The Case Against A Carbon Tax

In the first of a two-episode series, Tax Notes contributing editor Marie Sapirie interviews David Kreutzer, an economist at the Institute for Energy Research, about his views on a carbon tax.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: the carbon cycle, part one.

As reports of the devastating effects of climate change rise, so do the voices discussing how to tackle the anthropogenic causes of this phenomenon. One of the much discussed solutions today is a carbon tax, which would put a price on greenhouse gas emissions.

To further this discussion, we’ll be dedicating the next two episodes of Tax Notes Talk to the issue, highlighting both the positives and negatives of a carbon tax.

This week’s episode, part one, features an interview with David Kreutzer, an economist at the Institute for Energy Research. David was on the Trump presidential transition team at the Environmental Protection Agency in 2017, and previously was a senior research fellow in energy economics and climate change at the Heritage Foundation. He opposes taxing carbon emissions, which we’ll get to in a minute.

Next week’s episode, part two, will feature an interview with Shuting Pomerleau, a climate policy analyst at the Niskanen Center, who supports a carbon tax.

But before we get to our first interview, I’m joined by Tax Notes contributing editor Marie Sapirie for some background on the issue. Marie, welcome back to the podcast.

Marie Sapirie: Thank you. It’s always good to be here.

David D. Stewart: Let’s begin with the basics. What is a carbon tax?

Marie Sapirie: The term carbon tax is essentially shorthand for a tax regime that makes it more expensive for producers of goods and services to emit greenhouse gases that contribute to global warming. Most proposals would likely also cover emissions of methane, nitrous oxide, and possibly other types of gas.

Carbon dioxide is the gas that we admit the most of, according to a 2016 EPA report, and carbon dioxide emissions account for roughly 82 percent of greenhouse gases from human activities. Fluorinated gases make up a much smaller percent of emissions, but they’re considered particularly potent. It might make sense to include them too.

The basic idea is fairly simple. By making it more expensive to pollute, polluters will be more active in searching for ways to cut emissions, which will incentivize more innovation. They will also switch to less polluting options that are already available.

In a 2016 report titled “Effective Carbon Rates: Pricing CO₂ Through Taxes and Emissions Trading Systems,” the OECD said that the principle appeal of using prices to induce carbon abatement is that it encourages emission reductions where they are cheapest. Both in the sense of using the cheapest available options today and steering innovation and investment towards lower carbon technologies.

The thought is that a carbon tax could get us to a place where there are lower global emissions without making dramatic changes to the way many people live. This type of tax will be recognized by students of economics as a Pigouvian tax. That’s a tax on the negative externalities like pollution that aren’t included in the market price, but end up being absorbed by society at large.

The economist Arthur Pigou recommended taxing the producers whose processes produce such negative externalities by setting a tax to equalize the marginal private cost and the marginal social cost. The idea is to correct the market failure. But note that to apply Pigou’s principle requires measuring the externalities so that the tax is set appropriately.

That’s the general concept. But there are potential wrinkles in putting that idea into action to protect the environment.

David D. Stewart: How would implementation of such a tax work? Is there an approach that’s become prevalent?

Marie Sapirie: Implementation is one of the major open questions. How Congress might choose to design a carbon tax would necessarily drive what the implementation looks like. We don’t know yet where Congress might settle on the fundamental question of whether we should have a carbon tax in the first place.

As far as the design options go, the main pieces that Congress would have to decide include the rate of tax on emissions, which is an area where there’s a lot of debate because where the tax rate is set changes the impact on emissions, as well as the total revenues that would be raised.

Next, Congress would have to decide whether the rate should increase over time, perhaps by starting low and gradually ratcheting up to give companies some time to adjust and seek out alternatives with lower emissions. Also, where the ratcheting should stop, which depends on whether the goal is to mitigate emissions to some acceptable level or to eliminate them entirely.

Another question is when to collect the tax. There are options all along the supply chain, from the point of extraction, to the point of sale of the final product to consumers, or some combination. How to provide a rebate for sequestering carbon emissions is another question.

How to do a border adjustment, which is a way to prevent a carbon tax regime from resulting in American consumers shifting to purchasing more imported goods and services from places without a carbon tax and American companies from moving abroad or becoming less competitive relative to their overseas competitors.

Finally, how to solve the problem of regressivity. Because the incidence of a carbon tax would end up falling more heavily on taxpayers who consume more of their income, unless a carbon tax were enacted with some sort of rebate mechanism.

David D. Stewart: Now, you alluded to some debate on this issue in the U.S. Could you give us an idea of where the various sides stand on this issue?

Marie Sapirie: Perhaps the chief point of dispute is around the fact that a U.S. carbon tax regime has the potential to raise a large amount of revenue. That is either a point in favor of enacting a carbon tax or a point against it, depending on whether you agree with how the revenues might be spent.

As we know, members of Congress are frequently looking for ways to pay for items of spending that are important to them and their constituents. This is an area of a lot of discussion.

There are carbon tax proposals that rebate all of the revenue to American families, like the bipartisan climate roadmap from the Climate Leadership Council. But that’s a feature of the climate tax regime that is up for discussion should Congress take it up in the future.

The broader economic impact of the adding a carbon tax is another big question. A new tax would certainly have costs, but the extent of those depends on how the tax is designed.

Another issue that opponents point out is that there is uncertainty in the magnitude of the problems that climate change could cause for humans on the planet. The argument is that the focus should be on building a strong economy that’s better able to respond to adverse impacts of any sort, whether from climate change or some other disaster. That uncertainty could also be a potential argument for starting with a lower rate of tax.

Even if Congress were to enact a carbon tax, there are of course, all of the other details in the potential design of a U.S. carbon tax that I mentioned earlier that are still debated.

David D. Stewart: Now, enacting a carbon tax is not just a U.S. issue. How are other places around the globe fairing when it comes to enacting such a tax?

Marie Sapirie: In order to achieve the beneficial effects of reducing greenhouse gas emissions, there would need to be some sort of coordination around the world so that the sources of emissions aren’t simply shifted to jurisdictions where it’s less expensive to emit.

According to the World Bank’s carbon pricing dashboard, 45 national jurisdictions have carbon pricing initiatives today, which is far from 100 percent of countries in the world. Some countries have adopted emissions trading systems instead of carbon taxes. That’s another type of market-based approach that is sometimes called cap and trade.

Of the countries that have implemented carbon tax programs, some have been around longer than others. Finland, Poland, Norway, Sweden, Denmark, the Netherlands, and Germany all introduced taxes on carbon in the 1990s. The results of these taxes in lowering emissions are kind of mixed.

According to data from the World Bank, on a per capita basis, carbon dioxide emissions actually increased a bit Norway between 1990 and 2015. They stayed about the same in the Netherlands, during the same time. They dipped in Germany, went down in Finland, Poland, and Sweden, and dropped dramatically in Denmark. It should be noted that Sweden started out much lower than the others.

But even with its success, Denmark remained above the world average, and also above other European countries like France and Spain. By comparison, Belgium dropped its emissions during the same period in a pattern that was similar to Finland’s, but they didn’t have a carbon tax.

One of the interesting points about Denmark’s achievement was that part of the revenue was used to provide subsidies for technologies with lower environmental impacts.

Since the first carbon taxes were introduced in the 1990s, there’s been slow but steady growth in the number of taxes introduced around the world. Most recently in July, the European Union released a plan to impose a fee on imports of certain products as part of its climate package. That could be an opening for more global coordination on the cost of carbon.

David D. Stewart: Now, you interviewed both David and Shuting on this issue. Could you give us some highlights of your interview with David?

Marie Sapirie: David discussed why he doesn’t support carbon taxes as a climate policy tool. He doesn’t dispute that human greenhouse gas emissions have caused and continue to cause global warming. The problem is the implementation of the carbon tax and the ways that could go wrong.

David D. Stewart: All right, we’ll go to that interview.

Marie Sapirie: Thank you, David, for joining me today to talk about climate policy and how the tax laws might or might not be used to put limits on carbon dioxide and other greenhouse gas emissions.

David Kreutzer: Thanks for having me on.

Marie Sapirie: Proposals for imposing federal taxes on greenhouse gas emissions have been around for quite a while, but none of them have been put into effect in the U.S. There are a number of reasons for that.

Today we’ll go over the history of carbon tax proposals. Then we’ll cover the role of economic analysis in designing policies to regulate greenhouse gas emissions and what that can tell us about the frameworks legislators might select to accomplish emissions reduction goals. Finally, we’ll take a look at some of the challenges in implementing a carbon tax and consider alternatives.

To get started, would you give us a brief history of carbon tax proposals, including where they came from and how interest in them has evolved over time?

David Kreutzer: The basic theory of the carbon tax comes from Pigou, an economist who was around 100 years ago. His argument was that you have these market imperfections called an externality.

With carbon, we call it the social cost, which is somewhat misleading. What he said is we can have an offsetting tax that would bring the market back to, in essence, perfection. Where marginal benefits when you include all the benefits equals marginal costs when you include all the costs.

Economists have loved this. There has been a century of dissertations and theses written on finding market imperfections and correcting them with the exact right tax. That’s the economic theory.

There really haven’t been many successful uses of these offsetting taxes. There are few, but in the carbon area, none of them have been implemented.

You could say that the [British thermal unit] tax that Al Gore tried to get through in the 1990s was a sort of carbon tax. It turned out to be very, very unpopular. Right after the Obama administration came in office, there was something called cap and trade, which would have features similar to a carbon tax. Then in 2010, the Kerry-Lieberman bill was more explicitly a carbon tax.

People have been talking about it because you can draw such nice economic diagrams to show how wonderful it would be if you knew exactly what the tax level should be and if the implementation was costless.

Marie Sapirie: Setting the level of tax for a potential carbon tax is one of the major questions that policymakers would have to confront in designing any new tax. You’ve written about the difficulties in performing economic analysis on climate policies. Would you tell us about why that is and how economic analysis should be used to help shape the appropriate policy response?

David Kreutzer: What the policymakers would use as the guide for the level of the carbon tax is something called the social cost of carbon. There are some economists, one who won a Nobel prize, who have put together models where they try to estimate what the damage is for each ton of CO₂ that’s emitted now if you look at the damages over the next several centuries, and sometimes even thousands of years, which in my opinion, is laughable to try to do that.

The way they do that is they use the climate models and say, “Well, this much additional CO₂ will lead to this much warming, which will lead to this much more sea level rise. And, perhaps, some higher level of winds and hurricanes.” Though, we haven’t really seen that yet.

Then they translate that into economic damages. Then they discount it to bring it back to the future, saying, “OK, if there’s going to be $10,000 worth of damage in 150 years from a ton of CO₂ emitted today, how much would we be willing to spend to cut that CO₂ today?”

You want to compare it to, well, what if we made another investment that could generate $10,000 worth of benefits in 150 years? How much would we have to invest to get that benefit? You wouldn’t want to spend more than that on the climate benefit.

In any event, that discount rate is a huge area of controversy. But that’s just one of them. Trying to actually figure out where the economy is going and how much damage global warming is going to do is a nearly impossible task.

Marie Sapirie: Turning to the existing carbon tax proposals. A critique of them generally is that they will introduce complexity and administrative burdens. They’re also potentially regressive and less rebated to lower income taxpayers in some way, and are economically disruptive. Could you tell us about the challenges to implementing a carbon tax that need to be considered?

David Kreutzer: Pretty much anything that raises energy costs is going to be regressive because people with lower income spend a higher percentage of their income on energy, on gasoline, on heating, and so on. A carbon tax would be no different than just simply any regulation that would do the same thing.

The other complexities are where do you charge the tax? You could imagine the carbon tax proposal being similar to the cap and trade proposal, where they looked at oil and petroleum refiners, taxing the refiners, taxing natural gas producers, and taxing coal at the mine mouth.

But there is also going to be problems with what you do with people who are doing offsets. Certainly that’s going to be part of it because Wall Street wants to have something to trade. Then you get up, well, how much carbon is saved by a farmer that uses no till in Iowa that otherwise was going to use a plow?

All of that introduces scientific complexity, as well as just administrative complexity. They’re also simply administrative costs. Any tax has administrative costs. You’d want to look at whether those would be significant compared to whatever benefit you’re trying to provide and the problem of people viewing the carbon tax not as a market efficiency generator, but as a revenue generator.

Marie Sapirie: Are there ways to avoid or to minimize some of the potential problems with the implementation of a carbon tax?

David Kreutzer: I think it’s difficult to avoid the ones that I just laid out.

Economists have a bad habit of coming up with wonderful ideas that work in the abstract and ignore the politics of actually getting them implemented. One of my professors won a Nobel Prize doing something called public choice and saying, “You need to look at what are the political incentives that come around with these various tools that you want to implement.”

I did some modeling of the revenue part of a carbon tax with some colleagues when I was at the Heritage Foundation. Even a carbon tax of $25, $30, growing by the rate of interest, generates hundreds of billions of dollars a year in revenue. It also does hundreds of billions of dollars of economic damage to the economy each year.

If the solution to a problem is going to fund your pet project, you’re much more likely to believe there is that problem. I think we see that. People on Capitol Hill talk about we need to fix the climate problem, but they’re really excited about the revenue.

Marie Sapirie: Recent carbon tax proposals include a border adjustment. An export rebate coupled with an import tax equal to the domestic tax. What are the merits and the potential problems in that approach?

David Kreutzer: Yeah, that maybe is the most compelling sounding part of this thing. But it is, I think, the most dangerous.

It is a constant battle to keep people that want tariffs and other trade restrictions at bay. There are always special interests that want to protect whatever their industry is or whatever their product is. It’s an almost impossible task for economists to keep that as low as possible.

This carbon border adjustment would be very, very difficult to set up. I mean, you’d have to know, for instance, if you’re bringing in a car from Japan, how much of a carbon tax did they have in Japan? Did they import something from Korea where they had a different carbon tax? Did they use steel from some other country? What’s the carbon content that hasn’t been taxed and all of these products that are coming in?

There are going to be lobbyists who are going to go out and say, “Our competitors’ imports actually have more carbon than they claim.” There are going to be lawsuits. There’s going to be all sorts of rent-seeking and lobbying going on.

Once you get that in place, I think that would be the most difficult thing to unwind. It’s very, very difficult to get rid of tariffs because of what we call the special interests effect. The benefits are narrowly focused and the costs are spread out so there’s not much organized opposition to them. 

I think that the carbon border adjustment tax — that tariff — is the scariest of the proposals that they’ve put out.

Marie Sapirie: To conclude, what are the alternatives to a carbon tax that policymakers should consider?

David Kreutzer: I believe that manmade emissions of greenhouse gases have caused warming of the earth and will continue to do so. I’m also convinced that we’re not heading to an existential threat.

For instance, even the Intergovernmental Panel on Climate Change knows that we don’t have any upward trend in hurricanes, floods, droughts. The National Oceanic and Atmospheric Administration says, looking at the tornadoes, there’s no upward trend in tornadoes, after you adjust for the fact that we’ve been using radar to find them lately. 

I don’t think the climate problem is as scary as the solutions they’re offering. Even if it were, you can look and see, well, what would happen if we got rid of all CO₂ emissions in the U.S. altogether? It has a pretty minor effect on whatever global warming there might be, less than two tenths of a degree. You can do that for the whole developed world and you might get something of four tenths of a degree reduction. That’s talking about getting rid of all CO₂ emissions, which isn’t going to happen.

What you have to do is impose what I would consider some fairly draconian restrictions on the growth of CO₂ from the developing world. People that hardly produce any CO₂ at the moment who are desperately poor, who need affordable energy.

What I’m getting around to saying is I think what we need to do is promote economic growth, not just in the U.S., but worldwide. The impact of the climate will be something that rich people can adapt to. The projections for world income per capita world income by the end of this century would be four, five, six times what it is now and the more so for the developing world. If we do nothing, we’ll still do a lot.

People will still build stronger houses. People will continue to build the sand up on the beaches as they already do. We will make adaptations that will happen without any policies. But I think it’s a mistake to impose significant economic costs for almost trivial impact on global warming.

I also think it’s totally disingenuous to call climate change the greatest threat of the 21st century. I think poverty is a bigger threat. I think the potential of crazy world leaders with nuclear weapons on intercontinental ballistic missiles is a huge problem.

But whatever problems we’re going to come up with, the richer we are, the better we handle them. That’s absolutely crystal clear. You can look at the people that do this research. They say that the problems of climate are not that much for rich countries. If we allow economic growth to continue and to increase, in an absolute sense, all the countries are going to be rich in 150 years.

Marie Sapirie: Thank you, David, for joining us today.