CARBON TAX SHIFTS AND THE REVENUE-NEUTRALITY DILEMMA.

Author:Gillis, Rory
 
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INTRODUCTION 295 I. THE CASE FOR CARBON TAX SHIFTS 301 A. Economic and Political Impediments to Carbon Taxation 301 B. The Advantages of Carbon Tax Shifts 305 C. The Need for Pre-Commitment Devices 307 II. EXAMPLES 310 A. United Kingdom 311 B. British Columbia 313 C. Washington State 317 D. Canada 320 E. Partial Carbon Tax Shifts 321 III. THE REVENUE-NEUTRALITY DILEMMA 322 A. Alternative Conceptions of Revenue Neutrality 322 1. The Standard Definition 322 2. Two Conceptions of Revenue Neutrality 325 B. The Revenue-Neutrality Dilemma 327 1. Normative Considerations 327 2. Epistemic Considerations 329 C. Potential Responses 332 1. Leaving Revenue Neutrality Undefined 333 2. Tying Carbon Tax Shifts to Specific Tax Rates 334 3. Retrospective Voter Approval 336 D. Implications 336 IV. ALTERNATIVE USES OF CARBON PRICING REVENUES 338 A. Earmarks for Environmental Expenditures 339 1. Design and Justification 339 2. Enforcement and the Time-Inconsistency Problem 341 B. Carbon Dividends 344 1. Design and Justification 344 2. Comparison with Sideways-Looking Tax Shifts 346 3. Comparison with Backward-Looking Tax Shifts 347 CONCLUSION 347 INTRODUCTION

There is near universal agreement among economists and climate change experts that governments should implement carbon pricing, either in the form of a tax on carbon emissions or through a cap-and-trade system that auctions a finite number of emissions quotas to large-scale emitters. (1) Despite this widespread academic support, governments have been slow to implement carbon pricing. Their reticence results from two significant, and related, problems. The first is economic. At least in the short term, carbon pricing is likely to increase producer and consumer costs, which will in turn reduce economic growth. (2) The second is political. Carbon pricing encounters substantial opposition from voters across developed nations. (3) A government that implements carbon pricing risks political defeat.

In response to these problems, numerous experts and politicians have proposed carbon tax shifts, also known as "carbon tax swaps." (4) Under a carbon tax shift, the revenue generated by carbon pricing is used to reduce other taxes, such as corporate and personal income taxes, by an equal dollar amount. If properly executed, the tax shift is said to be "revenue neutral" in that it does not increase government revenues but instead simply substitutes one revenue source--the carbon pricing mechanism--for all or a portion of the revenue raised by an existing tax or combination of taxes. (5)

Proponents of carbon tax shifts note that the proposal can address both the economic and political impediments to carbon pricing. Tax shifts stimulate the economy by reducing taxes that discourage labour and investment, such as income and payroll taxes. (6) Tax shifts can also, according to numerous polls and academic studies, increase support for carbon pricing. (7) Experts have argued that revenue neutrality is "essential" to this political benefit. (8) Revenue neutrality ensures that taxpayers collectively receive tax cuts that offset the increase in the total tax burden. It also separates the debate over whether to implement carbon pricing from the enduring political dispute over the optimal size of government revenues. Many tax shift proposals call for governments to adopt legal or political pre-commitment mechanisms, such as statutory requirements, to assure skeptical taxpayers that carbon pricing revenues will be used to finance tax cuts rather than increased government spending. (9)

This Article provides the first retrospective review in the legal literature of four prominent carbon tax shifts. Despite their theoretical appeal, carbon tax shifts have a mixed track record. Two jurisdictions, the United Kingdom (UK) and the Canadian province of British Columbia (BC), have implemented carbon tax shifts. Both promised revenue neutrality in promoting the tax shifts to the public--BC even introduced a statutory requirement--but both jurisdictions subsequently repudiated revenue neutrality and used carbon tax revenues to finance spending. (10) The repudiation followed disputes over what revenue neutrality meant and whether each government had achieved and sustained it. Carbon tax shifts have also been proposed to voters in a 2016 ballot initiative in Washington State and in the 2008 Canadian federal election, but both proposals

were defeated, in part due to concerns that governments would not sustain revenue neutrality over time. (11)

The central claim of this Article is that this mixed track record can be explained, at least in part, by two related problems. The first is that there are only a handful of political and legal mechanisms that can be used to bind governments to policies, including tax policies, over time. The second, which is the main focus of this Article, is that these mechanisms are ineffective with carbon tax shifts due to an ambiguity in the concept of revenue neutrality. The definition of revenue neutrality used in academic literature, political discourse, and in BC's Carbon Tax Act--carbon tax revenues must be no greater than the value of offsetting tax cuts--obscures the choice between two substantially different conceptions of revenue neutrality. The first conception can be referred to as backward-looking revenue neutrality: assuming no economic growth or annual change in the size of tax bases, a carbon tax is revenue neutral if total government revenues are no greater after the carbon tax than before the carbon tax. This conception is backward looking in that it compares current government revenues to past government revenues. The second conception can be referred to as sideways-looking revenue neutrality: assuming no economic growth or annual change in the size of tax bases, a carbon tax is revenue neutral if total government revenues are no greater after the carbon tax than they would have been in the absence of the carbon tax. This conception is sideways looking in that it compares total government revenues not with past government revenues but with government revenues in the counterfactual year that would presently exist but for the carbon tax.

A simple example can illustrate the difference between the two conceptions. Imagine that a government implements a carbon tax and cuts its sales tax by two percentage points to offset the revenue. The next year, the government raises the sales tax by two percentage points to fund increased education spending. Is the carbon tax still revenue neutral? Under the backward-looking definition, it is not: government revenues are now higher than they were before the carbon tax was implemented. Under the sideways-looking definition, it may be: if the government would have increased total tax revenues to fund additional education spending even in the absence of the carbon tax, the carbon tax has not caused an increase in the total tax burden. Instead, it has simply changed the composition of government revenues.

While the choice between these two conceptions is seemingly technical, it has four implications for carbon tax shifts and tax policy. First, unless governments expressly commit to one conception or the other, it is impossible to determine whether most carbon tax shifts are revenue neutral and, consequently, difficult to use legal and political mechanisms to bind governments to revenue neutrality. The result is an acute time-inconsistency problem. Drawing on examples from the UK, BC, Washington, and Canada, this Article shows how confusion over the meaning of revenue neutrality diminishes the political appeal of carbon tax shifts. In both the UK and BC, for instance, governments alternated, to their apparent short-term political advantage, between the two conceptions. This inconsistency ultimately contributed to public skepticism that carbon tax shifts were thinly disguised tax increases.

Second, the choice between the two conceptions presents governments with a dilemma: the backward-looking conception is normatively undesirable while the sideways-looking conception presents significant epistemic impediments to enforcement. The normative concern is that backward-looking revenue neutrality prohibits all tax increases, even those that are welfare enhancing and unrelated to carbon pricing. The epistemic concern is that, to be enforced, sideways-looking revenue neutrality requires knowledge of the tax rates a government would have imposed in the absence of a carbon tax. Since these tax rates will commonly be unknown, sideways-looking revenue neutrality is difficult to enforce. (12) The dilemma's key implication is that carbon tax shifts cannot easily reconcile sound tax policy with effective enforcement of revenue neutrality. A backward-looking tax shift is easily enforced, but normatively undesirable. A sideways-looking tax shift has greater normative appeal but is not easily enforced.

Third, promises of revenue neutrality raise significant concerns for democratic discourse. Since backward-looking revenue neutrality can result in a broad tax rate freeze that limits future government spending, informed public debate over the meaning of revenue neutrality is essential before carbon tax shifts are implemented. The common confusion over the meaning of revenue neutrality, however, raises the risk that voters and governments will adopt carbon tax shifts without awareness of the implications for tax policy and government expenditures.

Fourth and finally, the revenue-neutrality dilemma reveals that it is harder to separate debates over "how to tax" from debates over "how much to tax" than is commonly understood. (13) Economists and politicians frequently propose revenue-neutral tax reforms that are intended to improve the efficiency of the tax system. (14) The common structure of these proposals is that a relatively efficient tax is substituted dollar-for-dollar for a less efficient tax. The conceptual and epistemic problems described...

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