The case for carbon taxes: Simple is better

By Janet E. Milne, September 5, 2008

In today’s climate change debate, carbon taxes lurk as a sleeper option compared to the cap-and-trade legislation pending in Congress. Carbon taxes aren’t without their downsides, but they should receive more consideration despite the almost Pavlovian aversion to taxes.

Carbon taxes are fairly laser-like in the way that they target carbon dioxide, which comprises 85 percent of U.S. greenhouse gas emissions. Carbon taxes are based on the carbon content of fossil fuel, and most fuel that’s consumed emits carbon dioxide in direct proportion to its carbon content. Because of this correlation, taxing carbon can serve as an easy surrogate for taxing carbon dioxide emissions, avoiding the need for end-of-tailpipe or end-of-smokestack monitoring technology. Refunds or exemptions can provide relief in situations where the carbon is consumed without producing emissions (such as when natural gas is used as a feedstock in making petrochemicals) or when carbon dioxide is sequestered.

Cap-and-trade regimes, which distribute a limited number of emissions allowances, also target carbon dioxide, but carbon taxes are simpler. As with a gas tax, a carbon tax can be imposed early in the production or distribution cycle of fossil fuels. Congress just sets the tax, and the IRS collects it. With a cap-and-trade system, Congress needs to create a new legal commodity–a fixed number of allowances to emit carbon dioxide. It then needs to design a system for distributing those allowances among regulated entities, rules for transferring and tracking them in the marketplace when emitters buy or sell allowances, and procedures for ensuring that emissions match the allowances a regulated entity has in hand. Cap-and-trade systems may be “market-based,” but they must first create a new product and market; carbon taxes add one new component to a traditional, well-established system.

The straightforwardness of carbon taxes makes them economically efficient, as the Congressional Budget Office has recognized. The cost of the carbon component of any fossil fuel–set by the tax rate–is known and predictable, so users can plan accordingly, whereas tradable allowances have fluctuating prices. Cap-and-trade proposals can build in features that limit the price exposure and allow flexibility in annual compliance, but add more layers of complexity.

Why not just keep it simple and impose a tax? A classic and serious argument is that the “cap” will produce a known limit on the quantity of emissions, whereas the tax would allow emitters to decide whether to emit more (or less) based on what is financially rational. But achieving a legitimate ceiling on emissions through a cap-and-trade regime will require accurate monitoring and verification support. Providing allowances for offset projects, which also must be verified, ups the ante even more.

Congress and a new president might be skittish about enacting a carbon tax high enough to drive down emissions. But a cap-and-trade system will also impose new–and uncertain costs–on society, particularly if allowances are auctioned rather than distributed without charge (a hotly debated topic that we will no doubt pursue as this conversation continues). The difference is that the costs of a cap-and-trade system are more politically opaque. Will voters really understand how cap and trade will work and how it will affect their bottom line? The debate about cap-and-trade needs to fully expose the costs to consumers; voters should have truth in lending.

In short, carbon taxes offer cost certainty and simplicity. In 10 years, we may have questions about whether the IRS is auditing enough carbon tax returns, but we won’t be wondering about whether middlemen are making too much money from allowance trading, if investors are manipulating the carbon market, or what new laws we need to guard against those risks.

Nevertheless, it’s not just about efficiency and simplicity; a broader, related principle underlies carbon taxes. As former Vice President Al Gore said last month when he reiterated his support for carbon taxes, “we could and should speed up this transition [to renewable energy] by insisting that the price of carbon-based energy include the costs of the environmental damage it causes.” Cost-internalization is a fundamental plank in the platform of market-based instruments, and it isn’t limited to carbon taxes. Carbon taxes could lead to other ways to build environmental costs into prices. What about a climate change tax on other greenhouse gases such as hydrofluorocarbons, or taxes on nuclear power or hydropower that recognize their non-carbon-related environmental impacts?

Congress has two carbon tax bills before it (the Save Our Climate Act of 2007 and the America’s Energy Security Trust Fund Act of 2007). It should look closely at the concept of carbon taxes–and beyond.

Topics: Climate Change