One Born Every Minute: A Primer on Carbon Taxes

A recent National Journal article on Arizona Senate-hopeful Jeff Flake underlines an unusual feature in today’s political landscape:[i] There are several prominent conservatives who proudly favor a carbon tax, including professional economists such as President Bush’s advisor Greg Mankiw. Just today, it was reported that former Congressman Bob Inglis has joined forced with Makiw, Art Laffer, and Douglas Holtz-Eakin to push for taxes on carbon and gasoline. Yet there are serious dangers from a carbon tax, both in terms of economic theory as well as political reality.

A Carbon Tax in Theory

In today’s economy, a tax on carbon is largely equivalent to a tax on energy usage. In this respect, a high carbon tax would be just as crippling to economic growth as a high tax on labor or a high tax on the use of machinery.

Yet the proponents of a carbon tax try to turn this analogy on its head, by saying the government should “tax bads, not goods.” In other words, they recommend implementing a revenue-neutral carbon tax, in which the government reduces economically inefficient taxes (such as the income or payroll tax) and replaces the lost revenues with a tax on what they have decided are socially harmful activities, such as carbon dioxide emissions. Thus we allegedly kill two birds with one stone: We reduce the threat of manmade climate change, while reducing the “deadweight loss” currently generated by taxes on labor or capital gains.

Even on a purely theoretical level, this case for a carbon tax is not as strong as its proponents believe. For example, the “optimal” carbon tax is probably nowhere near as high as they think. In their models, economists can calculate what they call the “social cost of carbon,” which is a gauge of the (present discounted value of) future damages due to manmade climate change that can be attributed to the emission of an additional unit of carbon today. Proponents want to calibrate the tax to make emitters internalize this “externality” and thus balance the social benefits of their economic activity with the full social costs, all things considered.

But to repeat, in these models the “social cost of carbon”—and the associated “optimal” carbon tax—are far too high. The models implicitly assume that all governments on the face of the planet will uniformly implement the carbon tax at its appropriate level, and will continually update the tax over the course of decades as circumstances change and the social cost of carbon evolves. Yet if only (say) half of the world’s governments participate in the plan to tax carbon, then the economic cost of achieving a given environmental objective rises by a whopping 250 percent, according to the modeling of William Nordhaus.[ii]

Another theoretical problem, raised by Roy Cordato, is that the government currently has all manner of measures in place that increase the price or reduce the use of carbon-based fuel including CAFE mileage standards; excessive regulation of coal, oil, and gas production and use; appliance efficiency mandates; the light bulb ban; the federal gasoline excise tax; state and local gasoline excise taxes; severance taxes; renewable fuels and electricity mandates (though it’s uncertain as to whether all these measures actually do on net reduce greenhouse gas emissions); and fiscal subsidies for “green” programs. Even from a purely theoretical level, the “optimum” carbon tax wouldn’t take zero as a baseline, but would have to take into account the net discouragement on carbon usage from all of these other programs, first.

The above discussion has shown that the correctly calculated “optimal carbon tax,” even on purely theoretical grounds, might be far lower than what the proponents believe. Consequently, if the government were to levy a carbon tax based on their inflated calculations, it would cause more economic harm than benefits (in terms of mitigated climate change damages in the future).

How big is this danger? Again we can turn to the modeling work of William Nordhaus, a pioneer in the economics of climate change and a strong proponent of carbon taxes. Nordhaus’ own DICE model suggests that an overly aggressive tax on carbon could be a cure far worse than the disease. For example, back in 2008 Nordhaus calculated that the so-called optimal carbon tax would yield net benefits of $3 trillion, in present-value terms. In contrast, if governments had been foolish enough to implement the aggressive emissions cutbacks proposed by Al Gore, Nordhaus’ model calculated that the net harm to humanity would have been $21 trillion, in present-value terms.[iii] Thus, the net harm from taxing carbon at the level implicitly proposed by Al Gore was seven times as high as the net benefit from the best possible carbon tax imaginable.

A Carbon Tax in Practice

So far we’ve just outlined some of the theoretical problems with a carbon tax. In practice, the academic discussions above are largely a sideshow. Even if the new tax is touted as “revenue-neutral,” it is very naïve to suppose that it will stay that way.

For example, when the modern individual income tax was first introduced in 1913, it was touted as a relatively minor nuisance that would just affect the super rich. Indeed, the original bracket structure was very modest. Adjusting for inflation, the top rate of 7% kicked in on incomes above $11.3 million, while the bottom bracket applied to all incomes up to $453,000, with a tax rate of a mere 1%.

But oh how things changed, and quickly: Because of the government’s need for revenue during World War I, a mere five years later the top rate had skyrocketed eleven-fold to an incredible 77%, while the bottom rate (with a much lower income threshold of $59,000) had risen six-fold to 6%.[iv] Keep this history in mind when supporters promise a “revenue-neutral” carbon tax.

In fact, it is doubtful that we would ever even see a moment of much lower income taxes, coupled with a new carbon tax. This is because the carbon tax, by its very nature, is “regressive,” meaning that it impacts lower-income households much more than the rich. After all, paying the utility bills and filling the gas tank are much bigger components of a poor household’s budget than a millionaire’s.

Because of its regressive nature—and because of the explicitly progressive (i.e. soak-the-rich) structure of the current federal income tax—it would be politically impossible to literally swap in an “efficient” carbon tax and remove, dollar-for-dollar, federal income taxes. Such a move would represent a massive tax cut for the rich and an equally massive tax hike on the poor. In practice, the move would be replete with all sorts of “compensating side payments,” with all of the opportunity for corruption and further economic distortions, that we saw with actual cap-and-trade legislation.

On the issue of regressivity, it’s true that swapping out the payroll tax and replacing it with a carbon tax would be an easier sell (since the payroll tax is itself regressive). However, this move would also be extremely difficult politically, inasmuch as the funding for Social Security and Medicare—due to demographics—would now be dependent on the vagaries of the climate’s sensitivity to carbon dioxide emissions. Even in theory, it would be hard to get this tradeoff right. In practice, it is extremely unlikely that taxpayers on net would see a lower burden, especially as the funding shortfalls in Social Security and Medicare become more obvious. The extra source of revenue flowing from the carbon tax would instead mean that the federal government would persist with unsustainable spending for that much longer.

Kenneth Green of AEI had a change of heart on carbon taxes for precisely this reason. Although he initially supported a tax swap deal because of its theoretical economic gains, he later wrote:

However, watching states loot “dedicated” eco-taxes for general revenue; seeing the emergence of more proposals for revenue-raising carbon taxes to finance continued deficit spending; and generally bearing witness to endless insincerity on the part of greens and their allies, I have to admit that my friends in the “free-market” movement [who had opposed carbon taxes all along] were right: A carbon tax would simply become another general revenue raiser, and a step in carbon-seduction. “Oh, come on, you’ve already accepted the tax, now let’s do cap-and-trade, and regulation.”

Conclusion

Even the theoretical case for a carbon tax is not as strong as its proponents think, because the “optimal” carbon tax (all things considered) might be fairly low, even stipulating the popular models of climate change. Yet the real problem with a carbon tax is that legislators and bureaucrats will hardly go to economists when designing the particulars of the plan. Instead, carbon taxes (and associated compensating payments) will be dictated by the seemingly infinite thirst of government officials for revenue and the opportunity to reward favored constituencies.  The shift from broad government taxation to concentrated taxes—which the general population only sees in the form of higher prices of energy products—also allows government officials to divert an overtaxed public’s ire from them to the producers of energy, thereby creating a convenient and unpopular scapegoat.

It is understandable why those who generally favor bigger government are enthusiastic supporters of a federal carbon tax. Yet conservatives and other skeptics of government intervention should be far more dubious.