Carbon Taxes as Part of the Fiscal Solution

Samuel Brown, William Gale and Fernando Saltiel Brookings/Tax Policy Center

The Economics of Carboon Taxes AEI/Brookings/IMF/RFF

November 13, 2012

Main Points

• We have a fiscal problem

• Higher taxes can/should be part of solution

• Taxes need not hurt growth

• Carbon taxes have many attractive features

• So do consumption taxes

• So do reforms of the income tax

The Fiscal Outlook

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2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

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Figure 1. Alternative Deficit Projections, 2012-2022

CBO Baseline

Extended Policy

Source: CBO and authors' calculations.

Policy Option % of GDP Extend Bush tax cuts 1.4

Index AMT for inflation (includes interaction) 0.9

Extend other expiring tax provisions 0.4

Cancel sequester 0.5

Policies Embedded in Current Policy Baseline

6 6 -20.0

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20.0

40.0

60.0

80.0

100.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

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Alternative Debt Projections, 2001-2022

2001 CBO Projection

Extended Policy

CBO Baseline

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400

600

800

1000

2012 2017 2022 2027 2032 2037 2042 2047 2052 2057 2062 2067 2072 2077 2082 2087

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Optimistic Scenario

Pessimistic Scenario

Alternative Projections of the National Debt, 2012-2089

The optimistic scenario assumes a current law baseline with health care spending growing in line with the intermediate projections of the Medicare

Trustees. It also assumes automatic cuts set out in the Budget Control Act represent a permanent downshift in spending. The pessimistic scenario assumes

our Extended Policy baseline with health care spending growing according to CBO's alternative projections. Sequestration and caps on discretionary

spending end in 2021.

Source: CBO, Medicare Trustees, and authors' calculations.

CBO Baseline Extended Policy1

Health Spending Assumptions Through 2089 Permanent Through 2089 Permanent

Medicare Trustees 2.08 3.02 5.09 6.09

CBO alternative scenario 3.57 5.87 6.62 9.02

Fiscal Gaps (as % of GDP)

Why Consider Tax Increases?

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Why consider tax increases?

• U.S. has the capacity to raise taxes – Revenues are at a 60-year low relative to GDP. They will rise as the

economy recovers but only to historical average levels.

• New taxes would reduce the extent of spending cuts required.

– Increasing numbers of elderly, health care cost growth, interest payments will create increasing spending needs.

• Public opinion supports tax increases as part of a fiscal solution.

• Shared Sacrifice – Spending cuts don’t get at the highest-income households. The only

way to have “shared sacrifice” is to include tax changes that target high-income households.

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“Starve the Beast” Doesn’t Work

• Effectiveness in containing spending

– Holding taxes low in order to cut spending doesn’t work. Not raising taxes makes the cost of spending appear lower than it actually is. (Buchanan; Romer and Romer)

• Political Sustainability

– A stable decision will require both sides give up cherished positions. It is not stable to have fiscal discipline on the spending side but fiscal largesse (low taxes) on the other.

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What We’ve Done in the Past

• 1983 Social Security Amendments • 1990 Budget Agreement • 1993 Agreement • 2011 Debt Ceiling • Perspectives

– Until 2011, we have never addressed a budget problem just with spending cuts (usually a combination of tax increases and spending cuts)

– The changes made previously were small relative to what we need now (no more than 1.5 percent of GDP after five years)

Taxes and Growth

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Consequences of Sustained Deficits – The Gradual Scenario

• Lower national saving Higher interest rates Less national investment Less future economic growth Lower future living standards

• Capital inflows from abroad don’t change the basic story: we effectively

owe more to other countries and have to pay it back (“mortgaging our future”)

• KEY POINT 1: Lower future living standards = the burden on future generations, even if there is no crisis.

• KEY POINT 2: The magnitude of the reduction in living standards is large, relative to other policy changes.

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Deficits and Growth

• A simple neoclassical growth model or Ball-Mankiw “debt fairy” calculations suggest that a sustained 1%-of-GDP deficit:

– Reduces output by 1-2%; and

– Raises interest rates by 30-80 basis points.

• IMF: Raising the initial debt/GDP ratio by 10 pp reduces the growth rate by 0.15 pp

– so reduces output by 1.5% over 10 years.

– Implies that the U.S. debt run-up has enormous implications for future economic growth.

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Taxes and Growth

• Two Effects of a Tax Hike – Direct effect on incentives and after-tax income

(income and substitution effects).

– Lower budget deficit (if spending is held constant) raises national saving.

• The sign of the net effect on economic growth is ambiguous.

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Previous Episodes

• Gale-Potter (NTJ 2002) estimate that EGTRRA (2001 tax act) reduced economic growth

– the deficit effects were large

– the marginal tax rate effects were small.

– By extension, letting the tax cuts expire would help economic growth.

• The 1993 Act does not appear to have hurt growth even though the top rate rose by 8.6 pp.

• Ditto with the WWII experience with even larger increases in taxes (see next slide).

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Source: Stokey and Rebelo (1995)

1980s Tax Reforms

• 1981 tax cuts

– Feldstein (1986) and Feldstein and Elmendorf (1989) find very little impact of the 1981 tax cuts on economic growth between 1981 and 1986

• 1986 Tax Reform Act

– Auerbach and Slemrod (1996) find relatively small impact of TRA 86 on various components of economic growth

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Options for Raising Revenues

• Carbon taxes (or cap and trade)

• Income tax reform

• Consumption taxes

Energy Taxes

Carbon Tax

• A tax on greenhouse gas emissions, not just carbon

• Implemented in several European countries

– The fact the tax exists and is administrable is an unsung but important consideration in consideration of tax reform options

• Environmental Benefits

– Pollution reduction (Health)

– Congestion

– Climate change

• Political Benefits

– Reduced dependence on Foreign Oil

Efficiency

• The ever-elusive first-best tax

– Pigouvian tax on externality created by carbon use and emissions

• Subsumes need for many other aspects of energy policy

– Conventional energy subsidies

– Alternative energy subsidies

– Energy regulations

• Permanent price incentive would encourage innovation in – Carbon abatement

– Cleaner energy sources

Revenue – 2015

Author Level of tax ($/tCO2) Revenue as % of GDP

McKibbin et al. (2012) 15 0.45%

CBO (2011) 22 0.59%

Rausch and Reilly (2012) 22 0.66%

Shapiro et al. (2008) 23 0.78%

Metcalf (2010) 31 1.13%

Paltsev et al. (2007) 41 1.62%

Distributional Issues

• Carbon taxes are regressive with respect to current income – Indirect effects (Higher prices due to higher costs of

production) may offset the direct impact on gas and electricity prices

– Measuring incidence with respect to consumption or lifetime income yields less or no regressivity

• In principle, regressivity could be dealt with via income tax offsets – Political problems though (adding to the 47 percent)

Cap and Trade versus Carbon Tax

• Choice of regulating quantity versus price – Depends in part on the relative benefits and costs

of having more variable Q or P

• Political economy issues – System is weaker because permits are often given

away in cap-and-trade systems; Not a problem in the short-term, but is a long-term issue

– On the other hand, once permits are issued, holders have incentives to keep the system in place.

Gasoline Taxes

• Not as efficient as a carbon tax (but beggars shouldn’t be choosers)

– Current federal and state tax is about 41 cents per gallon

• CBO – 50 cent/gallon tax would raise 0.3% of GDP.

• Raising the tax by 25 cents per year for 10 years could raise 1.0-1.5 percent of GDP after 10 years.

– Compare to the corporate tax

– Would still be lower than European gas taxes

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Value-Added Tax

• A 10 percent VAT

– With a demogrant offsetting regressivity

– With a fairly broad base

– And accounting for reductions in other taxes….

– Would net about 2 percent of GDP in revenues

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Tax Expenditure Options Eliminate All Tax Expenditures

Revenue as % of

GDP

Eliminate Individual Tax Expenditures (Toder & Banemen 2012) 6.59

Include Net Effect of Tax Expenditure Interaction 0.63

Total 7.23

Eliminate Groups of Expenditures (Nguyen et al 2012) 7.41

Deductions, Fringe Benefits, & Small Credits 2.98

Investment & Retirement Income 2.44

Child, Work-Related, and Social Security Benefits 0.73

Administratively Difficult Tax Preferences 1.27

Limit Aggregate Tax Expenditures Revenue as % of

GDP

Transform to 15-Percent Credits (CBO 2011) 0.66

Cap Tax Value (Feldstein et al. 2011)

2 Percent Cap 1.85

3 Percent Cap 1.38

5 Percent Cap 0.73

Conclusion

• Energy taxes are a good idea

– We need the money

• For deficit reduction

• To finance other tax reforms/cuts

– Efficiency gains

– Environmental gains

– Distributional effects can be addressed

– Administratively feasible

• Other revenue options are available and likely to be needed as well