Carbon Tax: Crucial Step to Stop Global Scorching

By Charles Komanoff and Daniel Rosenblum*

Why are carbon taxes essential?

Charging businesses and individuals a price to emit carbon dioxide (CO2) is essential to reduce U.S. emissions quickly and steeply enough to prevent atmospheric concentrations of CO2 from reaching an irreversible tipping point.

The transformation of our fossil fuels-based energy system to reliance on energy efficiency, renewable energy, and sustainable fuels won't happen without carbon taxes sending the appropriate price signals into every corner of the economy and every aspect of life.

Why a carbon tax instead of a cap-and-trade system?

A carbon tax is strongly preferable to cap-and-trade systems being promoted by some large corporations and several major environmental organizations. The key advantages of carbon taxes over cap-and-trade can be summarized in these words: predictability, transparency, immediacy, universality, and equity.

Carbon Taxes vs. Cap-and-Trade

Carbon taxes and cap-and-trade programs are both touted as economically sound approaches to reducing carbon emissions. Cap-and-trade systems are being promoted by some large corporations and several major environmental organizations. Why is a carbon tax preferable?

Carbon taxes are superior to cap-and-trade programs for six fundamental reasons:

1. Carbon taxes will lend predictability to energy prices, whereas cap-and-trade systems will do little to mitigate the price volatility that historically has discouraged investments in less carbon-intensive electricity generation, carbon-reducing energy efficiency and carbon-replacing renewable energy.

2. Carbon taxes can be implemented much sooner than complex cap-and-trade systems. Because of the urgency of the climate crisis, we do not have the luxury of waiting while the myriad details of a cap-and-trade system are resolved through lengthy negotiations.

3. Carbon taxes are transparent and easily understandable, making them more likely to elicit the necessary public support than an opaque and difficult to understand cap-and-trade system.

4. Carbon taxes can be implemented with far less opportunity for manipulation by special interests, while a cap-and-trade system's complexity opens it to exploitation by special interests and perverse incentives that can undermine public confidence and undercut its effectiveness.

5. Carbon taxes address emissions of carbon from every sector, whereas cap-and-trade systems discussed to date have only targeted the electricity industry, which accounts for less than 40% of emissions.

6. Carbon tax revenues can be returned to the public through progressive tax-shifting, while the costs of cap-and-trade systems are likely to become a hidden tax as dollars flow to market participants, lawyers and consultants.

Carbon Taxes Will Lend Predictability to Energy Prices.

With carbon taxes ramped up through a multi-year phase-in, future energy and power prices can be predicted with a reasonable degree of confidence well ahead of time. This will make it possible for literally millions of energy-critical decisions - from the design of new electricity generating plants to the purchase of the family car to the materials used in commercial airframes - to be made in full recognition of carbon-appropriate price signals.

In contrast, the primary virtue of cap-and-trade systems - that future levels of carbon emissions can be known ahead of time - is of questionable value, since there is no agreed-upon trajectory of emissions that can achieve climate stability and prevent disaster. The real target for which the U.S. must aim is to reduce carbon emissions as much as possible, and then more.

Carbon Taxes Will Provide Quicker Results.

The taxes themselves can be designed and adopted quickly and fairly. Cap-and-trade systems, by contrast, are devilishly complex and will take years to develop and implement. Key issues must be addressed intellectually and resolved politically; the proper level of the cap, timing, allowance allocations, certification procedures, standards for use of offsets, penalties, regional conflicts, the inevitable requests for exceptions by affected parties and a myriad of other complex issues must all be resolved before cap-and-trade systems can be implemented. During this time, polluters will continue to emit carbon with no cost consequences.

Carbon Taxes Are Transparent and Easier to Understand than Cap-and-Trade.

A carbon tax is transparent and easy to understand; the government simply imposes a tax per ton of carbon emitted, which is easily translated into a tax per kWh of electricity, gallon of gasoline or therm of natural gas. By contrast, the prices for carbon set under a cap-and-trade system will vary with market fluctuations and be impossible even for big business (let alone small businesses or consumers) to predict.

A cap-and-trade system will require a complex and difficult to understand market structure in order to balance the many competing interests and ensure that the trading system minimizes abuse and maximizes real carbon reductions.

A Carbon Tax's Simplicity Inoculates it Against the Perverse Incentives and Potential for Profiteering that Will Accompany Cap-and-Trade.

In contrast to the simple and straightforward process of implementing a carbon tax, the protracted negotiations necessary to implement a cap-and-trade system will provide constant opportunities for the fossil fuel industry and other invested parties to shape a system that maximizes their financial self-interests as opposed to an economically efficient system that maximizes societal well-being.

If allowances are allocated based on some type of baseline reflecting past pollution (which has been the practice with NOx and SO2 trading programs), rather than being auctioned, polluters will have perverse incentives to maximize emissions before the cap-and-trade system goes into effect in order to "earn" those pollution rights. (The voluntary cap-and-trade system currently operating has already been criticized for questionable offsets that have produced huge profits but little environmental benefit. See Outsize Profits, and Questions, in Effort to Cut Warming Gases, New York Times, Dec. 21, 2006.)

Carbon Taxes Address All Sectors and Activities Producing Carbon Emissions.

Carbon taxes target carbon emissions in all sectors - energy, industry and transportation - whereas at least some cap-and-trade proposals are limited to the electric industry. It would be unwise to ignore the non-electricity sectors that account for more than 60% of U.S. CO2 emissions.

Carbon Taxes Can Produce a Far More Equitable Result than Cap-and-Trade.

As discussed in more detail at [cite], carbon taxes can be used to fund progressive tax-shifting to reduce regressive payroll or sales taxes. The costs of cap-and-trade systems, both implementation and the costs incurred as more expensive technologies replace older and less expensive coal-fired combustion, are far more likely to be imposed upon consumers with less possibility of rebating or tax-shifting.

Moreover, because cap-and-trade relies on market participants to determine a fair price for carbon allowances on an ongoing basis, it could easily devolve into a self-perpetuating province of lawyers, economists, lobbyists and other market participants bent on maximizing their profits on each cap-and-trade transaction. The dollars that will be funneled into making the market work could be better spent reducing regressive taxes, protecting poorer households and/or helping consumers use less energy.

Energy Demand: How Sensitive to Price?

While carbon taxes could be justified on the bedrock principle that prices for fossil fuels should include the "externality costs" their use imposes on society - that polluters should pay for polluting - the premise of our carbon tax advocacy is that a carbon tax will reduce the demand for and emissions of carbon from the use of fossil fuels.

This is because demand is at least somewhat sensitive to price, i.e., because there is some "price-elasticity" (to use economic jargon) in energy usage. This means that taxing fossil fuels for their carbon emissions can be a powerful lever for controlling and reducing demand.

From our literature review, CTC believes that a "price-elasticity" of 40% is an appropriate assumption for first-level analysis. This means that a rise in fuel prices would engender a drop in demand that is a little less than half as steep as the price rise.

Because key determinants of energy use such as infrastructure, location and capital goods like houses and cars can't be changed overnight, drops in demand due to higher prices usually take years. Our 40% estimate is a "long-run" figure, requiring around a decade to manifest fully, as opposed to "short-run" elasticities that apply to rapid but smaller changes, i.e., within a year. Short-run elasticities also exist, of course, as everybody who hesitates before paying an increased price for a product is aware, but they are less than the long-run values.

This page gives links to articles and papers on energy price-elasticity in the United States. Some are for a general audience, some are technical. Many focus on automobiles and gasoline, the area of energy use that has been studied the most.

. Kenneth Small & Kurt Van Dender, Fuel Efficiency and Motor Vehicle Travel: The Declining Rebound Effect, 2006, forthcoming in Energy Journal in 2007. Small, a Professor of Economics at U-C Irvine and a peerless transportation economist and thinker, has co-authored the most perceptive and persuasive analysis of U.S. gasoline demand we've seen. The paper analyzes 1966-2001 data for each of the 50 states and finds (i) a short-run price elasticity of gasoline of roughly 9% (comprised equally of changes in fuel efficiency and miles driven); and (ii) a long-run price elasticity of gasoline of around 40% (also arising equally from changes in fuel efficiency and miles driven). Note: Prof. Small has told us that adding more recent data, through 2004, doesn't alter these findings.
. J.E. Hughes, C.R. Knittel, D. Sperling, Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand, 2006, National Bureau of Economic Research. The authors sift 2001-2006 gasoline use data and find the price-elasticity to be minuscule - just 4% in the short-run and, though they don't quantify it, not much greater in the long-run.
. C. Komanoff, Letter to Daniel Sperling. CTC's Komanoff asks Prof. Sperling to reconcile his findings with the contrary findings of Small & Van Dender. The letter was sent Dec. 4, 2006; no reply has been received.
. Nicholas Lutsey & Daniel Sperling, Energy Efficiency, Fuel Economy, and Policy Implications, Transportation Research Record, 2005. Though not strictly about price elasticity, this paper deconstructs technical changes in the U.S. auto fleet from 1975 to the early 1980s, a period in which most technical gains were devoted to improving fuel efficiency, and since then, when technical improvements have been used "to satisfy private desires (more power, size and amenities)." Anyone seeking to understand automobile fuel economy should read this paper.
Dermot Gately & Hillard G. Huntington, The Asymmetric Effects of Changes in Price and Income on Energy and Oil Demand, 2001, Economic Research Reports, RR# 2001-01, C.V. Starr Center for Applied Economics, NYU. Using 1971-1997 data, and lumping the U.S. with the other (OECD) industrial nations, the authors derive long-run price-elasticities of only 24% for all energy, but 64% for petroleum products alone. (Could fuel substitution be the reason for the disparity?) Encouragingly, they report a relatively low long-run income-elasticity, 55-60%, for both oil and energy in the OECD countries, indicating that, all things equal (i.e., with constant prices), each 3% growth of GDP gives rise to less than a 2% rise in energy use.

Softening the Impact of Carbon Taxes

Carbon taxes, to be effective, will raise large amounts of money. That's their job - to cut carbon dioxide emissions by decisively raising prices of fossil fuels. Part of our mission at CTC is to advocate for carbon taxation to be as "progressive" as possible, with the tax revenues used to protect the interests of middle-income and low-income Americans.

It is true that most middle- and low-income households spend a larger percentage of their income on gasoline than do wealthy households. (We discuss gasoline here because data are readily available and because gasoline tops most families' energy budgets.) The top 20% of U.S. households spend just 2.3% of their after-tax income on gasoline; the percentage for the lowest "quintile," 9.1%, is four times as high. Clearly, imposing a gasoline tax or, by implication, a carbon tax, without tax-shifting or rebating, would have a disproportionate percentage impact on lower-income families.

But the picture is quite different when energy expenditures are viewed in absolute dollar terms - which we believe is a more meaningful measure. In 2005, the most recent year available, the upper-echelon quintile spent an average of $3,182 on gasoline, or 3.6 times as much as the $882 spent by the poorest 20% of households. Put differently, when all household outlays for gasoline are apportioned among quintiles, the highest-earning quintile accounted for 32% of the total, while the lowest quintile contributed just 9%. (The middle quintile, true to its name, spent exactly 20% of the total.)

What's true for gasoline applies to energy in general. Wealthier households not only drive more, they also fly more (burning jet fuel), they have bigger (and sometimes multiple) houses to heat and cool (consuming heat and power), and they buy more stuff that requires electricity or industrial fuels to manufacture and use.

This means that most carbon taxes will be paid, directly or indirectly, by families of above-average means. For the gasoline part of carbon taxes, we estimate that around two-thirds of the taxes will be paid by above-average-income households. (We calculated this by combining the first quintile's share of gasoline expenditures, 31.6%, with the second quintile's share, 25.0%, and one-half of the middle quintile's share, 19.8%, which yielded 66.6%. All data here are from the Bureau of Labor Statistics' Consumer Expenditure Survey, 2005.)

This progressive distribution of carbon tax revenues is what creates a basis for progressive tax-shifting: transferring a portion of the tax burden from regressive taxes such as the payroll tax (at the federal level), as Al Gore is urging, and the sales tax (at the state level) onto carbon emissions instead.

Although we at CTC haven't finished running the numbers - allocating carbon tax payments by corporations and government adds a twist to the analysis - we believe it is possible that one or both of these approaches may have a net progressive effect, i.e., that tax-shifting from payroll and/or sales taxes to carbon taxes will raise, not lower, the after-tax incomes of a majority of below-median-income households.

An alternative approach that is unquestionably progressive, as well as straightforward, is to rebate the carbon tax revenues equally to all U.S. residents. This would be a national version of the Alaska Permanent Fund, which once a year sends every resident of that state an identical check drawn from the state's North Slope oil royalties. (For a federal carbon tax, the rebate checks should be provided at least quarterly to keep households ahead of the budget treadmill.) With carbon tax revenues rebated in this pro rata fashion, the vast majority of poorer households would get back more in the rebates than they would pay in the tax.

A numerical illustration may help to grasp the progressive impact of rebating carbon tax revenues equally to all U.S. residents. Here are the steps leading to this conclusion:

. We estimate that the revenues from Year 1 of our graduated "Starter Tax" of $37 per ton of carbon emitted would be approximately $55 billion a year. (The actual dollar amount isn't critical for this example.)
. Assuming that this entire amount is rebated equally to all 300 million U.S. residents, each annual rebate would be $183.
. From our earlier observation that the lowest-income quintile makes 9% of gasoline expenditures, $4.8 billion of the carbon tax payments would be made by the 60 million people comprising this quintile. (Yes, we are using gasoline as a "proxy" for carbon fuels, for the reasons given earlier.)
. Averaged over those 60 million, each individual in the lowest-income group would spend an average of $80 a year in carbon taxes.
. Netting this $80 per-person carbon tax from the $183 per capita rebate, we see that the average person in the bottom quintile would gain approximately $100 in the first year of our $37/ton carbon tax. Annual installments to ramp up the tax rate would only add to the gains of this lowest-income group.
Using the same methodology, we calculate that carbon tax payments for the top quintile would average $290 per person per year. Since each person in this group would also receive a $183 rebate, we see that the average person in the top quintile would pay a net of a little over $100 in carbon taxes during the first year. The same result of the more affluent paying a net tax and the less affluent receiving a net gain applies to the second and fourth quintiles as well, though the magnitudes of the impacts are smaller. The middle group would experience no net change in after-tax income, on average.

We recognize that some individuals in the lower-income quintiles would be subject to higher than average carbon taxes because they have old fuel-guzzling cars, drive long distances to work, have old inefficient furnaces and/or live in poorly insulated homes. A portion of the carbon tax revenues could and should be used to help reduce the energy use of their cars and homes.

These observations are preliminary, and much more analytical work remains to be done, particularly on the tax-shifting alternative. But the principles are clear: tax rebating or shifting can ameliorate the disproportionate impact of carbon taxing, perhaps to the point that below-median households become net beneficiaries. CTC is committed to advocating for such an outcome, for both pragmatic and ethical considerations. Pragmatically, because the politics of a carbon tax require support from economic justice advocates; and ethically, because it's not tenable to solve the climate crisis on the backs of those who can least afford it.

* Charles Komanoff is an internationally known energy-economist and transport-economist and an environmental activist in New York City. He "re-founded" NYC's bike-advocacy group Transportation Alternatives in the 1980s, co-founded the pedestrian-rights group Right Of Way in the 1990s, and wrote or edited the landmark reports Subsidies for Traffic, The Bicycle Blueprint, and Killed By Automobile. Earlier, Komanoff gained prominence for deconstructing the disastrous economics of nuclear power as author-researcher and expert witness for states and municipalities across the U.S. A math-and-economics graduate of Harvard, Komanoff lives with his wife and two sons in lower Manhattan. He wrote his visionary oil-saving report, Ending The Oil Age, after witnessing at close range the traumatic events of 9/11.

* David Rosenblum has been Senior Attorney of the Pace Law School Energy Project_ since November 2001. Before that, he was Senior Attorney of the Environmental Law and Policy Center of the Midwest_ (March 1997 - October 2001) and Director of the Mid-Atlantic Energy Project_(December 1992 - February 1997).
Even before that, he had more than sixteen years of energy and telecommunications regulatory experience, as a commissioner in Illinois and senior staff in New York, serving on the National Association of Regulatory Utility Commissioners' Telecommunications Committee and as a founding member of the Ad Hoc Committee on Energy Conservation and as an attorney for the City of New York, State of New York and low-income consumers in Chicago.