Ezra Klein reported a fantasy of his in the Washington Post this past weekend. Klein dreamed a tax on carbon dioxide emissions could be part of a bipartisan deal to avoid the fiscal cliff caused in part by the expiring Bush area tax cuts that will lead to higher taxes on two very important components of the US economy – capital and labor. Klein ran his fantasy idea past Grover Norquist, who Klein calls the “lord of the anti-tax pledge” to get his opinion. In response Norquist is quoted as saying “If one cut the income tax dollar for dollar and had a carbon tax in its place, it would not be a violation of the taxpayer protection pledge, but you’re creating a new tax that will grow.” Therein lies the problem, the fear that any new tax, not matter how small initially, can grow into a monster.
Surely, revenue from taxes on income and labor can grow, one need only raise the rates; but this is not true of taxes on carbon dioxide. As one very astute Republican recently remarked to me, “a tax on carbon is a self-extinguishing tax,” that is, it can grow, but not forever. Indeed, no matter what CO2 tax rate you begin with and no matter how far and how fast you raise the rate, there is a camel humped shape to the revenues from the tax. Initially as the rate rises so too does revenue, but then at some point higher tax rates begin to generate lower revenues. The reason is textbook economics; the higher the initial rate and the faster you raise the rate, the quicker the owners of CO2 emitting capital invest in non-emitting capital and the more quickly you decarbonize the economy thereby lowering the base (CO2 emissions) against which the tax is levied. At some point the base erodes to practically noting and the tax self-extinguishes.