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May 24, 2013

MURPHY: Using the CBO Report to Critique a US Carbon Tax

May 24, 2013
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The advocates of a US federal carbon tax are in an awkward position. They have stressed to the public that the majority of natural scientists believe human-caused carbon emissions are at least partially responsible for the rise in global temperatures over the last century, and that any physicist or climatologist who denies this is outside “the consensus.” They think this is sufficient to prove that a US carbon tax is therefore a wise policy move. Unfortunately for them, “the consensus” in the economics literature shows that this conclusion is far more dubious.

To prove my point, I will walk the reader through the recent report from the CBO on the economic and environmental effects of a carbon tax. Just glancing through the Executive Summary, one gets the impression that there is a slam-dunk case for implementing a carbon tax, both to raise needed revenues and to help mitigate the damage from climate change. But I’ll list several major problems with that argument, and what’s more, I won’t go to the Heritage Foundation or the Heartland Institute for my facts. I will quote from the same CBO report itself to show that the economic cost/benefit case for a US carbon tax is much weaker than the public has been led to believe.

The authors of the CBO report know what the Obama Administration wants to hear, but they are also competent economists and the awkward facts (from their perspective) are what they are. Let’s walk through and see all of the problems with a US carbon tax, and why we should not expect the rosy outcomes that its advocates describe.

A Carbon Tax Would Suck Trillions Out of the Private Sector While Doing Little to Reduce Global Emissions

First let’s get a sense of the climate bang-for-the-buck we’d get from a carbon tax of the magnitude policymakers are considering. The CBO report tells us on page 1 that they didn’t formally model this, but that previous estimates of a cap-and-trade program (which would have very similar impacts) that would imply a $20 per ton tax on carbon dioxide would raise $1.2 trillion in revenue over the first decade. In exchange for this enormous drain of resources from the private sector, we would see a drop in US emissions (relative to the no-cap baseline) of 8 percent.

Right off the bat, does this sound like a good deal to the average American? In 2011, the US was only responsible for 16% of global CO2 emissions (China was the leader with 29%), and going forward the US share will only shrink as China and other developing economies surge. Reducing US emissions by 8 percent, in exchange for a $1.2 trillion new levy on American citizens in the first decade alone—do most Americans really want to sign up for this?

A Carbon Tax Would Lower Economic Output, Raise Prices, and Disproportionately Hurt the Poor

How exactly would a carbon tax affect the economy? The CBO report tells us, and again this comes from page 1:

By raising the cost of using fossil fuels, a carbon tax would tend to increase the cost of producing goods and services—especially things, such as electricity or transportation, that involve relatively large amounts of CO2 emissions…

Without accounting for how the revenues from a carbon tax would be used, such a tax would have a negative effect on the economy. The higher prices it caused would diminish the purchasing power of people’s earnings, effectively reducing their real (inflation-adjusted) wages. Lower real wages would have the net effect of reducing the amount that people worked, thus decreasing the overall supply of labor. Investment would also decline, further reducing the economy’s total output.

Later the CBO explains quantifies the regressive nature of the carbon tax:

The higher prices resulting from a carbon tax would tend to be regressive—that is, they would impose a larger burden (relative to income) on low-income households than on high-income households. The reason is that low income households spend a larger share of their income on goods and services whose prices would increase the most, such as electricity and transportation. For example, an earlier CBO analysis concluded that a policy that set a price of $28 per metric ton on CO2 emissions would increase costs for households by amounts that would equal about 2.5 percent of after-tax income for the average household in the lowest one-fifth (quintile) of the income distribution but less than 1 percent of after-tax income for the average household in the highest quintile. (pp. 8-9, emphasis added)

Later the report is more specific, explaining that average US electricity prices would rise by 16 percent, while “[h]ouseholds in Illinois, Indiana, Kentucky, Michigan, Missouri, Ohio, West Virginia, and Wisconsin would see the biggest rise in electricity prices (27 percent)” (p. 9).

Using Carbon Tax Revenue to Help the Poor Would Not Mitigate the Economic Impact

When faced with the inconvenient truth that a carbon tax would fall disproportionately on the poor, progressive supporters of the idea are quick to suggest that some of the trillions in new revenue be devoted to compensate such unfortunate citizens from rising electricity and gasoline prices. Ah, but the catch is, the more the government does this, the less efficient the whole scheme becomes. As the CBO report itself admits:

[U]nlike using carbon tax revenues to reduce deficits or marginal tax rates, using them to provide relief from the tax’s effects on certain groups would generally not lessen the total economic costs of a carbon tax, including the reduction in total output. For example, lump-sum payments to low-income households would not provide benefits to the broader economy under normal economic conditions, because those payments would not increase people’s incentives to work or invest and thus would not lead to greater economic productivity. Conversely, using the revenues to cut marginal tax rates on corporate or individual income would benefit the economy more broadly but would probably have limited value to low-income households, who typically owe little, if any, income tax. As a result, lawmakers could face a tradeoff between using carbon tax revenues to minimize the tax’s adverse effects on the economy as a whole and using them to minimize the tax’s impact on disproportionately affected groups. [p. 12, bold added.]

Thus we see that the progressives who claim a carbon tax would bring in gushers of new money, which could be used to minimize the burden on the poor, are at loggerheads with the conservatives who claim a carbon tax would bring in gushers of new money to reduce the deficit and/or other taxes. The two goals operate at cross-purposes; you can’t use the same $1.2 trillion to compensate the poor for rising energy costs, and to reduce corporate income tax rates. (And anyone who thinks $1.2 trillion in new revenue will be devoted solely to deficit reduction, needs to review the history of Washington, DC.)

The Economics Literature Does Not Support a Carbon “Tax Swap”

Yet it gets worse. Not only will the goal of a grand carbon “tax swap” deal be undercut by the need to compensate disadvantaged groups, but even on its own terms, the evidence in the technical economics literature comes down to the conclusion that even a dollar-for-dollar carbon tax swap deal would hurt the conventional economy. Again, let us quote from the CBO report itself:

Different studies reach different conclusions about the extent to which a tax swap would offset the costs of a carbon tax. For example, one study examined the impact of using carbon tax revenues to fund several specific tax cuts—including reductions in marginal rates for payroll taxes, corporate income taxes, and individual income taxes. It concluded that the reduction in output caused by the carbon tax would be larger than the increase in output caused by the accompanying tax cuts

Another, more recent study concluded that using the revenues from a carbon tax to pay for a cut in marginal tax rates on capital…would cause output to be higher for several decades than it would be without the carbon tax and corresponding tax cut. That study also estimated that cutting marginal tax rates on labor would help limit the reduction in output caused by a carbon tax…but that the net effect of the carbon tax and tax swap on output would still be negative. Another recent study estimated that using half of the revenues from a carbon tax to reduce the deficit and the other half to reduce marginal tax rates on individual income would lead to lower output throughout the 50-year period examined.

Thus, although many researchers agree that a tax swap could limit the economic costs of a carbon tax, they differ in their estimates of how far the tax swap would go to offset those costs…[p. 11, bold added]

In case the reader is lost in the details, let me spell out the shocking implications of the above block quotation. The CBO report is summarizing the literature on the extent to which devoting 100 percent of carbon tax revenues to other tax reductions (and/or deficit reduction which reduces future taxes) could help mitigate the impact on the economy. To this end, the CBO reported the results of three representative studies. Two of them (the first and third) unambiguously say that conventional GDP will be lower, even with a 100 percent carbon tax swap deal. The second study cited does find that using 100 percent of the carbon tax swap revenue to cut existing taxes on capital could actually increase conventional GDP (in addition to environmental gains), but even this study admits that if the carbon tax swap deal is devoted to reducing taxes on labor, then the net effect on the economy will be to reduce output.

This is a crucial point I stressed in my recent study on carbon tax swap deals. Conservative proponents of such a deal need to understand that the best guess among technical researchers is that even if the government took 100 percent of the carbon tax revenue and used it to reduce marginal income tax rates across the board, then this would probably hurt the conventional economy. When you factor in the political realities that we will never get a 100 percent devotion of the revenues for reducing top marginal income tax rates or corporate tax rates, the case for a “double dividend” or a “win-win” outcome is even weaker.

If conservatives want to say, “Hey, this train is leaving the station, we might as well fight for some tax rate relief,” that at least is a justifiable argument. But they should stop claiming that a carbon tax swap deal will help the economy and the environment simultaneously; the peer-reviewed literature says that it probably won’t, and the CBO admits it.

Conclusion

The case for a US carbon tax is much weaker than the public has been led to believe. It would cost trillions of dollars to achieve minor reductions in global emissions in the coming decades, it would fall disproportionately on the poor, any attempts to mitigate this burden would undercut the other possible economic gains, and even if 100 percent of the revenue were used to offset other taxes, the conventional economy would still suffer. Every one of these points comes right from the CBO’s latest report—although you wouldn’t realize it from reading the Executive Summary.

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