Tax Analysts Blog

The Carbon Tax Designed for Conservatives?

Posted on Aug 2, 2017

In case you missed it, the border-adjustable tax officially got the boot. Don’t feel bad if you were among those intrigued by the House GOP blueprint for tax reform. The proposal enjoyed a good run, and served as a useful tutorial on foreign currency adjustments.

With the BAT out of the picture, Congress lacks a revenue source sufficient to pay for the desired rate reduction. If only there were a better “better way” to salvage revenue-neutral tax reform. Enter the American Opportunity Carbon Fee Act (AOCFA), which was recently unveiled at the American Enterprise Institute in Washington.

The AOCFA would impose a broad-based carbon tax. It would establish a mechanism to capture negative externalities that now escape market pricing. That makes it a classic Pigouvian tax. Proponents would rather frame the discussion in terms of the “carbon dividend” it produces. Much like the BAT, a carbon tax would generate a lot of revenue that could be used to finance tax reform.

The political viability of any carbon tax, however elegantly crafted, is an obvious concern. Most Democrats will not like a carbon tax because it’s regressive, and most Republicans will not like it because it’s a tax. Note that bipartisan efforts to index the federal gas excise tax to inflation have consistently failed for the same reason

The AOCFA is a definite long shot, but its design elements are worthy of further consideration. It has also received support from several unlikely sources.

Taxes vs. Fees

Let’s get one thing out of the way first. The word “tax” does not appear in the plan’s title; the word “fee” is used instead. The clever phrasing is supposed to make the proposal more palatable, but I doubt anyone will be fooled.

Conservatives generally prefer user fees to taxes. That’s because user fees are associated with discretionary choices. Individuals can avoid user fees that aren’t to their liking by simply modifying their behavior. Admittance fees for national parks are a classic example. By contrast, taxes are normally viewed as nondiscretionary. If you can choose not to pay a thing, it probably isn’t best described as a tax.

Given that framework, the tax under the AOCFA could be portrayed as a user fee that corresponds to those lifestyle decisions that add to our carbon footprint. I get where its backers are coming from, but I find that reasoning a bit strained. Most Americans don’t view the relinquishment of central air conditioning as a realistic lifestyle choice, especially if they reside in Washington during the summer. Ditto for giving up our cars and walking to work.

Regardless of these nuances, it’s folly for progressives to pitch the tax under the AOCFA as a user fee. They already tried that with the Affordable Care Act (i.e., the penalty for violating the individual mandate), and it left a bitter aftertaste. Ultimately, people will look beyond semantics. 

The Carbon Dividend

The AOCFA would directly accomplish three things: (1) It would establish a price on carbon emissions reflecting an externality now ignored by market forces; (2) It would generate a boatload of tax revenue in the process; and (3) It would give every dime of that money back to the American people.

Cash inflows equal cash disbursements – the latter being known as a “carbon dividend.” In that sense the AOCFA is better viewed as a tax-and-spend plan. Proponents say it would not increase the size or scope of the federal government. In fact, they say it would actually reduce the scope of the current regulatory state – as discussed below.

The plan sets the price of carbon at $49 per metric ton. It’s estimated that would result in a 36 percent reduction in U.S. carbon by 2025 -- relative to the benchmark year of 2005. That exceeds our target reductions under the Paris climate accord – which the U.S. has withdrawn from. Unlike the Paris accord, the AOCFA does not include “green fund” contributions. There are no transfer payments to foreign countries.

The tax is projected to raise $2.1 trillion in revenue over a 10-year period, almost double the expected haul of the BAT. The plan has some interesting ways of returning all those tax dollars to taxpayers. As drafted, the carbon dividend would take the following forms, each intended to benefit a particular set of stakeholders.

• Relief for corporations: $600 billion would be dedicated to tax relief for corporations in the form of a statutory rate reduction. The plan references a rate cut from the current level, 35 percent, down to 29 percent. That’s not enough to satisfy the business lobby, but it’s a start. One gets the sense the quoted rate is more of an opening bid.

• Relief for workers: $500 billion would be dedicated to tax relief for working Americans. It would take the form of a refundable payroll tax credit. Because payroll taxes are more regressive than income taxes, they’re a more suitable vehicle to achieve a distributional neutrality. Remember, the carbon tax viewed in isolation is regressive.

• Relief for former workers: Payroll tax credits won’t reach everyone, like retirees. For that reason, another $500 billion in carbon dividends would be plowed into tax relief for former workers. This would take the form of matching benefits for Social Security recipients, retirees, and veterans.

• Block grants to states: Finally, $100 billion in carbon dividends would be allocated to state governments in the form of block grants. The idea is that states would use those funds to address spending obligations related to the economic consequences of climate change. In coastal states (think Florida), the money would be spent on the prevention of shoreline erosion as sea levels rise. In coal-producing states (think West Virginia), the money could be spent on providing financial assistance to coal workers. That could take the form of supplemental pension payments, tuition credits for children of coal miners, health insurance premium assistance, or direct cash distributions. Since these would be block grants, the details would be left to the states.

Tally those four categories of carbon dividends, and you match the $2.1 trillion in revenue the new tax regime is expected to generate. Dollars in, dollars out.

A Tax Conservatives Could Love?

An oddity about the AOCFA is that you don’t need to be a raging environmentalist to get behind it. Viewed through a different prism, the AOCFA is attempting to shift the federal tax base toward consumption and away from capital income. Conservatives have been trying to do that for decades.

The desire to reorient the tax base was the essence of the destination-based cash flow tax. The BAT didn’t come about because Republicans in the House wanted to tax exports (although that might be so for President Trump, who seems to favor tariffs). The BAT was a byproduct, the logical extension of affording multinationals cash flow treatment. The AOCFA is a further manifestation of the same concept: Tax consumption a bit more, while taxing capital income a bit less. That’s straight from the Paul Ryan playbook.

Think of the AOCFA as a kindred spirit of the Michael Graetz tax reform plan, except you have a carbon tax in lieu of the VAT.

Both sponsors of the AOCFA are Democrats, Sens. Sheldon Whitehouse and Brian Schatz. But there’s a growing body of conservative thinkers who see merit in trading a carbon tax for large income tax cuts. That group includes three former Treasury secretaries who served Republican presidents: George Schultz, James Baker, and Henry Paulson. The concept has also been praised by prominent conservative economists such as Douglas Holtz-Eakin, Gregory Mankiw, and Martin Feldstein.

Why the conservative support? One explanation is that they regard carbon taxes as far preferable to a cap-and-trade regime. Or perhaps they’re so eager to slash income tax rates that they’re willing to jump on the bandwagon for any revenue raiser that isn’t a BAT. Another possibility is that they genuinely worry about the long-term risks of climate change and seek a market-based solution in which all sides can claim victory.

Whatever the case, it’s worth noting that none of the aforementioned conservative icons are running for public office. They occupy a political safe zone – unconcerned about fundraising, reelection, and primary challenges from the far right. The members of Congress who will eventually be asked to vote for the AOCFA don’t enjoy that same luxury.

To that end, Baker, Schultz, and Paulson are giving intellectual cover to GOP lawmakers tempted to consider a carbon tax. Earlier this year a group called the Climate Leadership Council released a policy paper outlining “the conservative case” for a broad-based carbon tax. The same arguments are well summarized in a TED Talk presented by council President Ted Halstead.  Another take on pro-growth carbon tax policy is a recent piece from American Enterprise Institute scholars Alex Brill, Aparna Mathur, and Alan Viard.

For a contrary view, I recommend an article by Benjamin Zycher, another American Enterprise Institute scholar. Zycher finds the conservative argument for a carbon tax deeply flawed. The thrust of his argument is that all carbon taxes are based on emission reduction goals, which are chosen by a political determination (exogenous process), rather than being imposed from pure science (endogenous process). Which is to say emission reduction goals aren’t inherently fixed by nature; they are entirely selective. As a result, the marginal cost of reduced emissions will be perpetually misaligned with the corresponding marginal benefits.

These are some of the same policy arguments raised against cap-and-trade regimes. I suspect that critics don’t perceive a meaningful difference between cap-and-trade plans and a straightforward carbon tax, although the two schemes purport to be very different in their structure. 

Taxation vs. Regulation

The founding members of the Climate Leadership Council include some large energy firms, including BP, ExxonMobil, and Shell. You’d think oil and gas firms would oppose a carbon tax, so what’s going on? 

Here’s one explanation. As things now stand, most environmental rules related to carbon emissions are generally dealt with through regulation – not by statute. That’s not ideal for business. Regulations are subject to the political whims of whomever occupies the White House. Initiatives promoted by one administration can be easily revoked by the next, and along the way regulations can be nullified by the courts through Administrative Procedure Act challenges. Corporations need to plan beyond the four-year election cycle. That’s less problematic with legislation. Sure, laws enacted by Congress can be changed by future Congresses, but that’s far more difficult to do compared with fiddling with regulatory reforms.

The passage of the AOCFA would create an opportunity to significantly scale back the scope of the Environmental Protection Agency regulation. If the country had a broad-based carbon tax, why would we need the Corporate Average Fuel Economy standards for vehicles? Ditto for the Clean Power Plan, the renewable fuel standards, and the appliance and equipment efficiency standards. You could make a persuasive case that those four regulatory regimes would be made redundant if federal legislation placed a price on carbon emissions. EPA resources could then be focused on other worthwhile endeavors.

I’m not an expert on climate change. The AOCFA’s relevance to our debate is that it has the potential to be a massive revenue raiser. With the BAT off the table, the political pathway for tax reform anytime soon is looking shaky. Some would say it’s closed off entirely, and the best we can manage is some form of watered-down “skinny” tax reform. That would be an opportunity missed.

Read Comments (6)

Mike55Aug 3, 2017

I think the carbon tax could serve as a helpful "grand bargain" between the parties, for all the reasons you've done a great job of laying out. I'd probably upgrade your "unlikely" to "impossible" though, at least as things stand.

The problem for Republicans is that even if they could trust Democrats on the Hill (unlikely), they'd also need to trust Democrats at the state level (impossible). The 3rd item (taxes vs. regulation) is the only selling point that appeals to core Republicans. But core Republicans assume most Blue states will just enact their own versions of whatever Federal environmental rules get eliminated, so the deal can't work.

And the trouble for Democrats is that "climate change" is no longer just about stemming harmful carbon emissions. The change in messaging from "global warming" to "climate change" was in part a rebranding, but also reflected an legitimate effort to focus on a broader range of important environmental issues. That's problematic for striking a deal; a large carbon tax would indeed do a great job of reducing harmful carbon emissions, but wouldn't do much else (e.g., protect biodiversity, promote sustainability, etc.).

Edmund DantesAug 11, 2017

You and others write about a carbon tax as if it is free money, just lying around waiting to picked up. It's not. Any tax that raises the massive amounts you project would create enormous economic dislocations, most of which are not foreseeable. Bad idea.

A "massive tax cut" will typically net me about $10, while a "slight tax increase" costs me $100 or more. The carbon tax would likely fall into this category--the "carbon dividend" for consumers would fall far below projections, while the disruptive effects of increasing carbon costs would ripple through the economy, raising the prices of everything, likely in a feedback loop. Those who are rich enough and nimble enough to profit from change and uncertainly will reap nearly all the benefits, while ordinary citizens bear the cost burden.

I also agree with Mike's analysis of the politics of the situation.

As the sunspots continue to decline, "global warming" is going to become harder to detect, and the political urgency of carbon reduction will recede.

Travis RechAug 11, 2017

"As the sunspots continue to decline, "global warming" is going to become harder to detect, and the political urgency of carbon reduction will recede."

In addition to being a tax expert, you're also a climate scientist! Modern day renaissance man. Looking at the statistics for average ocean temperatures over the last few decades, I'm not sure where your optimism is derived from or where this "sunspot" conclusion exists in peer reviewed research.

Mike55Aug 11, 2017

I also disagree with Edmund's opinion regarding sun spots (tentatively) and their impact on environmental politics/policy (very strongly). However that does not make your sarcastic attack on Edmund valid.

The impact of sun spots on climate is a matter of legitimate scientific debate, not some whacky "denier" conspiracy theory. To be sure the majority view is currently against sun spots as a primary cause of the recent warming trend, but not to such an overwhelming degree those who believe the opposite are worthy of your scorn.

Edmund DantesAug 14, 2017

No Travis, I don't claim to be a climate scientist. However, I do follow the work of those who are trying to incorporate variations in the sun's output into climate models. There are many, and they are up against some fierce resistance.

The Little Ice Age did happen, and it did coincide with the disappearance of sunspots. I will be the first to argue that correlation is not causation. Still, the subject is worth exploring instead of suppressing.

Mike55Aug 11, 2017

Your arguments above make sense, but I think the 3rd argument in Bob's post (taxes vs. regulation) still works. No matter how bad you think a carbon tax would be, there's just no way it could be more distortionary than the haphazard web of regulatory prohibitions that currently exist in the name of carbon emissions.

In other words, a "lesser of two evils" deal is being offered here. You don't need to think a carbon tax is a good idea to support it. Instead, you just need to accept that a carbon tax is less bad than, say, offering large government subsidies for the purchase of a Tesla X (or pick your own favorite example of the silliest thing happening in the name of "green" right now).

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