Discussion Paper

Moving U.S. Climate Policy Forward: Are Carbon Taxes the Only Good Alternative?

Feb 22, 2011 | Ian W.H. Parry, Roberton C. Williams III


This paper estimates the welfare costs of the main medium-term options for significantly reducing U.S. energy-related carbon dioxide (CO2) emissions, including carbon taxes and cap-and-trade systems applied economy-wide and to the power sector only, and an emissions rate standard for power generation. The key theme is that welfare costs depend importantly on how policies interact with distortions in the economy created by the broader fiscal system. If allowance rent is not used to increase economic efficiency, economy-wide cap-and-trade systems perform the worst on cost-effectiveness grounds. In contrast, if revenues are used to substitute for distortionary income taxes (either directly, or indirectly through deficit reduction), economy-wide carbontaxes (or auctioned allowance systems) may have (slightly) negative costs. The bottom line is that revenues or rents created under economy-wide, market-based carbon policies must be used to increase economic efficiency to ensure that these instruments are more cost-effective than regulatory or sectoral approaches.

Now is the perfect time to reevaluate the main options for moving U.S. climate policy forward, given that Congress has been unable to pass a comprehensive climate bill. There are three broad areas for consideration. First is some form of cap-and-trade policy, though perhaps less ambitious in both scale and scope than what has previously been proposed. Second is its market-based rival—a tax on the carbon dioxide (CO2) potential of fossil fuels. And third are the regulatory alternatives, the most promising of which is an emissions rate standard for (new and existing) power generation sources.

In “Moving U.S. Climate Policy Forward: Are Carbon Taxes the Only Good Alternative?” authors Ian W.H. Parry and Roberton C. Williams III assess the costs and economic benefits as well as the efficiency and feasibility trade-offs of the policy alternatives, noting the overall policy goal of reducing domestic, energy-related CO2 emissions. Considering economic efficiency as the primary criterion, there is a solid case for moving ahead with carbon tax shifts in the United States. This policy would not only achieve climate objectives, but could also provide enough revenue to cover roughly a third of the projected federal budget deficit out to the year 2030.