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November 15, 2012

Carbon Taxes, Income Taxes, and Distributional Effects

Posted in: Uncategorized

Dave Roberts is right. Environmentalists and green energy boosters will be disappointed when whatever resolution comes of the fiscal slope does not include a carbon tax. This was clear well before Grover Norquist flipped on the idea within 24 hours, but cemented by that action. Conservative wonks outside of government may give their endorsement, but when the head of the House Energy and Commerce Committee says “I’m not a carbon tax guy,” believe him. This is a dead issue.

But that’s no reason to waste all this material I’ve accumulated on the idea! So let’s conjure up that hypothetical world where carbon can get a price, because the combination of, I don’t know, eight extreme weather events in a row finally shocks the political class into understanding that they should stop their work on the budget deficit in 2040 and get to discouraging carbon pollution, and the best way to strike a compromise on the issue is through the tax code.

The real issue here is that carbon taxes are being brought up in the context of a grand bargain on deficit reduction. But Norquist’s idea was to “swap” a carbon tax with reductions in the income tax. That assumes revenue neutrality, which is the opposite of the stated intention. So the carbon tax would have to be much bigger than the common suggestions ($20-$28 a ton) if it’s going to actually increase revenue and lower income tax rates meaningfully.

Furthermore, as Ethan Pollack of the Economic Policy Institute explained to me, this replaces a progressive tax, the income tax, with a carbon tax that by its design is regressive. The Congressional Budget Office estimated that under a $28/ton carbon tax, the bottom 20% of income earners would pay 2.5% more in taxes, while the top 20% would pay less than 1% more. “Shifting from an income to carbon tax would mean a decent-sized tax increase on the middle class,” Pollack said.

There are ways around this, as Mark Thoma points out. You would have to compensate those at the low end of the income scale to reduce the distributional effects of the carbon tax. But at that point, you’re reducing the revenue to the government by cycling it back out to the public. And then how much of a swap are we talking about?

All of these attempts to insulate various groups from the consequences of the tax (through fancy schemes that retain te incentive to save energy) will eat into potential revenue, and the fact that the response to the tax will be greater as more time passes — for example as people switch to more efficient cars and appliances — will also reduce revenue (this is not a problem in a larger sense, such substitutions are the whole point of the tax, but it does reduce the revenue).

This brings up another point. Over time, the goal is to discourage use of carbon. That means you want the revenue collection to shrink over time. But if it’s replacing a more stable source of revenue like the income tax, the end result is less overall revenue for the government. In addition, Dean Baker of the Center for Economic and Policy Research pointed out to me that “if not indexed to inflation, energy prices, GDP growth or something, then (carbon taxes) will decline relative to the size of the economy, even if carbon use did not decline. This certainly has been the history with federal gasoline taxes.” Right, and this has caused a crisis in funding for highway improvements.

None of this is necessarily a reason not to do carbon taxes; they can exist separately as a way to incentivize the reduction in greenhouse gas emissions, and if well-designed, this won’t have a large impact on those who cannot afford it. It just means that you cannot expect carbon taxes to be a large or even stable source of revenue, which means you cannot substitute them for something more stable like the income tax. That’s especially true because cuts in the income tax wouldn’t even reach most households at the low end. They would literally get a tax increase from the carbon tax, in exchange for no change from the reduced income tax.

OK, back from “there might be a carbon tax at some point in the future” fantasyland. Hope you enjoyed the trip.

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