RESEARCH INSTITUTE POLITICAL ECONOMY Keeping the Government Whole: The Impact of a Cap-and-Dividend Policy for Curbing Global Warming on Government Revenue and Expenditure James K. Boyce & Matthew Riddle November 2008 Gordon Hall 418 North Pleasant Street Amherst, MA 01002 Phone: 413.545.6355 Fax: 413.577.0261 [email protected] www.peri.umass.edu WORKINGPAPER SERIES Number 188 KEEPING THE GOVERNMEGOVERNMENTNT WHOLE: The Impact of a CapCap----andandand----DividendDividend Policy for Curbing Global Warming on Government Revenue and Expenditure James K. Boyce & Matthew Riddle Political Economy Research Institute University of Massachusetts, Amherst November 2008 ABSTRACT When the United States puts a cap on carbon sure that additional revenues to government emissions as part of the effort to address the compensate adequately for the additional costs problem of global climate change, this will in- to government as a result of the carbon cap. We crease the prices of fossil fuels, significantly compare the distributional impacts of two policy impacting not only consumers but also local, alternatives: (i) setting aside a portion of the state, and federal governments. Consumers can revenue from carbon permit auctions for gov- be “made whole,” in the sense that whatever ernment, and distributing the remainder of the amount the public pays in higher fuel prices is revenue to the public in the form of tax-free recycled to the public, by means of a cap-and- dividends; or (ii) distributing all of the carbon dividend policy: individual households will come revenue to households as taxable dividends. out ahead or behind in monetary terms depend- The policy of recycling 100% of carbon revenue ing on whether they consume above-average or to the public as taxable dividends has the below-average amounts of carbon. In this pa- strongest progressive impact, yielding the big- per, we consider policy options for “keeping the gest net monetary benefits for the largest ma- s government whole,” too; that is, policies to en- jority of the people. Key words: Global warming; fossil fuels; climate change; carbon permits; cap-and-dividend; cap-and-auction; cap-and-trade JEL codes: H22, H23, Q48, Q52, Q54, Q58 INTRODUCTION rise for homeowners. The prices of gasoline and As the United States moves to craft serious poli- diesel will rise for the Pentagon and other gov- cies to tackle the problem of global warming, ernment agencies, just as it will for private citi- discussion is focusing on the impacts of a cap on zens. To “keep the government whole” – to total emissions of carbon dioxide from burning compensate for these higher costs and to main- fossil fuels. Carbon permits will be issued up to tain real government spending at current levels – the cap, the number of permits declining over revenues will need to grow by a corresponding time as the cap is gradually tightened. From an amount. administrative standpoint, the most efficient way to accomplish this is to issue the permits “up- The price impacts of a carbon cap will stream” to the few hundred firms that bring fossil be felt not only by consumers, but also fuels into the nation’s economy at roughly 2,000 by governments. locations – oil terminals, gas pipelines, coal mines – rather than issuing downstream permits In this paper, we analyze two policy options for to far larger numbers of end-users. addressing the impacts of a cap-and-dividend program on government: A carbon permit system will raise the prices of • fossil fuels throughout the economy, as the cap Distribute 100% of revenue to individuals as restricts their supply much as OPEC raises prices taxable dividends: In our calculations we as- by cutting production. The effects will be felt by sume that dividends are subject to federal every household, but the price increases will hit and state income taxes at the same rate as low-income and middle-income families harder ordinary income, and that dividends are than more affluent households because they spent by households and hence subject to spend a higher fraction of their incomes on fuels. state sales tax. We find that 24.2% of divi- dends (on average) would be returned to the To protect the real incomes of American families, federal and state governments under this and to protect the carbon cap from the political option, an amount sufficient to keep the backlash that otherwise is likely to result from government whole in that it compensates for substantially higher prices for gasoline, heating the impact of higher fossil fuel prices on gov- oil and electricity, one policy option that is gaining ernment purchasing power. increasing attention is a “cap-and-dividend” sys- • tem in which revenues from the sale of permits Revenue set aside for government, coupled are recycled to the public as equal per capita with tax-free dividends to individuals: An al- dividends. In an earlier paper, we analyzed the ternative policy option is to earmark a frac- distributional impacts of such a policy and tion of the carbon revenue (that is, the showed that the majority of American households revenue from sale of permits) for govern- would be net winners in monetary terms – receiv- ments, rather than recycling 100% of this ing more in dividends than they pay in higher fuel revenue to the public. In this option, divi- costs – with the biggest benefits accruing to low- dends to individuals would be treated as tax- income families (Boyce and Riddle 2007). 1 free. To facilitate comparison of the two op- tions, we assume that the set-aside is cali- The price impacts of a carbon cap will be felt not brated to keep the government share of only by consumers, but also by governments at total carbon revenue the same as under the the local, state, and federal levels. The prices of first option. heating oil and coal-fired electricity will rise for schools and other public buildings, just as it will We examine the distributional impacts of both policy options by dividing the U.S. population into ten deciles, ranked from poorest to richest on the 1 For further discussion of cap-and-dividend policies, see Barnes (2008), DeCanio (2008), and capanddividend.org. basis of per capita expenditure. As in Boyce and KEEPING THE GOVERNMENT WHOLE / BOYCE & RIDDLE / PAGE 2 Riddle (2007), our calculations are based on a expenditure. 3 Government expenditure ac- permit price of $200 per ton of carbon, a price counted for 14.5% of the nation’s “carbon foot- that we estimate would result from an initial cap print” in the year 2002. 4 This is close to the that cuts U.S. carbon emissions by approximately estimate of Dinan and Rogers (2002, p. 205), 7%. We estimate that this cap and price would who put the government share of U.S. carbon emissions in 1998 at 13%. yield annual carbon revenues of roughly $300 billion/year. State and local government accounted for 10.8% of total U.S. carbon emissions, and federal gov- What will happen as the carbon cap tightens in ernment for 3.6%. These percentages are smaller successive years, moving towards the much than their shares in expenditure: the carbon in- greater emissions reductions now endorsed by tensity of public expenditure is less than that of an increasing number of policy makers? 2 As the private consumption, reflecting the higher pro- quantity of permits (and emissions) falls, their portion of services (e.g., salaries) in the govern- price will rise. The percentage increase in prices ment consumption basket. 5 being larger than the percentage decrease in In addition to the impact of increased costs due quantity of permits (because demand for fossil to higher fossil fuel prices, the introduction of fuels is price-inelastic), total revenue will rise, too. carbon permits could have indirect impacts on This will increase the magnitude of the distribu- the balance between government expenditure tional effects reported below, but not their pat- and revenue. These include increases in gov- tern: with a doubling of total carbon revenues, for ernment transfer payments (e.g., for Social Secu- example, the net benefits for low-income and rity benefits and federal pensions) that are middle-income households double, as do the net indexed to prices, and reduced personal income costs for high-income households. tax collections as a result of the indexing of ex- emptions and tax brackets. Dinan and Rogers “KEEPING THE GOVERNMENT WHOLE” (2002, p. 211) estimate that each of these would have impacts roughly equivalent to a further 7% What share of revenue from the sale of carbon permits would be required to keep government of carbon revenue. If so, adding these to the di- rect effects of higher fuel prices on government whole, that is, to offset the effects of the cap-and- purchasing power would mean that 28% of total permit policy on the balance between govern- ment expenditures and government revenues, carbon revenues will be needed to keep the gov- ernment whole. 6 with “government” here taken to encompass federal, state and local governments? The most evident effect of a cap-and-dividend 3 Breakdowns of government expenditures by industrial sector are taken from 2002 benchmark input-output ac- policy (or for that matter, of any policy that in- counts. Carbon emissions from coal, oil and natural gas are cludes a cap on carbon emissions) on govern- based on Energy Information Administration data. Carbon ment is to raise the cost of government’s own emissions associated with each industrial sector are calcu- consumption of fossil fuels and everything that lated by following the use of coal, oil, and natural gas uses these fuels in its production and distribu- through the economy using input-output accounts.