The Perils of a Carbon Tax: High-minded proposals for a "revenue neutral" Pigouvian tax could result in bigger government, but they could also make it smaller.

• Author: Marlow, Michael L.
• Position: ENERGY & ENVIRONMENT

The debate over climate change and the need for government intervention to combat it is often portrayed in "left-right" terms, with the political left claiming that urgent action is required and the right dismissing both climate change's existence and the need for intervention. However, a 2017 poll by the University of Chicago' Energy Policy Institute and the Associated Press-NORC Center for Public Affairs Research found that 60% of Americans, including 43% of Republicans, say that government should address climate change.

Accordingly, some right-leaning groups have suggested climate change policies featuring a Pigouvian tax on carbon emissions. (Such a tax could be extended to other greenhouse gases, but for simplicity this article will refer to a "carbon tax.") True to the right's "limited government" philosophy, many of these proposals would use the tax's resulting revenue to reduce other taxes that are more economically distortionary, resulting in a "revenue neutral" outcome. Some of these proposals would include the rollback of some costly environmental regulations. Another proposal, by the Climate Leadership Council, would use the carbon tax revenue to fund a universal "dividend" program for U.S. citizens.

These ideas are intriguing theoretically, but implementing them would expose them to the machinations of politics. Left-leaning groups, for instance, would likely oppose revenue neutrality and a tradeoff of deregulation, preferring instead to pursue other policy goals. Politicians, who would adopt such legislation, would have their own priorities. The result would likely be something very different from what right-leaning, limited government groups envision.

This article develops a harm-reduction strategy for such policy proposals. This would steer the debate toward what tradeoffs would be acceptable in order to mitigate harm from climate change.

WILL CARBON TAXES CORRECT EXTERNALITIES?

Carbon pollution is a negative externality because it imposes external costs on people who did not create the pollution. The social cost of carbon (SCC) refers to the cost of an additional ton of carbon dioxide pollution. Pricing the correct SCC through a "Pigouvian tax, named after British economist Arthur C. Pigou (1877-1959), internalizes the negative externality so that all costs are accounted for in market prices. Most taxes push resources away from efficient outcomes, but "correct" Pigouvian taxes push resources toward efficient market outcomes. Most economists believe taxes are superior to regulation in efficiently dealing with externalities.

In contrast, regulation offers very blunt methods that "command and control" all businesses identically. One-size-fits-all mandates ignore individual characteristics of firms and are inefficient, as some firms reduce emissions by reducing output. Because these regulations dictate what methods should be used to reduce emissions or what emissions levels are acceptable, firms lose incentive to find innovative emissions-reducing alternatives.

Critics are correct that a theoretical basis for carbon taxes does not necessarily imply that their implementation corrects externalities. The EPA offers a range of SCC estimates from $14 to $138 per metric ton; that wide range indicates considerable uncertainty on the part of policymakers. Garnering support for "correct" carbon taxes would be difficult because the benefits are uncertain, they may take decades to emerge, and mitigation of climate change is a global public good with many free riders. Even if government knew the "correct" Pigouvian tax, political decisions are rarely based on efficiency grounds alone, as demonstrated in a 2012 paper on emissions pricing by Tom Tieteberg. Still, he found that the predominant effect has been to reduce emissions.

Transforming economic theory into practice is clearly imperfect. But it is also naive to believe that perfection is on offer. Regulatory policies exhibit a wide divide between theory and practice, making comparisons of a politically chosen carbon tax to its textbook rendition something of a misplaced debate. Taxation may also be easier to understand, monitor, alter, and is less subject to "crony capitalism" than regulation.

DO TAX SWAPS INCREASE WELFARE?

There is a long economic literature indicating that economic growth is inversely related to government size. (See, e.g., Robert Barro's 1990 Journal of Political Economy article.) This inverse relationship is consistent with distortions to resource allocations stemming from over-regulation and excessive taxation that reinforce commitment to constrained government.

Tax swaps focus on substituting taxes with high excess burdens (deadweight loss or welfare cost) for ones with lower burdens. Excess burdens are additional costs that arise when tax policies (beyond simple tax collections) cause resources to be allocated inefficiently. Taxes raise prices and decrease consumption away from efficient allocations. Unlike "correct" Pigouvian taxes that push markets toward efficient outcomes, most taxes push markets in the other direction as government pursues revenues to fund its programs.

Recent studies estimate that substituting carbon taxes for other tax sources yields significant reductions in excess burdens. A 2015 paper by Donald Marron, Eric Toder, and Lydia Austin summarizes the evidence from separate modeling exercises in five recent academic papers. Estimates differ because of different methodologies, data sets, and time periods, but the studies found that reducing tax rates on capital income was the best choice for reducing the excess burden of our tax system. This result is consistent with standard predictions that lowering taxes on capital income, either through tax rate reductions on all investment or specifically to the corporation tax, raises savings that eventually raise worker productivity and wages as businesses fund more capital investment. Corporation taxes are thus a very expensive method of funding government, resulting in the economy producing fewer jobs, higher prices, and less income for citizens. In fact, a 2007 U.S. Treasury paper estimated that 73% of the corporation tax is borne by workers.

This view that carbon taxation yields environmental benefits and a greater tax efficiency is often...