Policy commentary

Getting Serious about Deficits and Climate at the Same Time

Dec 13, 2010 | Ian W.H. Parry

U.S. policymakers face two significant challenges: reducing budget deficits and reducing the threat of global climate change. Introducing a tax on carbon dioxide emissions would effectively address both challenges.

Like it or not, the president’s bipartisan commission on deficit reduction is telling Americans that sooner or later, taxes will have to rise and spending will have to fall to address the nation’s chronic fiscal imbalances. At the same time, Congress’s failure to enact meaningful climate legislation has effectively put international climate mitigation efforts on hold. However, there is a very simple and economically sound way to make some progress on both of these very challenging problems.

A Carbon Tax is Good Fiscal Policy

While we can debate endlessly how fast greenhouse gas emissions should be cut over coming decades, the pressing domestic issue at present should be to put a price on carbon. Based on the recommendations of a recent study conducted by multiple government agencies, a reasonable starting price would be about $20 per ton of carbon dioxide (CO2), rising to perhaps $30 by 2020.

From a budgetary perspective, a tax of $30 per ton on the (potential) CO2 emissions from fossil fuels would account for a large chunk (a quarter or more) of projected annual deficits out to 2020 and beyond. The extra revenue would reduce the need to raise other taxes or cut other spending, measures that would be inevitable sooner or later.

Increasing income taxes would impose economic costs by discouraging work effort and capital accumulation, and encouraging excessive spending on employer medical insurance, homeownership, and other tax-exempt or tax-deductible items. Recent evidence suggests that raising more revenue from these taxes costs society about 30 cents for each extra dollar of revenue, reflecting the costs of increasing distortions in the economy created by the broader fiscal system. Gauging the cost of reducing public spending is trickier, as it depends on the specifics of the programs that are being cut. But if programs with favorable benefit–cost ratios are scaled back, again there will be a net cost imposed on society.

Using carbon taxes, on the other hand, to address some of the deficit makes a lot of economic sense. Carbon taxes do impose costs. For example, they induce power generators to switch to cleaner but more expensive fuels and encourage households to drive less than they would otherwise prefer. And to the extent that carbon taxes increase energy prices they also slightly depress the overall level of economic activity, which in turn reduces employment and capital investment. Nonetheless, at least for the scale of taxes envisioned here, raising revenue from carbon taxes is no more costly, and perhaps even less costly, than raising the same amount of revenue through higher income taxes.

But carbon taxes have value beyond raising revenue—they would also provide important environmental benefits. A $30 tax per ton of CO2 would reduce energy-related CO2 emissions by around 9 percent a year, or about 0.5 billion tons, by 2020, producing worldwide benefits from avoided global warming of about $15 billion (if we value emissions reductions at $30 per ton). So there appears to be a strong economic case for including carbon taxes as part of a package of measures to reduce the deficit.

A Carbon Tax is Good Environmental Policy

Putting a price on CO2 exploits all potential options for emissions reductions throughout the economy. For example, as the CO2 price is passed forward into higher fuel and electricity prices, firms will switch away from dirty fuels (such as coal) toward lower-emitting fuels (natural gas) or zero-carbon fuels (nuclear and renewables) while higher energy prices will encourage energy efficient investments and less use of energy intensive products (such as autos).

Instead, Congress and the U.S. Environmental Protection Agency are trying to achieve some of these emissions reductions by mandate, but in a patchwork fashion. For example, automakers are being required to make vehicles with much better gasoline mileage and power companies are being pushed toward renewable fuels. Although some of these approaches may be better than doing nothing at all, they are far less cost-effective than the comprehensive pricing approach because they do not fully exploit all options for emissions reductions throughout the economy. For example, the impact on electricity prices and, hence, incentives for energy conservation are weaker under this approach than under the carbon tax. My colleague and I (see Further Reading) estimate that even a well-designed standard that reduces CO2 emissions per kWh from the power sector costs $29 per ton for a 0.5 billion ton reduction of CO2 in 2020. By contrast, the costs of the carbon tax are –$9 per ton when we account for the reduced burden on other distortionary taxes to meet deficit goals.

Cap-and-trade systems share the same advantage of carbon taxes in that they place a price on economywide CO2 emissions. If the allowances are given away for free, however, this dramatically undermines the cost-effectiveness of this approach. According to our estimates, under a cap-and-trade system, the average costs of reducing CO2 emissions by 0.5 billion tons in 2020 would be about $90 per ton. This is actually higher than for the emissions standard, given that such systems have a much larger impact on energy prices (as the value of allowances is reflected in higher prices), implying a larger contraction in overall economy activity, employment, and investment.

In principle, all the allowances in cap-and-trade systems could be auctioned, and all proceeds remitted to the Treasury, but this is a far cry from the actual allocation of allowances in previous cap-and-trade proposals. To be fair, revenues raised by a carbon tax might also be wasted in special interest spending. The main point here is that, to be cost-effective, carbon taxes or cap-and-trade systems need to be well designed in terms of using the revenues (or allowance value) for deficit reduction or other socially beneficial purposes.

Looking Further Ahead

A further possible advantage of carbon taxes compared to cap-and-trade approaches is that firms know what the future CO2 price is and this helps create a stable business environment for the long-term development of cleaner technologies, such as alternative fuel vehicles and technologies for capturing industrial sources of CO2 emissions and storing them underground. The tax rate could ramp up automatically each year to increase revenues over time and encourage progressively larger reductions in emissions. Down the road, if global warming becomes more imminent than currently expected, the tax rate could be adjusted upward.

Imposing a carbon tax at home would give the United States credibility in efforts to persuade others, especially rapidly growing countries like Brazil, China, and India, to get a grip on their CO2 emissions. The longer the leading CO2-emitting countries delay, the more warming the world will likely experience and the greater the need will be to adapt to it—and the greater the likelihood that we will have to seriously consider risky alternatives, such as deliberately putting particles in the stratosphere to deflect sunlight.

In recent years, carbon taxes were quickly dismissed in Washington, given voters’ and politicians’ aversion to the “T” word. But whenever policymakers get real about the deficit, many sacred cows may be on the table. Look across the pond, where Britain’s Coalition government is busy making deep, across-the-board cuts in government spending to restore order to the public finances. And following the lead of neighboring Ireland, the coalition government is also considering a carbon tax.

This commentary was written while Ian Parry was full time Allen V. Kneese Chair and senior fellow at Resources for the Future.

Further Readings:

Parry, Ian W.H., and Roberton C. Williams. Moving U.S. Climate Policy Forward: Are Carbon Tax Shifts the Only Good Alternative? Forthcoming discussion paper. Washington, DC: Resources for the Future.