Budget – Page 4

Carbon Tax Center

Pricing carbon efficiently and equitably

Are EPA Hammers The Best Tools to Ratchet Down Global Warming Pollution?

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Massachusetts v. EPA (2007), the Supreme Court’s 5-4 decision upholding EPA’s authority to regulate greenhouse gases, is rightly considered a legal milestone in the fight against global warming. But it’s nearly impossible to find an economist, business person, or even an environmental advocate who thinks that EPA regulation of the numerous and diverse activities causing global warming can ever be more productive, fair and cost-effective than policies using price incentives. Even Environmental Protection Administrator Lisa Jackson testified to the House Energy & Commerce Committee that regulation by her agency under the Clean Air Act isn’t the best response to global warming.

Where does EPA regulation of greenhouse gases stand today, after the failure two years ago of carbon cap-and-trade legislation? Recall that in 2009, a huge campaign by environmental groups, along with a well-coordinated effort by the House Democratic leadership, led to House passage of the Waxman-Markey climate bill. That bill would have largely supplanted EPA greenhouse gas regulation with a cap-and-trade-offset system, an indirect way to put a hidden and fluctuating price on CO2 pollution. But in the Senate, John Kerry’s frenzied effort to build a coalition around cap-and-trade with offsets came to naught in 2010. The failure of climate legislation, along with the GOP takeover of the House later that year, leaves climate policy exactly where the Supreme Court left it: at EPA’s doorstep.

The Environmental Protection Agency has issued rules mandating aggressive improvement in efficiency of new autos and trucks, and rules mandating “Best Available Control Technology” for new and expanded coal-fired power plants and other stationary sources. For CO2 emissions, BACT is essentially a combustion efficiency standard. But EPA has yet to propose rules for a far larger category of GHG’s: CO2 emissions from existing stationary sources such as power plants and oil refineries. And indeed, fears of economic dislocation and job loss ― which are always concerns when existing facilities come under stringent regulation ― will make it hard for the agency to clamp down hard on these sources, particularly in today’s heavily politicized climate.

Nevertheless, it’s important to ask what a maximal strategy of EPA GHG regulation might accomplish, and how that approach stacks up against indirect pricing proposals like Waxman-Markey and simpler, more direct carbon pollution taxes such as Reps. Larson and Stark have proposed. Economists Dallas Burtraw, Arthur Fraas and attorney Nathan Richardson of Resources for the Future recently examined EPA’s regulatory options. Looking at a decidedly optimistic scenario, they concluded that EPA regulations would reduce domestic greenhouse gas emissions by 12.9% by 2020 (from a 2005 baseline). That estimate assumes that EPA adopts a flexible approach involving tradeable performance standards, which they concede may be less legally defensible than more prescriptive and costly facility-specific regulatory approaches. Their figure also includes non-CO2 GHG emissions reductions counted in CO2-equivalent terms. By comparison, they estimate that the Waxman-Markey bill would have achieved nearly identical reductions in domestic emissions, 12.7%, in the same eight-year time frame.

What carbon tax level and ramp-up would yield the same 12.9% reduction that Burtraw et al. project for EPA regulations? To see, I ran the Carbon Tax Center model developed by director Charles Komanoff. The model uses historic price elasticities in five sectors to estimate emissions reductions for a given CO2 price trajectory. Thus, the model relies on history to predict future behavior — it assumes we will find ways to use less fossil fuel to the same degree as we’ve responded to price changes in the past; the model also accounts for the increasing difficulty (“diminishing returns”) of reducing emissions.

In the table below, I’ve summarized and ranked in order of effectiveness (which corresponds well with revenue), three legislative and two economists’ carbon tax proposals as well as two carbon tax scenarios that the CTC model indicates would mimic the expected emissions reductions of EPA GHG regulations by 2020:

Proposal Initial Rate ($/T CO2) Increase / yr CO2 Tax Rate in 2020 ($/T CO2) Emission change by 2020 Cumulative Gross Revenue 2012-2020 ($B)
Cantwell-Collins $14 (+/-7) 6% $22.31 – 9.1% 866
Krupnick: Waxman-Markey equiv. $18 8% $33 – 12.3% 1,181
CTC: EPA equiv. (% increase) *
 $21.50 6% $34.27 – 12.9% 1,289
CTC: EPA equiv. (step increase) $10 $3.50 $38 – 12.9% 1,136
AEI / Peterson $26 6% $41.44 – 15.1% 1,532
Stark $10 $10 $90 – 24.0% 2,166
Larson $15 $12.50 $115 – 28.9% 2,694
The Cantwell-Collins “CLEAR Act,” a cap with a “price collar” sets a CO2 price between $7 and $21, rising 6% annually. Krupnick et al. (RFF) used the US DOE’s NEMS model to estimate that an $18T/CO2 carbon tax rising 8%/yr to $33/T CO2 by 2020 would achieve equivalent domestic emissions reductions to Waxman-Markey, very similar to the emissions reductions which Burtraw et al. expect from EPA regulations. (Reassuringly, CTC’s model applied to Krupnick’s price trajectory predicts similar results.) For the third scenario, I chose a 6% annual increment in the CO2 price and used the model to estimate the starting price needed to achieve the same reductions as EPA regulations. For the fourth scenario, I took the opposite tack, specifying a $10 starting price and letting the model determine the annual increment rate that would achieve the same reductions as EPA regulation. The fifth estimate uses the carbon price proposed in Fiscal Solutions: A Balanced Plan for Fiscal Stability and Economic Growth, (Peterson Foundation & American Enterprise Institute, 2011). Finally, I ran the price levels and increments in the carbon tax bills introduced by Rep’s Pete Stark D-CA and John Larson D-CT respectively, to estimate the emissions reductions that their climate bills would achieve by 2020.

The results suggest that, holding other things equal, until 2020 climate advocates should be indifferent between EPA GHG regulations and either (i) a carbon tax starting at $21.50 per ton of carbon dioxide and rising at 6% a year, or (ii) a carbon tax of $10/ton rising by $3.50/yr. But of course, other things aren’t equal: a carbon pollution tax would generate billions in revenue, as shown in the far right column in the table. Indeed, economists Ian Parry and Roberton Williams of RFF estimate that the Krupnick proposal would close 1/3 of the U.S. budget gap by 2030. Moreover, as Burtraw et al. point out, it’s not clear how much further EPA regulation could reduce emissions after 2020. That’s because regulations are essentially static and do little to induce innovation or to reduce fossil fuel demand via conservation.

Burtraw et al. conclude:

EPA action under the Clean Air Act is inferior to new [carbon pricing] legislation from Congress, especially over the long term. Although it is possible to identify some readily available opportunities for emissions reductions and push them via regulation (with market tools to keep costs down), it quickly becomes difficult to identify what steps should be taken next. A carbon price (either cap-and-trade or a carbon tax) created by legislation would allow the market to make these decisions.

The numbers tell a sobering story: EPA regulations might, optimistically, achieve significant near-term reductions, albeit at a higher cost than a CO2 pollution pricing system. But more importantly, those regulations can’t be expected to induce further innovation and reduce demand (for example by encouraging improved efficiency) and EPA has explicitly stated that it is not mandating replacement of high carbon energy sources (coal and oil) with lower or zero carbon sources (gas or renewables).

Where does this leave us? Consider the interesting situation that could arise by year’s end. Congress faces both mandatory “sequestration” of the military and domestic budgets (imposed by the debt ceiling legislation) and expiration of the Bush/Obama tax cuts. The House and Senate may therefore be forced to consider ways to raise revenue, perhaps as early as in the “lame-duck” session after the Nov. 6 elections, when the pending retirement of some members and the passing of the election season might allow political “grand bargains” to be struck.

In that eventuality, it will be important to hammer home the point that a rising carbon pollution tax offers not only the potential to achieve greater and far more sustained emissions reductions than EPA regulations, but also a growing stream of revenue from taxing pollution. That is especially salient now, when every tool available is needed to encourage job growth and productive economic activity including reducing or at least avoiding new taxes on work and investment.

Photo by “thefixer” (Flickr).

* Postscript: In A Balanced Plan to Stabilize Public Debt and Promote Economic Growth (2010), William Galston (Brookings) and Maya MacGuineas (Committee for a Responsible Federal Budget) recommended a carbon pollution tax similar to my third scenario: starting at $23/T CO2, rising 5.8% yearly, with proceeds to reduce payroll taxes and deficits.

Carbon Tax Offers Super Powers to Super-Committee

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With a $1.5 trillion budget “canyon” to leap across, the new “super-committee” would be wise to summon the special elastic power of a gradually-rising carbon tax.

After prolonged high-wire suspense and partisan brinksmanship, President Obama and Congress agreed in early August to establish the twelve-member “Joint Select Committee on Deficit Reduction” to tackle the budget deficit and the national debt. The “super-committee,” as the JSC was instantly dubbed, comprises six Representatives and six Senators, three chosen by the leadership of each party in each chamber.

The JSC’s mission is to agree on $1.5 trillion in deficit reduction steps to be undertaken over the next decade. These spending cuts or revenue enhancements are to constitute a second installment beyond the $917 billion in cuts agreed to in the bargain to raise the debt ceiling. The JSC is to deliver its recommendations to Congress on Nov. 23, with the House and Senate required to vote the entire package “up or down” a month later. If the JSC cannot agree on deficit reduction steps of the required magnitude, or if Congress fails to adopt them, that will trigger $1.2 trillion of automatic cuts divided equally between domestic and military spending.

To be sure, Washington’s obsession with putting our faltering economy on an austerity diet is deeply troubling to Keynesians, including the Carbon Tax Center. Nevertheless, the fix is in, so let’s examine how a carbon tax could be made part of the debt and deficit solution.

The JSC’s options fall into three categories:

1) More budget cuts, which would contract the economy, compounding unemployment and speeding our descent into another recession,

2) Raising revenue by reforming the tax code, for instance by closing loopholes or reducing tax “expenditures” (i.e., tax exemptions that function as government grants), or

3) Finding new sources of tax revenue.

Given the Herculean dimensions of the super-committee’s task, the JSC may find itself pressing all three buttons. In the revenue category, there’s been some discussion of a “value added tax,” but less about a carbon tax or a Tobin (financial transactions) tax both of which have strong policy advantages.

Last year, William Galston of Brookings and Maya MacGuineas of the Committee for a Responsible Federal Budget included a carbon tax in their report, A Balanced Plan to Stabilize Public Debt and Promote Economic Growth. Also in 2010, Congressional Budget Office founder Alice Rivlin reportedly suggested a carbon tax to both the Simpson-Bowles commission, and the Rivlin-Domenici commission. Unfortunately, her recommendation didn’t make it into either final report, even though well-known economists Gilbert Metcalf and William Nordhaus conveyed the same recommendation to the Simpson-Bowles commission. Now the advent of the JSC with its $1.5 trillion mandate and short deadline has dialed up the pressure to look for revenue sources.

How much would a carbon tax reduce deficits? In May, the deficit-hawkish Peterson Institute hosted a fiscal summit in Washington, at which four out of six leading think tanks, including the conservative American Enterprise Institute, suggested pricing carbon as a way to raise government revenue. AEI recommended a carbon tax starting at $26 per ton and growing by 5.6 % per year after that. According Peterson, the proposal would raise $161 billion per year by 2020, enough to reduce the federal budget deficit by 22% that year. They point out that this is greater than the savings from raising the national retirement age to 70 and would reduce the deficit the same amount as eliminating all foreign aid and federal funding for education.

The Carbon Tax Center’s model shows that a more aggressive carbon tax proposed by Rep. John Larson, rising each year by an average of $12.50 per ton of CO2, would generate about $475 billion of new revenue by the tenth year. This would eliminate around 80% of that year’s CBO-projected deficit while reducing U.S. carbon emissions by 30%. Moreover, the mere expectation of a gradually-rising carbon price will reduce the risks and increase the returns to investors in low- and zero-carbon energy and energy efficiency, as former Federal Reserve economist Alan Blinder pointed out last winter in the Wall Street Journal. In other words, simply enacting a carbon tax – even one with a “grace period” prior to startup – would provide a stimulus to a key technology sector (not to mention one in which the U.S. is falling behind China and Germany).

Aside from the carbon tax rate, what other design criteria need to be weighed for a carbon tax to reduce both deficits and CO2 emissions? Economist Gilbert Metcalf recommends a tax covering not just CO2 but other greenhouse gases: methane, nitrous oxide, fluorinated gases and sulfur hexafluoride. Metcalf, a Tufts University economist now serving the Treasury Department, argues that this more broadly-based tax would achieve much greater emissions reduction, particularly in the early years, by inducing replacement of climate-damaging refrigerants and solvents with more benign substitutes – an easier task than rapidly phasing out fossil fuels.

What about the potentially regressive effects of carbon or GHG taxes on modest-income households? When Chad Stone, chief economist at the Center on Budget and Policy Priorities, analyzed the Waxman-Markey cap-and-trade bill in 2009, he concluded that only 15% of the permit revenues would be needed to compensate households in the bottom 20% of the income range for the price increases induced by carbon pricing. Presumably, this finding holds for a simple carbon tax as well. (The revenue could be distributed in a monthly or even weekly “lump sum” by electronic funds transfer). To build in this protection for the most vulnerable, we should reduce estimates of revenue available for deficit reduction by about 15% to provide funding for low income assistance.

If legislators choose to compensate a larger income range from the effects of a carbon tax, then of course, a greater share of revenue will be needed. But because of the strong upward skew in carbon use over the income range, the revenue needed to compensate lower and even modest income levels is substantially less than their proportion of the population, leaving a large portion available for deficit reduction.

Both the Domenici-Rivlin and the Simpson-Bowles deficit commissions considered a so-called “Value Added Tax.” A VAT is a sales tax applied at every level, which would particularly burden retailers and is likely to be even more regressive than a carbon tax. Europeans routinely refer to the EU’s VAT as a nuisance to business – it must be factored into virtually every business transaction – and punishment of the poor. Moreover, VAT’s have no climate or other social benefits, aside from being a source of revenue. When the energy and climate benefits of a carbon tax are compared to gumming up our economy with a VAT that “sticks” to everything, a carbon tax looks sleek, maybe even sexy.

A carbon tax should also be structured to protect energy-intensive industries in relation to overseas competitors. In their 2009 paper, “Design of a Carbon Tax,” Gilbert Metcalf and David Weisbach articulated a simple structure for harmonizing border tax adjustments that, consistent with the WTO’s prohibition on discriminatory taxes, would apply a carbon-equivalent import duty to energy-intensive commodities such as steel, aluminum, paper, chemicals and cement, along with finished products containing them. If a foreign manufacturer could show that its process is less carbon-intensive than production in the U.S., then its harmonizing carbon tax would be reduced.

Harmonizing taxes would incentivize our trading partners to enact their own carbon taxes – in effect, we would be taxing their carbon-intensive exports for them until they enacted their own carbon taxes. With a rising U.S. carbon price, the incentive for our trading partners to enact carbon taxes would rise as well.

In summary, a rising carbon tax offers the JSC an attractive revenue stream for deficit reduction, obviating the need for more onerous and regressive levies such as Value Added Taxes. Low income households could be protected from disproportionate regressive effects by setting aside 15% of carbon tax revenues. And with WTO-sanctioned border tax adjustments, a carbon tax will not disadvantage U.S. industry and will spur much-needed innovation, investment and job growth in low-carbon energy and efficiency in the U.S. It will also encourage establishment of a global carbon price with commensurate global emissions reductions.

The super-committee will need nothing short of super powers to leap across a $1.5 trillion chasm. A carbon tax can provide the extra “bounce” of a substantial and growing revenue stream along with the clear, predictable price incentives needed for sound climate policy and a healthy and growing clean energy sector.

Photo: Flickr — Chanchanchepon