efficiency of the economy and provide stimulus that could more than offset income effects of a carbon tax on middle- and low-income families, always a salient point but particularly now, as a deep recession looms.

Comments

  1. David Collins says

    An excellent report and summary, Mr Handley.
    My own visceral reaction is that that the "marginal cost" of CO2 emissions is not really so well known or understood to be figured in calculations of what the Carbon Tax rate should be. I hesitate to put a dollar or euro price on the loss of species, of reduced flows in major Asian rivers, etc. Economics, even at its best, can help establish prices but is helpless at determining values. That being said, count me among those who opine that we will never reduce or mitigate AGW with a list of Thou-Sall-Not’s. The "best guess" CO2 marginal costs should set floors under carbon tax rates. And thanks again for an interesting, thought-provoking essay.

  2. David Collins says

    A separate comment (I wish I could separate paragraphs!): I do not like the idea of governments "picking winners" in technologies whose pumps should be primed by Carbon Tax revenues. That being said, I would like to see some of the revenues go toward improving rail and public transport infrastructure, making roads (urban, suburban, rural) more bicycle-friendly, and so forth. Up to a point; only up to a point, though. If people do recreational stuff closer to home, less transportation energy is expended, so let’s put Carbon Tax money to work cleaning rivers, so folks can go fishing nearby (and dare to eat the fish!), developing ski hills near Chicago so folks don’t have to go to Vail, and so forth. But this gets to be like the relationship between The Cow with the Crumpled Horn and The House that Jack Built.

  3. says

    Note that the IPCC does not make any recommendations. Indeed, it’s mandate is to assess the research and give the necessary knowledge to policy makers to reach an informed decision. Any "recommendation" by the IPCC is in the mind of the reader only.

  4. says

    Dr. Tol,

    Thanks for your contributions to economic policy to address global warming and specifically to assessment of the cost of climate damage.

    True, the IPCC doesn’t make policy recommendations. But its report has provided support for others, notably NASA’s lead climate scientist, Dr. James Hansen, the Stern Report, the UN Framework Convention on Climate Change (UNFCCC), a number of European countries, the State of California and others who have either suggested or explicitly referred to 80% carbon cuts by 2050 as a target commensurate with the scale of the problem.

    More recently, Dr. Hansen and other climatologists’ concern about approaching climate "tipping points" (beyond which run-away climate feedback would ensue) led Bill McKibben and others to advocate a more protective goal of stabilizing CO2 levels at 350ppm. Regardless of the specific goal, it’s fair to say that there is no case for further delay in setting aggressive policy to reduce GHG emissions; I wanted to be sure to credit the IPCC for sounding that clear alarm.

    Dr. Tol, you’re an economist who’s studied estimates of the projected cost of climate damage. I’m curious about your views on: a) the need for carbon pricing policy, b) the most effective policy, and c) the subject of my article, appropriate rates.

  5. says

    Perhaps it’s not quite a "recommendation," but the IPCC’s "Summary for Policymakers" (p. 18) says,

    "An effective carbon-price signal could realise significant mitigation potential in all sectors. Modelling studies show that global carbon prices rising to US$20-80/tCO2-eq by 2030 are consistent with stabilisation at around 550ppm CO2-eq by 2100."

    Thus IPCC’s “suggestion” is a bit below CTC’s recommendation to start at $10/tCO2, stepping up to $100, while IPCC is higher than the other three economists’ proposed rates. But rates based on a goal of 550ppm may not be protective enough. For example, Dr. Hansen now says 550ppm CO2 would lead to "disaster" including a 2 meter sea level rise.

  6. Mike says

    Taxes on the American people and businesses need to be reduced or eliminated on every level. To talk about a new tax is insane. New low or non carbon fuels should be sought after by private companies driven by the free market. The neutral tax will only be the beginning. How long will it be neutral? Not long if you put it in the hands of the politicians.  

  7. says

    This is a very nice summary, Mr. Handley. I want to point out one minor, but repeated error, though. You state the taxes in “per ton CO2,” but I’m quite sure most if not all of them are actually per ton of carbon in the fuel, a factor of 3.67 difference. For example, in The Climate Casino, Nordhaus describes a tax “reaching $53 per ton of CO2 in 2030,” which converts to $14.5 per ton of carbon, close to the rate in 20 years on your table. Likewise, $7.4/tonC converts to $27/tonCO2, and in TCC Nordhaus suggests $25/tonCO2 in 2015.
    This common error is understandable, since we want to limit CO2 emissions, but it’s only feasible to tax the carbon content of fossil fuels. I hope you will make the correction soon, before the error propagates like a virus.
    Thanks,
    Peter Gray
    WSU, Pullman, WA

  8. says

    Hi Peter,

    We’re working in tons CO2 here which has more or less become standard even though we use the term “carbon tax” rather than “CO2 tax” which might be less confusing. I converted Nordhaus’ rate (and the others, where needed) to tons CO2, which does reveal that Nordhaus is very low. Good to know that since writing “Question of Balance” Nordhaus has recommended a higher rate.

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Last modified: October 18, 2008