A Revenue Neutral Carbon Tax?

May 17th, 2007 by David
David's friend Aaron Swoboda at his Pittsburgh house

While in Pittsburgh, in addition to staying with cyclist Tim Kelly, Bill and I visited some our friends in town, and I stayed with my friends Kip and Aaron (meanwhile, Bill stayed with his friends, April and John Paul) . My friend Aaron, shown on the right in his Pittsburgh apartment, recently finished his PhD in environmental economics (you can call him ‘Dr. Swoboda’ if you like) and is now a professor at the University of Pittsburgh (here is his blog). Over a drink, I asked Aaron how he would make us reduce our carbon dioxide emissions.

“A revenue neutral carbon tax,” he told me.

The idea is to put a tax on carbon dioxide emissions, so that we have incentives to reduce our use of fossil fuels. This means energy from coal would cost more, as would gasoline. To make a difference, Aaron suggested that each gallon of gasoline might cost 50 cents to a dollar more. Aaron liked this solution because people who reduce their use of fossil fuel would be rewarded.

The revenue neutral part means that taxes elsewhere would be cut. For instance, income tax might be reduced. (The tricky part is that poorer people spend a much higher percentage of their paycheck on energy and gasoline, so they would be hurt more by a carbon tax – thus, their taxes would have to be cut much more). If done correctly, everyone would pay about the same amount of taxes, only now we would have a bigger incentive to pollute less and switch to non-greenhouse gas producing energy. Ok – yes, gas prices are already high, but this tax would be different, becuase instead of the money going to oil companies, the money would go towards lowering your taxes elsewhere.

Crossing over a freeway

I will admit that we got into a bit of an argument, as I argued that we should also have higher efficiency standards, and that we need more policies than just a tax to encourage us to be more efficient, to which Aaron replied that such efficiency standards were government interference when a carbon tax would be much simpler and have the same result.

I still believe in efficiency standards (as they are more politically viable as well), but why shouldn’t we take some of Aaron’s advice? Why not put a tax on things we should consume less of? Doesn’t a tax on gas and fossil fuels make some sense, especially if it is balanced with tax cuts elsewhere?

7 responses to “A Revenue Neutral Carbon Tax?”

  1. Yoram says:

    How about a carbon tax on electricity generation plus higher efficiency standards for cars because a $1/gallon gas tax seems politically daunting?

  2. Aaron Swoboda says:

    The fundamental problem of climate change is that we release too much carbon into the atmosphere from burning too many fossil fuels. I believe a carbon tax is the most direct solution to this problem. Why? Because the fundamental law of economics is that prices matter; as the cost of doing something goes up, people will respond and do less of it or find substitutes. Mandating increased efficiency is another way to reduce consumption, but I believe a carbon tax has several advantages.

    A carbon tax will affect all sources of carbon emissions, whereas efficiency standards only affect the regulated uses. For example, a carbon tax will raise the price of gasoline which will affect the driving habits of all car owners. This will have immediate results as all of us try to find ways to reduce our consumption and save on gasoline costs. On the other hand, a fuel efficiency standard only applies to new cars, which means that the results of the increased efficiency will not be felt until the new cars become a large proportion of the car fleet.

    Second, part of any gains from increased efficiency standards will be lost to the “rebound effect.” If we increase the fuel efficiency of your car but keep the price of gasoline the same, the cost to you of driving one more mile has actually gone down. If the price of driving has decreased, I predict you will drive more. Driving more will begin to burn up some of the gasoline savings from the increased fuel efficiency, which we call the rebound effect.

    Third, carbon taxes will encourage more technological innovation, increases in efficiency, and research into alternative fuels. Under efficiency standards the only incentive a firm has is to comply with the law and no more. A firm has little incentive to develop technologies and products that go beyond the efficiency standards. It is little wonder that the fleet average fuel efficiency for U.S. automakers has closely tracked the Corporate Average Fuel Efficiency standards. They stop as soon as they satisfy the law. They have no incentive to produce more fuel efficient cars because consumers do not demand them. And why should they when fuel is cheap! Under a carbon tax, firms and consumers are rewarded for any and all methods of reducing consumption. Further increases in efficiency always create real savings since fuel is expensive. A carbon tax also encourages more research into alternative fuels, another way to reduce consumption of fossil fuels.

    Fourth, the costs of an efficiency standard are hidden and lumped into the purchase price of the car. This affects everyone who purchases a car equally. On the contrary, the heaviest burden of a carbon tax is born by those who consume the most fossil fuels. Those who respond to the tax most, by driving less and purchasing more fuel efficient vehicles, will bear less of a burden. Those who change their behavior (the goal of our policy) are rewarded by paying less total carbon tax. It is more equitable to financially punish those who use their cars not simply those who purchase a car.

    If those effects weren’t enough to convince you that a carbon tax is a superior policy, there is also the revenue generated by a carbon tax. Taxing all those carbon emissions will result in a lot of revenue. The government could use this money to shore up Social Security and Medicare or spend it on alternative energy research and development. Or, we could use this revenue to offset other taxes. My preferred use of carbon tax revenue would be to reduce other taxes and make the taxes revenue neutral. In this sense a carbon tax is not a new tax but simply replaces other taxes.

    The government has to generate money to perform many valuable services for the country. Let’s raise that revenue by taxing activities we want people to do less of, like burning fossil fuels, and reduce the taxes on things we want people to do, like working. We shouldn’t discourage people from working, but that is exactly what we do when we tax income. I would use the revenue created from a carbon tax to reduce income taxes such that net taxes do not increase. In fact, citizens who reduce their consumption of fossil fuels most are likely to even receive a tax break!

    One of the biggest complaints about a carbon tax is that it might be regressive (poorer people might spend a larger percentage of their income on the tax than richer people). This is a valid concern but is easily remedied by reducing other taxes on the poor to offset their extra carbon tax expenditures.

    A revenue neutral carbon tax, with the greatest income tax reductions for the poorest and those least able to change their behavior, is the best strategy for reducing our consumption of fossil fuels and combating climate change. If we want people to do less of something we should increase the cost of doing it. This is exactly what a carbon tax will do and exactly why I support it.

  3. David says:

    REPLY TO AARON. Hey ‘Dr. Swoboda,’ I think you’ve made your point very well, and I am convinced, but, well, will it ever be politically feasible? People are complaining so much about gas prices right now…we need to get people to accept that they should use less gas (and fossil fuel-based electricity) before we can get them to accept the idea of a carbon tax. How far away do you think we are from that?

  4. Brent says:

    You could do both, if the Port Authority would get their “Rack ‘n Roll” program in shape. The poor transit system here is the reason our streets are overcrowded. You can’t incentivise people to give up their cars without having a reliable alternative. Unfortunately pure cycling isn’t it, and probably never will be in this country/region. Rising gas prices hasn’t reduced vehicle useage. Congestion charging wouldn’t work any better than taxing gas. It all starts with “PAT”, before we can consider other options.

  5. David says:

    REPLY TO BRENT: I biked by a Park and Ride today – one of those parking lots along the freeway, and was literally shocked to see cars parking in it. I asked someone pulling out of it if more people were using to car pool because of high gas prices, and he said twice as many cars are parked there as before, so, it looks like people are deciding to use less gasoline because of gas prices.

    But, of course, you are right. We need alternatives to cars that make sense – especially in cities.

  6. Aaron Swoboda says:

    This whole talk about the political feasibility really irks me. A carbon tax will never be politically feasible if we constantly say in is politically infeasible. It will never be politically feasible if people who know and believe a carbon tax is a better policy than CAFE standards “cop out” and instead advocate for other policies.

    I am especially irked at the Sierra Club for their recent “MPG calculator” that is especially misleading about the benefits of increased CAFE standards. You can read more of my rant against the Sierra Club over at my blog.

  7. Julia says:

    I, too, like the idea of a revenue-neutral carbon tax, and have two caveats to offer to the above discussion:

    1) I don’t think that you will see large “immediate” impacts in gasoline use. Gasoline consumption is notorious ineleatic, and recent study (Hughes, 2007) found that even in the long run, it may only have an elasticity of 4%. Of course, in the really long run, people will make joint residential/transportation decisions that can help them reduce their VMT, but in the short run, people just don’t have as much power to reduce their driving. Or, at least, they don’t think they have that power, and gas prices only $1 more won’t make them think they do. It may mean a little more carpooling, and fewer trips to the store, but nothing dramatic, nothing wedge-worthy, to use Socolow and Pacala’s thinking.

    2) I think this problem is too big for one solution, even one as elegant as a revenue-neutral carbon tax. I think you still need efficiency standards, and I don’t buy the economists’ line of ‘don’t interfere with the market,’ Some markets are meant to be messed with.

    3) I am worried that the redistribution of the revenue from the tax will not be equitable, and the tax will have a regressive effect regardless of redistribution. Also, it may make people feel poorer to be taxed heavily at the pump, even if they get a bigger refund, and wouldn’t there be some problem of taking money from people and then there being a lag between when they pay the tax and when they get the money back? So people with less liquidity would be more adversely affected by it? (I am no economist, so I may be misunderstanding how the tax would work.)

    I guess that was three, not two, so I’d better stop before I hit five…

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