‘Revenue-Neutral’ Carbon Tax: Merely Implausible or Mathematically Impossible?
This summer Australia implemented a new tax on the country’s top 500 carbon emitters, which has already led to significant increase in electricity prices. Meanwhile, on August 2, Congressman Jim McDermott (D-Wash.) introduced his own carbon tax bill in the House of Representatives, which like the Australian tax is targeted at certain disfavored emitters.
Talk of a federal carbon tax has been recently revived by several conservative-leaning groups. Earlier this year Robert Inglis (former Republican Congressman from South Carolina) launched the Energy and Enterprise Institute, a new advocacy group aimed at marketing carbon taxes to Republicans. And last month rumors of carbon tax discussions at the American Enterprise Institute led AEI’s own Ken Green to reiterate his opposition to the carbon tax idea.
What sets the new conservative proponents of carbon taxes apart from traditional advocates is revenue neutrality. Instead of adding a carbon tax to existing taxes, Inglis proposes offsetting any increased revenue from a carbon tax with reductions in income and capital gains taxes. The question is: should we take the bait?
Some Carbon Tax Basics
The idea of shifting taxes away from income and investment to consumption has long been popular in conservative circles. But while revenue neutral tax swaps can make sense in theory, they are hard to achieve in practice. Even if a carbon tax is initially paired with other offsetting tax cuts, there is no guarantee that government won’t raise taxes a few years down the line and offset the offset. As economist Robert Murphy recently noted:
[W]hen the modern individual income tax was first introduced in 1913, it was touted as a relatively minor nuisance that would just affect the super rich. Indeed, the original bracket structure was very modest. Adjusting for inflation, the top rate of 7% kicked in on incomes above $11.3 million, while the bottom bracket applied to all incomes up to $453,000, with a tax rate of a mere 1%.
But oh how things changed, and quickly: Because of the government’s need for revenue during World War I, a mere five years later the top rate had skyrocketed eleven-fold to an incredible 77%, while the bottom rate (with a much lower income threshold of $59,000) had risen six-fold to 6%. Keep this history in mind when supporters promise a “revenue-neutral” carbon tax.
Maintaining a revenue neutral carbon tax would be particularly difficult because of the inherently fluid nature of the tax. If imposing carbon taxes leads to a reduction in carbon emissions, then it may be necessary to increase the tax rate to maintain the same level of revenue. If each increase in the tax leads to further reductions of emissions, it may not be possible to stabilize carbon tax revenue at a revenue neutral level.
By contrast, if a carbon tax fails to adequately reduce emissions, then it may be necessary to increase the tax to achieve desired environmental goals. So even if a revenue neutral carbon tax can be enacted in the short run, whether it will stay revenue neutral over the long run is impossible to determine.
Enter Richard Tol
Even leaving these issues aside, a new working paper by Richard Tol casts doubt on whether a carbon tax could remain revenue neutral and be successful from an environmental perspective. Tol begins by noting that there is a limit on how high a carbon tax could be and remain revenue neutral. Once carbon tax revenue reaches the total amount of revenue from all other taxes, any additional revenue cannot be offset by other tax cuts, and hence the tax cannot remain revenue neutral.
In addition to the maximum rate at which a carbon tax could be imposed while remaining revenue neutral, there is also a minimum rate at which a carbon tax must be imposed if it is to achieve desired reductions in carbon emissions. Most environmental groups, including the IPPC, have called for stabilizing atmospheric carbon at no more than 450 ppm, which climate models suggest would hold global temperatures to 2 degrees Celsius above pre-industrial levels. Tol estimates that stabilizing CO2 at 450 ppm would require a minimum initial tax of $149 per ton.
This, of course, assumes a uniform tax imposed by all countries on the planet (according to the IPPC, even a 100% reduction in carbon emissions from the United States would only forgo a few tenths of a percent of warming, so to be effective any carbon tax would have to be an international effort). For purposes of comparison, the implied price of a ton of carbon under the Europe Emissions Trading Scheme is below $10.
As it turns out, the maximum revenue neutral carbon tax is surprisingly low for many countries. The maximum revenue neutral carbon tax is $29 per ton of CO2 for China, $36 for Russia, and $45 for India. Overall, countries representing approximately 10% of current emissions have a maximum revenue neutral carbon tax level below the minimum level needed to achieve IPPC goals. Many of these countries (such as China and India) do not current impose carbon taxes at all, and are unlikely to do so at anywhere near these levels.
For the United States, the maximum carbon tax level is $223 per ton of CO2. A revenue neutral carbon tax is therefore theoretically possible, though it would require carbon taxes equal to about two-thirds of all tax revenue, which is approximately the same as the entire income tax. Given the regressive nature of carbon taxes, it is unlikely that completely replacing the income tax with a carbon tax would ever be politically achievable.
Further, the $149 per ton tax assumes a uniform tax imposed by all countries simultaneously. Should a substantial number of countries decline to impose a carbon tax (or impose it at a lower rate than $149 per ton) tax rates in the United States would have to be even higher to make up the difference.
Combining the above, it may not be possible for an effective carbon tax to be revenue neutral in either the short or long run. In the short run, Tol’s analysis shows that a revenue neutral tax may not be sufficient to meet IPPC goals. And in the long run the general uncertainty surrounding taxation makes it impossible to know whether any tax swap will remain revenue neutral.
If correct, this suggests that advocates of a carbon tax cannot simply hide behind the idea of revenue neutrality, but must accept that an effective carbon tax would require the growth of government.