Tax Analysts Blog

Cap and Trade Charade

Posted on May 26, 2009

Fulfilling his campaign promise, President Obama's budget included a cap-and-trade program where polluters would have to buy permits initially auctioned by the government. He would use the auction proceeds for low-income tax cuts in the form of an extension of the "Make Work Pay" tax credit. A cap-and-trade plan with 100% auctioning of permits is like a carbon tax. Obama's plan to use revenue from the auctions to pay for targeted low-income tax relief makes perfect sense because the implicit carbon tax disproportionately burdens the poor.

But in their quest to pass what they delude themselves into calling "decisive and historic" legislation, members of the House Energy and Commerce Committee made massive concessions to carbon polluters. Instead of auctioning permits (as is sensible and as proposed by Obama), the House will give away 85 percent of the permits to polluters. The bill still has a lot more hurdles to pass just to make it out of the House, so the bill -- if it survives at all -- is subject to a lot of changes. But if the giveaway of permits is retained, it will be an extremely bad bill under either of two scenarios Congress is now considering.

Option 1 ("You- are-screwed") Give away permits. The limited number of permits raises the price of carbon, and through price increases carbon emissions are reduced. That's good from the environmental standpoint. But it also taxes consumption, and therefore disproportionately burdens the poor. Giving permits to polluters does nothing to reduce the price in a free market setting. It is a pure windfall to shareholders of the companies getting the free permits. As OMB Director Peter Orszag said in March: "If you didn't auction the permit, it would represent the largest corporate welfare program that has ever been enacted in United States history." So, in this case, Congress takes from the poor to give to the rich while it improves the environment. (This is essentially what happened with the European Union's cap-and-trade plan.)

Option 2. ("You-are-scammed") Give away permits, restrict price increases on carbon-using products. In this case consumers are not burdened (because there is no price increase on carbon goods). And there is no windfall for firms getting free permits because the value of the permits given to them is offset by the reduced profit margin as the (marginal) cost increases resulting from the increased price of carbon are not passed on to consumers. So far, so good, right? Well, no, because the whole purpose of the bill has been defeated. With no increase in products to consumers there is no incentive to reduce carbon emissions. There is no environmental benefit. So we go full circle: a bill that looks like cap-and-trade legislation but negates all of its good and its bad effects. So why have a bill at all? (If one more person talks about symbolic value, I'm gonna scream.)

The current House bill appears to be a mixture of Option 1 and Option 2 and in the end, IF this bill ever becomes law, the final version could similarly be a combination of the two. We need to get back to the Obama version with 100 percent auctioning which will address environmental concerns and compensate low-income families for their new burden. Unfortunately, there are some reports that Obama may be backing down.

My fear is that Option 1 will prevail. (Some believe Option 2 is unworkable, that is, it is impossible to get windfall benefits of free permits passed on to consumers.) In this case polluters and environmentalists both win at the expense of consumers--particularly low-income consumers. This variant is better than nothing at all, as some argue, only if you care more about the environment than you do about the poor. And certainly environmentalists are better represented on Capitol Hill.

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