How Would We Implement A Carbon Tax? (Almost) Everything You Need To Know

If you had told me on Tuesday morning that I was about to spend my day at a standing room only event that had nothing to do with the election, I would’ve said, “But, I’m not planning to go to a David Petraeus news conference!” Ah, but it turns out that there are other topics that bring out the masses. I did, in fact, spend the day at a standing room only event that had nothing to do with the election.

The topic? Carbon taxes, of course.

Yesterday, the American Enterprise Institute hosted a conference to talk about anything and everything related to the economics of carbon taxes. Normally, a full-day conference with more than a dozen speakers on a tax issue in DC will be lucky to get more than a few dozen attendees, even with a free lunch. Carbon taxes, though, are different. The enthusiasm for this issue is such that there were over 200 attendees, many of whom stood for half the day.

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What makes carbon taxes different? Simply put, people across the political spectrum now know that putting a price on carbon is an indispensable tool for dealing with our climate and budget problems, and that a carbon tax is the most politically viable path forward. This dynamic has created an exciting amount of momentum that now needs to be turned into policy.

Not only is the political situation ripe for a carbon tax, but yesterday’s AEI conference demonstrated that the thought leadership is ripe as well. That’s not to say that there’s agreement on the best way to design a carbon tax; the ultimate design will likely be about political decisions as much as policy ones. But, the implications of different policy choices are largely known, which was the focus of the conference.

The benefits of a carbon tax would be tremendous. According to the Brookings Institution’s William Gale, the amount of money a carbon tax could raise is roughly comparable to the size of the Bush tax cuts, indexing the alternative minimum tax for inflation, or the budget sequester that’s part of the upcoming fiscal cliff. Instituting a carbon tax would make it much easier to deal with our country’s budget crisis, because it would give us another tool for solving the problem. And, a carbon tax can get significant reductions in greenhouse gas pollution. Allen Fawcett presented findings from the Energy Modeling Forum that show a multitude of technology development scenarios that get to 50 percent reductions in greenhouse gases with a carbon tax.

Broadly speaking, there are two questions about designing a carbon tax: how to collect the money, and what to do with the money? Neither of these is simple, and virtually every option involves tradeoffs.

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First, let’s talk about collecting the revenue. Do you want to cover the entire economy, just the energy sector, or even a smaller subset of industries? As Rob Williams of Resources for the Future pointed out, most of the greenhouse gas reductions with a modest carbon tax will come from the electric power sector, which would seem to indicate that you could only deal with a small part of the economy and get almost all of the benefits at much lower political cost. At the other extreme, you could cover things like agricultural-related methane emissions, although the mechanics of this are much more complicated.

After deciding how much of the economy to cover, you also need to decide where to assess the tax, which Jack Calder of the International Monetary Fund discussed. You can assess the tax very far upstream, where fossil fuels enter the economy (at the mine mouth or wellhead, for instance). This is relatively simple and gets at every use of fuels, but the problem is that it puts a tax on fuels that ultimately don’t get burned and contribute to climate change. Oil used as a feedstock for plastics production, for instance, doesn’t add to greenhouse gas pollution, nor does coal burned in a hypothetical power plant with carbon capture and storage technology. All things being equal, Calder’s ultimate recommendation is to make a carbon tax as similar as possible to our existing tax system, which should minimize administrative challenges and unintended consequences.

What about complementary policies? That is, what should happen with the state renewable energy standards, federal incentives, and EPA regulations after a carbon tax is put in place. While the conventional wisdom among economists is that these other policies simply make a carbon tax more expensive, Karen Palmer from Resources for the Future argued that these policies often deal with externalities — including positive externalities — that a carbon tax doesn’t fix. And, the lesson from the acid rain program is that EPA needs to have the authority to go above and beyond a carbon tax based on up-to-date information about the costs and benefits of further pollution reductions.

Second, after you collect the revenue, you need to do something with it. The biggest issue is that a carbon tax is most likely to be regressive; that is, it has a disproportionate impact on poor people. Modeling by Aparna Mathur at AEI finds that a $15 carbon tax is effectively a tax of 3.54 percent of the income of the poorest decile of the population, but just .63 percent for the wealthiest. Terry Dinan, a senior advisor at the Congressional Budget Office, has studied seven different ways to deal with this problem, and found that while there is no perfect solution, doing some sort of income tax or payroll tax rebate has a very positive effect.

Of course, once you have a pot of money (which will still be large even after fixing the regressivity problem), you want to spend the money wisely. RFF’s Williams proposed three uses: cutting pre-existing taxes, reducing the deficit, and valuable public spending. In the short term, it’s worth noting that simply reducing the deficit is probably not as valuable as spending on infrastructure, including clean energy infrastructure.

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This is just a small sample of the issues that will come up in designing a carbon tax, and many of these choices don’t have options that are immediately obvious as being the “best” way to design the system. But it’s clear that we know the implications of different policy choices. After yesterday’s conference, no one should ever say that we don’t know how to design a carbon tax. The bigger issue is that politicians need to decide what they want a carbon tax to achieve and then plug in the right policy tools.

And this is where the slowdown begins. Of the standing room only crowd at AEI, there was almost certainly no consensus on any of the important questions. Is the primary goal of a carbon tax to reduce the deficit? Or to offset corporate income tax reductions? Or to raise money for clean energy investments? Or to simply cut pollution, with all of the money going back to consumers?

This issue will come to a head in 2013, and Climate Progress and CAP will have recommendations for building a progressive carbon tax. Be on the lookout for new work on this issue in the coming weeks.

Richard W. Caperton is Director of Clean Energy Investment at the Center for American Progress.