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January 16, 2014

Revenue-Neutral Carbon Tax?! California Dreamin’

January 16, 2014
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One of the most seductive arguments for a carbon tax tries to have its cake and eat it too: Proponents claim that so long as it’s “revenue neutral”—meaning that the receipts from a carbon tax are used to offset other taxes, not to increase spending—then a new carbon tax gets us the best of both worlds. They claim that it would reduce greenhouse gas emissions, thus slowing climate change, and the tax cuts on labor and investment would spur economic growth.

Even on its own terms, this is a dubious argument that ignores the academic literature on climate change economics. But we can safely put aside the intellectual arguments, because in the real world, a carbon tax will not be revenue neutral. As Governor Brown’s administration in California shows, the revenues from a carbon tax will be used to fund all sorts of goodies—to the cheering of “green” groups. Consequently, no one has any business justifying a new carbon tax at the federal level by claiming it would be used to provide tax relief.

The Standard Case for a “Revenue-Neutral” Carbon Tax Swap

Recognizing that the American public is very suspicious of tax increases—especially ones that would directly drive up the price of energy—proponents of a carbon tax have tried to spin it as  “pro-growth” measure, even one that “conservatives” could love. They argue that so long as the new carbon tax revenues were used dollar-for-dollar to reduce pre-existing income or capital taxes, then the total drag on the economy would be reduced. We would—they claim—see faster job creation and GDP growth, plus we’d have lower greenhouse gas emissions as a bonus.

Even on its own terms, this argument doesn’t work. As I have written extensively elsewhere (e.g. here and here), the consensus in the peer-reviewed economics literature is that the “tax interaction effect” swamps the benefits of reducing other taxes. In other words, the baseline result among economists in this area is that even if the government imposed a truly revenue-neutral carbon tax, conventional economic growth would suffer. Proponents can argue that it’s worth sacrificing visible wealth today, in order to mitigate climate change damages decades down the road—but there is a tradeoff, even with a 100 percent devotion of new carbon tax receipts to offsetting other taxes.

Interesting as these pointy-headed analyses may be, they are mostly beside the point. In reality, we can be quite sure that the revenues from a new carbon tax will not be devoted exclusively to reducing pre-existing taxes. Instead, they will be used (at least in part) to fund government spending du jour.  In particular, it will seem “appropriate” if they are used to further so-called “green” projects. This is no mere hypothetical; we can see exactly how the politics play out on this issue in California, in real time.

Governor Brown and California’s Cap and Trade Program

As part of the 2006 “Global Warming Solutions Act”—known as “AB 32”—California has implemented a state-wide cap-and-trade program, which became binding on major emitters of greenhouse gases in 2013.

In the very first year of its operations, Governor Brown was criticized by environmentalist groups for “raiding” the cap-and-trade fund. The state was in a deep budget hole—as so often happens in California—and Brown couldn’t resist “borrowing” half a billion dollars from the cap and trade revenues in order to make ends meet.

This year, the governor is patching up relations with “green” groups by spending boatloads of money on their preferred pet projects, as laid out in the budget summary for the next fiscal year, including some $250–$300 million for “high speed rail.” Debra Kahn in an E&E article spells out the politics of the move:

Last year, California environmental groups howled when Gov. Jerry Brown (D) diverted half a billion dollars from the auction of carbon dioxide permits to bolster the state’s financial reserves.

The news this week that Brown wants to keep the lion’s share of the money for at least another year was met with muted criticism, however, as environmentalists were lured by another piece of news: $600 million of cap-and-trade money would go for renewable energy, energy efficiency and other carbon-cutting programs.

“That’s a significant chunk of money, and that’s what we’re happy about, as opposed to last time, when that number was zero,” said Bill Magavern, policy director for the Coalition for Clean Air. “It should be more than $600 million, but to go from zero to $600 million is a lot of progress.” [Bold added.]

This is despite the fact that the California Legislative Analyst’s Office (the California legislature’s non-partisan watchdog) questioned the climate benefits of the rail project explaining, “it would contribute a relatively minor amount of GHG remission reductions to the state.”

In any other context, what’s happening would be quite obvious: A politician wins support from special interest groups by shoveling hundreds of millions of dollars to projects they favor. Yet because these are “green” groups claiming they are motivated solely by concern for future generations, the normal skepticism concerning pork barrel spending goes out the window.


Proponents of a carbon tax argue that it can be used to correct a market “negative externality,” and that its revenues will be used to offset other, distortionary taxes. Some advocates go so far as to claim that with a carbon tax in place, all of the other regulations, mandates, and subsidies on “green” projects can be phased out, since the carbon tax (or cap and trade program) will allow a “market solution” to the problem of climate change.

The experience in California shows just how naïve these assurances are. The revenues from its cap and trade program were not devoted to reducing California’s onerous income tax schedule, but instead are being used to cover general spending and “green” projects that make little economic or environmental sense.

It is understandable why progressives—who generally endorse political overrides on market outcomes—would support a carbon tax. But how any American self-described conservative can possibly think a carbon tax will be “pro-growth” remains a mystery.

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