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Policy Brief THE Advancing Opportunity, HAMILTON Prosperity and Growth PROJECT P O L I C Y B RIE F NO . 2 0 0 7 - 1 2 OCTO B ER 2 0 0 7 A Carbon Tax Swap to Mitigate Global Climate Change CONTROVERSIAL UNTIL RECENTLY, the proposi- tion that human activity is altering the climate at an unprec- edented rate is now widely accepted. Global annual tempera- tures are rising more rapidly as greenhouse gas emissions from human activity—most notably from the burning of fossil fuels—trap heat at the Earth’s surface. The potential consequences—rising sea levels, extreme drought and flood- ing, water stress, and shorter growing seasons—could result in dramatic changes in our way of life and in long-term economic harm. Recent polls show that a majority of Americans think the government should do more to slow climate change. But what? That’s where the consensus ends. In a discussion paper for The Hamilton Project, economist Gilbert E. Metcalf of Tufts University proposes a carbon tax to reduce the greenhouse gas emissions that contribute to climate change. The tax would start at a low initial rate and increase gradually to give the economy time to adjust. Metcalf argues that this proposal would be economically efficient, providing businesses and consumers with incentives to reduce carbon emissions in the most cost-effective manner possible. To combat the regressive impact of higher energy prices, Metcalf proposes using the revenue from the carbon tax to pay for a progres- sive tax reduction—a policy he calls a “carbon tax swap.” WWW.HAMILTONPROJECT.OR G The Brookings Institution 1775 Massachusetts Avenue NW, Washington, DC 20036 A CARBON TAX SWAP TO MITIGATE GLOBAL CLIMATE CHANGE Climate change is a global tation patterns could introduce new risks for the THE phenomenon, with emis- spread of water- and insect-borne diseases. Though CHALLENGE sions from every part of the average surface temperatures are expected to rise, world contributing to the some regions such as western Europe may enter problem. The Intergovernmental Panel on Climate cold spells as ocean currents carrying heat slow. Change (IPCC) recently reported that global sur- face temperatures have increased 0.7°C in the past Governments have begun to recognize the need for 100 years, and that warming has accelerated in the a global solution to this global problem. But a global past 30 years. There is little doubt that rising emis- solution is unlikely unless the United States—the sions of greenhouse gases (GHGs) from human ac- world’s largest carbon emitter and its wealthiest na- tivities are playing a role in increasing the Earth’s tion—assumes leadership on the climate issue. And surface temperature and overall climate volatility. As given that serious action on climate change could the IPCC recently concluded: entail significant costs, theU nited States is unlikely to act unless it can develop a policy that reduces Continued greenhouse gas emissions at or emissions cost-effectively and spreads the burden of above current rates would cause further warm- these costs fairly across society. ing and induce many changes in the global cli- mate system during the 21st century that would In considering cost effectiveness, the United States very likely be larger than those observed during must decide between two basic options for reduc- the 20th century (emphasis in original). ing GHG emissions: limiting them through direct regulation or putting a price on them using market The IPCC predicts warming of almost 4°C over the incentives. Economists agree that market incentives next century if rapid economic growth powered by are more efficient than direct regulation. When fossil fuels continues. designed properly, market incentives produce the same reduction in emissions but at lower cost to Like its causes, the human impact of climate change society. Market mechanisms encourage firms and will be global, with the developing world hit hardest. households to identify the most cost-effective ways Low-lying agricultural areas and coastal populations to reduce emissions, while direct regulation drives may experience flooding, while other areas may suf- up abatement costs by dictating when, how, and by fer drought and water shortages. Changing precipi- whom emissions are to be reduced. Distributional equity is a distinct but equally im- portant concern in designing climate policy. Any policy that raises energy prices—even the cost-ef- fective market mechanisms—would place a dispro- A global solution is unlikely portionate burden on low-income consumers, who spend a greater percentage of their income on en- unless the United States— ergy than higher-income consumers. According to the Department of Energy, low-income households the largest carbon emitter and spend about 14 percent of their income on energy, compared to the national average of 3.5 percent. wealthiest nation—assumes The regressive impact of higher energy prices thus presents a challenge to adopting an environmentally leadership on the climate issue effective, yet distributionally fair, climate policy. P OLIC Y BRIEF NO. 20 07-12 | OCTO BER 20 07 THE HAMILTON PROJECT A gradually increasing tax on Confronting this challenge, greenhouse gas emissions A NEW Gilbert Metcalf proposes a APPROACH carbon tax that would re- would encourage consumers duce greenhouse gas emis- sions while also addressing concerns about eco- and firms to reduce emissions nomic efficiency and distributional equity. Arguing for market incentives over direct regulation, Met- while giving the economy calf identifies two market mechanisms that have been proposed to reduce GHG emissions: a cap- time to adjust. and-trade system, in which the government issues a limited amount of tradable rights to emit green- house gases, and a tax on emissions of carbon diox- ide (CO2) and other GHGs. future. He proposes offering a refundable tax credit Metcalf favors a carbon tax. The goal is to set the to producers who can bury GHGs or otherwise keep amount of the tax such that firms reduce emissions them out of the atmosphere. until the cost of further reductions equals the po- tential damage of extra emissions. Unfortunately, The initial $15 carbon tax would have varying effects he writes, cost estimates of potential damage from on the prices paid by consumers for different com- climate change vary widely, from $3 to $95 per ton modities (see Table 1). The price of gasoline at the of CO2 emissions. Much of this variation arises from pump would rise by just under 9 percent. Metcalf uncertainty about the optimal stabilized GHG con- observes that this 25¢ increase is smaller than the centration, which many scientists place around 450 natural fluctuation of gasoline prices, which varied to 550 parts per million. An analysis at MIT predicts by as much as $1.44 on a weekly basis between Janu- that a carbon tax with an initial rate of $18 per ton ary 2005 and May 2007. The most significant effect and an increase of 4 percent per year would yield of the carbon tax would be on electricity and natural a target concentration of 550 parts per million by gas prices, which would rise by about 14 percent. 2100 as long as other countries adopted climate Metcalf’s model predicts minimal price increases for mitigation policies as well. Given the uncertainty of commodities besides electricity and heating, in the the target CO2 concentration, Metcalf argues for a range of 0.3 to 1.0 percent. lower initial tax rate of $15 per ton of CO2, with a gradual increase to give the economy time to adjust Metcalf recognizes that these changes in energy to carbon pricing. prices would have a disproportionate impact on low- For simplicity’s sake, the tax would be imposed TABLE 1 at the producer level: for example, at the nation’s Consumer Price Impacts of a Carbon Tax 1,415 functioning coal mines, 150 oil refineries, and Commodity Price increase (%) about 110,000 wells (that produce 90 percent of its Electricity and natural gas 14.1 natural gas). This “upstream” tax—at the producer Home heating 10.9 level rather than the consumer level—would have the advantage of easier enforcement and collection. Gasoline 8.8 However, Metcalf recognizes that producers should Air travel . be rewarded for capturing carbon downstream if Other commodities 0.3 to 1.0 “carbon capture” technology becomes viable in the Source: Author’s calculations. WWW.HAMiltonpROJEct.O RG A CARBON TAX SWAP TO MITIGATE GLOBAL CLIMATE CHANGE Key Highlights income consumers. As seen in Table 2, the carbon tax would cut real disposable income for households in the lowest decile by 3.4 percent, while reducing The Challenge the income of households in the top decile by just Climate policy must target the environmental problem 0.8 percent. To offset this regressive impact, Met- of climate change while considering efficiency and calf proposes a carbon tax swap in which revenue distributional concerns: from the carbon tax would fund an environmental n Greenhouse gas emissions from human activity are tax credit based on earnings. He estimates that rev- contributing to climate change, resulting in severe enue from the initial $15 per ton carbon tax would weather, higher sea levels, flooding and drought. be about $82.5 billion after firms and consumers un- n Direct regulation of greenhouse gas emissions is dertook initial efforts to reduce emissions. Metcalf unnecessarily inefficient because it requires firms would use this revenue to provide all workers with to reduce emissions regardless of abatement costs. a refundable income tax credit equal to their 15.3 percent payroll tax up to a maximum credit of $560.1 n Increases in energy prices hurt low-income Under this progressive structure, individuals with consumers, who spend a larger percentage of their annual wages of $5,000 would receive a credit equal income on energy than higher-income consumers.
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