As the federal government looks for ways to address the fiscal challenges posed by large and growing federal deficits, discussions about a carbon tax have quietly emerged to identify a potentially important source of new revenue.
The role a carbon tax could play in fiscal policy efforts will depend on how much revenue such a tax is likely to produce—which, in turn, depends on the level of the tax and how it is designed, including which sectors are covered. The electricity sector (which currently produces around 40 percent of domestic carbon dioxide emissions) would almost certainly be covered by the tax in some fashion, and would therefore account for a significant portion of revenues raised.
In a new issue brief, “The Variability of Potential Revenue from a Carbon Tax,” RFF researchers show that carbon tax revenues from the electricity sector are notably uncertain, based not only on the level of the tax but also on several market conditions beyond the price of carbon itself. These include forecasted levels of natural gas prices and electricity demand, both of which have changed significantly in the past few years. Karen Palmer, Anthony Paul, and Matt Woerman use RFF’s Haiku model to analyze potential carbon tax revenues under a range of assumptions, including carbon tax rates of $10, $25, and $40 per ton. They find that revenues from the electricity sector will vary substantially with tax rates, and that revenues are uniformly lower when natural gas is less expensive and when demand growth is lower. In addition, the effect of these factors is amplified as the carbon tax rate increases.
Under a carbon tax of $25 per ton in 2020, for example, revenues from the electricity sector can vary by roughly 18 percent and total carbon tax revenues can vary by up to 7 percent. With the higher $40 tax trajectory, tax revenues vary by as much as $25 billion per year, which is equal to roughly 30 percent of total annual tax revenue in the electricity sector. These variations are important to keep in mind as analysts and policymakers consider deficit reduction and revenue raising goals.
Finally, the political economy of a carbon tax proposal will depend importantly on what happens to electricity prices locally. Palmer, Paul, and Woerman’s analysis suggests that some of the regions that have low electricity prices currently will tend to be the hardest hit, in part because of their heavy reliance on coal. Nonetheless, for moderate carbon tax rates, these regions will continue to have low electricity prices, and existing price differences will be reduced across regions.