The Economics Don’t Add Up For Latest Carbon Tax Pitch

A CNN article discusses the recent attempt by some establishment Republicans to pitch the Trump Administration on a massive carbon tax that would raise some $300 billion annually—making its gross tax hike (before considering possible rebates) triple the bite of the Affordable Care Act. Their plan calls for policymakers to pick climate targets and send checks to millions of households, and yet is described as “free market” and “conservative.” In this post I’ll explain why the economics don’t add up.

Yet Another Change in Pro-Carbon-Tax Rhetoric

During the Obama years, conservatives and libertarians were lectured by a few Republicans who wanted a carbon tax along the following lines: “Hey you obstinate purists, whether you come along or not, the Democrats are pushing through aggressive climate change regulations. If you come to the table, maybe we can get more efficient reforms like a carbon tax coupled with corporate tax relief. But if you stomp your feet and whine about Big Government, you’ll get top-down edicts on power plants. The choice is yours.”

All of that changes with the election of Donald Trump. There may very well be large reforms in energy regulation without agreeing to a large carbon tax. In fact, during a campaign speech at the New York Economic Club, Trump stated:

“…I will eliminate all needless and job-killing regulations now on the books. This includes eliminating some of our most intrusive regulations, like the Waters of The U.S. Rule. It also means scrapping the EPA’s so-called Clean Power Plan which the government itself estimates will cost $7.2 billion a year.”

Thus, the pro-carbon tax camp has altered its rhetoric yet again. Now they are warning Republicans that certain voting blocks care very strongly about climate change, and will punish the GOP if they don’t take action. This seems very odd considering Donald Trump was just elected president. It seems that these voters would be far more alarmed at a $40/ton carbon tax that would raise gas prices by 36 cents per gallon, as well as raising other energy prices.

Handing Out Checks From Washington Is Not “Conservative”

The carbon taxers try to get around the awkward fact of energy price spikes by saying all of the new revenue—some $300 billion annually when the scheme is first implemented—would be returned to households in the form of rebate checks: “the typical family of four would receive $2,000 a year.”

How is this “conservative”? How is this a “market solution”?

Furthermore, as Marlo Lewis of the Competitive Enterprise Institute emphasized in his critique of the plan, does anyone seriously believe that the revenues from such a massive new tax would be completely refunded? Wouldn’t there be an extraordinary temptation to spend some of the new receipts on new government projects, perhaps euphemistically labeled “green investments”?

The Carbon Tax Proponents Ignores the Published Literature

There are many problems with the so-called “social cost of carbon” which is how this tax plan arrives at its initial target figure of $40/ton. We won’t review our critique here, as a recent post summarizes our main objections.

However, let’s stipulate for the sake of argument that the approach to calibrate the textbook “ideal” carbon tax makes sense. Even so, once we take into account the pre-existing tax code, the case for a carbon tax becomes much weaker. The problem is that a carbon tax is levied on a small “tax base,” much smaller than a broad labor or capital tax. Thus the distortions from a new carbon tax are higher than from the current taxes, and even a revenue-neutral reform can exacerbate the total harm from the original taxes.

Furthermore, if the carbon tax receipts are returned to citizens in a lump-sum rebate fashion—as opposed to reducing the marginal tax rates on personal or corporate income—then the new carbon tax is worse still, because lump-sum checks don’t stimulate economic growth as much as marginal rate reductions.

This phenomenon is called the “tax interaction effect.” It’s not a mere curiosity; estimates of its size can be very large. For example, in a pioneering 1994 article, Bovenberg and Goulder ran a simulation of the U.S. economy and tax code, and presented these results:

Source: Table 1 from Murphy’s EconLib article, available here.

In the table above, we see just how powerful the tax interaction effect can be. For example, if we assume the “social cost of carbon” is $50 per ton, then the “optimal” textbook carbon tax is $50 per ton—assuming a blank slate with the rest of the tax code. (However, note that their numbers refer to tons of carbon, not carbon dioxide. With a conversion rate of 3.67, the current estimates of the “social cost of carbon” would mean about $132/ton tax on carbon, in the table above.)

But look what happens if we now assume that prior existence of the U.S. tax code, circa 1994. If the proceeds of the carbon tax are returned lump-sum to citizens (meaning it is revenue neutral, and doesn’t fuel new government spending), then the optimal carbon tax falls to $0 per ton. Even stipulating a large environmental “negative externality” of $50 per ton, if the proceeds are simply returned in lump-sum fashion back to households, then even a $1 per ton carbon tax would cause more total economic damage than it would spare in climate change. Thus the government should “do nothing” if it’s only option were to enact a carbon tax and return all the revenue back to households in lump-sum fashion.

To repeat, with the levels of tax being considered, in the table above we would be in the high end. Thus the “optimal” amount according to their calculations wouldn’t fall to $0, but it would still be chopped in a third. And this assumes the money is returned to households without a single penny fueling more government spending.

A Modern Estimate

These qualitative results about the harm of a large carbon tax have held up over time. Consider for example a chart from a 2013 Resources for the Future (RFF) study (source and analysis here)—and keep in mind that RFF as an organization is favorable to a carbon tax.

Source: My earlier IER article.

In the above chart taken from the 2013 RFF study, we see that if a new carbon tax is used to fully fund any of (a) lump-sum rebates to households (purple line), (b) a reduction in sales taxes (green line), or (c) a reduction in payroll taxes (red line), then GDP will be stifled. So we see that a revenue-neutral carbon tax is not sufficient to spare the economy.

Remember, the people pitching a carbon tax to Trump are suggesting lump-sum rebate checks to households. But as the chart above shows, a large new carbon tax coupled with lump-sum rebates will hurt economic growth. According to the particular estimates in the model shown above, the conclusion was that the economy would be about 3.5 percent smaller by the mid-2030s.

One more time, let me repeat: The above results assume a perfectly revenue-neutral lump sum plan, where the government watches as hundreds of billions of dollars annually flow through its hands, and it doesn’t increase spending by a penny. This is an unrealistic assumption.

Conclusion

You have to hand it to the carbon taxers, they are tenacious. Originally they warned conservatives that a new Hillary Clinton Administration was going to ram top-down regulations through, unless placated by agreeing to a carbon tax. But now that this rhetorical ploy has collapsed, they are arguing that GOP voters are really concerned about climate change.

This is simply not true. American voters in general, and those who supported Trump in particular, care about the economy. And the published literature—coming from academics who support a carbon tax—shows that if the U.S. enacts a carbon tax of the magnitude being suggested, even with a full lump-sum rebate of the revenues it will slow economic growth.

Moreover, once we are realistic about the politics involved, it should be obvious that hundreds of billions in new revenue will at least partly fuel new government spending. Furthermore, getting millions of American households dependent on checks from Washington in order to pay their gasoline and electricity bills is hardly a “free market” or “conservative” outcome.

After being pitched on this latest proposal, the Trump Administration should review the full impact of a carbon tax—it will see that the numbers don’t add up.

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