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Climate change is a classic market failure. The price of fossil fuels does not reflect the costly effects of those fuels on the environment and climate. As long as the cost of climate change remains outside the market, the economy will consume more fossil fuels than it otherwise would if prices accurately reflected the costs and risks posed to society and the economy by greenhouse gas pollution.

To address this market failure, economists and other scholars across the political spectrum have made the case for a carbon tax as the most efficient way to internalize the cost of greenhouse gas emissions and achieve pollution reductions across all sectors. In essence, a carbon tax sends a powerful market signal that would shift private and public investment away from polluting sources of energy to lower-carbon sources of energy.

Left unchecked, climate change will have costly—not to mention catastrophic and irreversible—effects on human health, the environment, national security, and the global economy. The window of opportunity is closing to decarbonize the world’s economy on a trajectory sufficient to avert the worst impacts of climate change.

The Center for American Progress has developed one approach to implementing a carbon tax in the United States that would achieve a dual goal: setting the United States on a path toward decarbonization of the economy, while protecting low- and middle-income energy consumers and ensuring the nation’s continued economic growth.

CAP modeled the effects of imposing a tax on all greenhouse gases beginning in 2020 at $30 per ton of carbon dioxide equivalent, or CO2e. For the first 10 years, the tax would escalate at a 5.2 percent annual rate until it hits the social cost of carbon, or SCC, in 2030, which is currently set at $50 (in 2007 dollars). The carbon tax would then track the SCC, rising to $55 in 2035 and $60 in 2040 (in 2007 dollars). The SCC reflects the best estimate of the economic damage wrought by 1 ton of carbon emissions.

The proposed carbon tax would generate an average of $200 billion per year over 20 years. Carbon tax experts and other stakeholders have varying opinions about the best way to use this revenue, ranging from corporate tax breaks to investing all of it in new spending.

One approach to carbon taxation that has gained traction is a revenue neutral approach in which any new carbon tax revenue is offset by returning it to taxpayers. Carbon tax experts generally lay out three primary options for returning the revenue: as a lump sum to taxpayers, the most progressive option that provides the greatest relative benefit to lower-income households; as a labor tax cut to wage earners; or as a corporate tax cut to businesses, which provides the least benefit to lower-income households.

CAP examined the benefits of a hybrid approach that combines the progressivity of a lump sum return with a labor tax cut that recognizes the economic value of work. The hybrid revenue return includes a guarantee that 11 percent of the carbon tax revenues will go ratably to households with annual incomes below $25,000; a flat percentage, refundable labor tax cut will go to households with combined wage and nonwage incomes of $25,000 to $150,000; and an additional lump sum supplement will go to households with combined wage and nonwage incomes of less than $100,000.

This hybrid approach has several benefits, as described in more detail in this report:

• All households making less than $150,000 are protected from increases in direct energy and consumer costs. The lump sum rebate and labor tax cut are progressive and counteract the inherently regressive nature of consumer price increases.
• It protects the poorest households from the impacts of other indirect costs and mitigates the impact for other households.
• The refundable labor tax cut lowers the overall effective tax rate on wages.
• The impact on national gross domestic product, or GDP, is minimal overall and is negligible when compared with the potential economic impact of unmitigated climate change.

The revenue return is a key component of a progressive carbon tax design. But policymakers will have to grapple with a number of other design issues, including how to address concerns from industry sectors that are energy intensive and trade exposed and how to overlap a federal carbon tax with state climate programs and federal environmental regulations. This report describes how to tackle these questions in a way that achieves emissions reductions while positioning the U.S. economy for continued growth in the 21st century.

The burning of fossil fuels releases greenhouse gases that cause climate change, but the price of fossil fuels does not reflect these costly environmental impacts. As long as climate change remains an external market cost—also called a negative externality, in economists’ parlance—the market will not respond appropriately to incentivize the development and deployment of cleaner, lower-carbon processes. Instead, the economy will consume more fossil fuels than it otherwise would if prices accurately reflected the costs of greenhouse gas pollution.

Economists and other scholars across the political spectrum have made the case for a carbon tax as the most efficient way to internalize the cost of carbon and achieve greenhouse gas emissions reductions across all sectors. Ian Parry, the principal environmental fiscal policy expert at the International Monetary Fund, has said that “there is near-universal agreement among economists that [carbon pricing] will be essential if U.S. emissions are ultimately to be rolled back at reasonable cost.”¹ Adele Morris, a senior fellow at the Brookings Institution, has cited the “remarkable consensus of economists” on how a carbon tax would “minimize the cost of steering economic activity away from the greenhouse gas emissions that threaten the climate.”²

Many conservatives agree with the need to combat climate change through market mechanisms, though they often pair support for a carbon tax with elimination of environmental regulations. Jerry Taylor of the Niskanen Center, a libertarian think tank, argues that a carbon tax can cut pollution at the least cost by “leaving the decision about where, when, and how to reduce greenhouse gas emissions to market actors (via price signals) rather than to regulators (via administrative orders).”³ Similarly, Andrew Moylan from the R Street Institute says the “best policy to address greenhouse gas emissions, while adhering to conservative principles, is a carbon tax combined with tax and regulatory reform.”⁴

Models predict that a carbon tax would achieve significant emissions reductions in the United States. For example, the U.S. Energy Information Administration, or EIA, examined the impact of a $25-per-ton tax on energy-related carbon dioxide emissions.⁵ According to the EIA’s analysis, if the United States had assessed a $25-per-ton carbon tax in 2014, energy-related carbon dioxide emissions in 2025 would have fallen 22 percent below business-as-usual projections and 28 percent below 2005 levels. By 2040, energy-related carbon dioxide emissions would have fallen 36 percent below business-as-usual projections and 40 percent below 2005 levels.⁶ In another study, researchers modeled a $15 tax on each ton of carbon dioxide escalating at 4 percent above inflation each year. They found that after 25 years, carbon dioxide emissions would be 20 percent lower than the business-as-usual baseline.⁷ Similarly, researchers at the Massachusetts Institute of Technology modeled a $20 tax starting in 2013 at $20 per ton and rising at 4 percent annually in real terms. In their simulations, this tax reduced carbon dioxide emissions to 14 percent below 2006 levels by 2020 and 20 percent below by 2050.⁸

The model outputs vary based on assumptions, starting price, and the annual tax ramp, but the conclusions are similar: A carbon tax produces substantial emissions reductions.

The impact of a carbon tax—on emissions, the U.S. economy, and households—depends entirely on its design. A poorly designed carbon tax will shift the costs of higher energy prices to consumers without achieving the necessary environmental goals. A properly designed carbon tax, however, has the potential to reduce greenhouse gas emissions across all industries while shielding low- and middle-income households from these potential price increases.

This report offers an approach to a U.S. carbon tax that would set the United States on a path toward decarbonization of the economy while protecting low- and middle-income energy consumers and ensuring continued economic growth. Key elements of CAP’s carbon tax proposal are described below.

Start the carbon tax at a reasonable level and escalate to meet the social cost of carbon

In 1993, Executive Order 12866 directed federal agencies to assess the costs and benefits of regulatory actions.⁹ In 2007, the U.S. Court of Appeals for the 9th Circuit ruled that a vehicle rulemaking during the George W. Bush administration failed to account for the cost of carbon pollution, which the court said is “certainly not zero.”¹⁰ Following this ruling, agencies began to put a value on this social cost of carbon, which is an estimate “of the long-term damage done by one ton of carbon emissions.”¹¹ In 2015, the White House updated its analysis of the SCC to be $36 per metric ton in 2007 dollars at a 3 percent discount rate.¹² While this analysis has undergone rigorous government review, it may well prove to underestimate the actual SCC emissions, as it does not factor in ocean acidification and other climate impacts. Stanford University analysts believe that the true SCC could be as high as $220 per metric ton.¹³

Rather than setting a carbon tax to match the SCC in the first year, CAP proposes starting the tax at a lower level and ramping it up over time to meet the SCC. Specifically, CAP proposes imposing a tax on all greenhouse gases beginning in 2020 at $30 per ton of carbon dioxide equivalent. For the first 10 years, the tax would escalate at a 5.2 percent annual rate until it hits the SCC in 2030, which is currently set at $50 (in 2007 dollars). The carbon tax then would track the SCC, rising to $55 in 2035 and $60 in 2040 (in 2007 dollars). (see Figure 1)

An interagency working group first estimated the SCC in 2010. Since that time, the working group has updated it twice to reflect the latest models and technical corrections.¹⁴ If experts revise the SCC to better reflect the costs of climate change, the tax should respond accordingly.

Assess the tax using data from the Greenhouse Gas Reporting Program

Policymakers should apply the carbon tax at a point that both maximizes coverage and minimizes administrative complexity. CAP’s proposal assesses the carbon tax using the greenhouse gas pollution data that the federal government already collects through the Environmental Protection Agency’s Greenhouse Gas Reporting Program, or GHGRP. Each year, the EPA collects facility-level greenhouse gas data from the top emitting sectors of the U.S. economy. The EPA uses these data to inform domestic policy and improve the U.S. Greenhouse Gas Inventory, a comprehensive annual report that is submitted to the United Nations in accordance with the Framework Convention on Climate Change.

The GHGRP data would determine which entities are subject to the tax and the volume of emissions subject to the tax. Using the GHGRP as the basis for assessing the carbon tax has several advantages. Foremost, the GHGRP currently tracks 85 percent to 90 percent of U.S. greenhouse gas emissions from large industrial facilities and end-use fuel.¹⁵ By using the GHGRP to identify emissions subject to the carbon tax, policymakers could achieve near-complete coverage of domestic greenhouse gas emissions while minimizing the compliance burden for emitters and the federal government.

In addition, stakeholders have provided input into the shape and scope of the GHGRP and offered the EPA constant feedback on the data. When the EPA first proposed the rule creating the GHGRP, the agency received more than 17,000 comments from stakeholders and interested parties, including the American Petroleum Institute, the U.S. Chamber of Commerce, and energy companies such as Exelon and Duke Energy.¹⁶ Since the EPA finalized the rule in 2009, the agency has revised it on several occasions to address concerns about monitoring requirements and data disclosure.¹⁷

The carbon tax would be assessed on industrial sources of pollution and fuel suppliers, reflecting the structure of the GHGRP.

• Industrial sources. Facilities in most industrial sectors—including electric utilities; oil and gas production and refinery operations; and industrial manufacturing of concrete, metals, paper, and chemicals—report their greenhouse gas emissions to the GHGRP if their annual emissions exceed 25,000 metric tons of CO2e.
• Suppliers of fuels for consumer use. Fuel suppliers provide a variety of fuels and industrial gases that are used throughout the economy. Unlike the industrial sources of emissions, the greenhouse gas emissions they report do not occur at the supplier’s facility but instead at the point of use. Fuel suppliers, such as refineries and local natural gas distribution companies, report the quantity of greenhouse gases that would be emitted if the fuels and industrial gases that they “produce, import, or export each year were combusted, released, or oxidized.”¹⁸

Using carbon tax revenue to protect lower- and middle-income households

According to modeling completed by RTI International for the authors, the proposed carbon tax would generate an average of $200 billion per year over 20 years. (see Table 1) The revenue would decline as greenhouse gas emissions abated in response to the carbon tax.

There are many ways to use this revenue, such as funding tax breaks elsewhere in the economy or increasing spending. Some policymakers and stakeholders have pointed to the importance of revenue neutrality of any carbon tax—that is, that the carbon tax does not generate any new net revenue for the government assessing the tax. British Columbia’s carbon tax, for example, was designed to be revenue neutral.¹⁹

Carbon tax experts generally lay out three primary options for designing a revenue neutral return of carbon tax revenues to the economy. First, policymakers could return the revenue as a corporate, or capital, tax cut. This would be nominally net positive for the overall economy; however, because these taxes are concentrated among high-income earners, this option is regressive and provides the least benefit to the majority of households. Second, policymakers could return all of the revenue to American households as a dividend or lump sum payment. This is the most progressive option, since this dividend, as a proportion of household income, would benefit lower-income households more than wealthier households. Many economists believe, however, that this option could slow the economy over time. A third option—often seen as the middle ground—would be to use the carbon tax revenue to cut taxes on labor, such as through a payroll tax cut. This option would have a minimal impact on the economy while leaving the majority of households better off than they would be under a corporate tax cut.²⁰

CAP proposes a hybrid approach that combines the benefits of a labor tax cut with the progressivity of a lump sum revenue return. In total, the CAP proposal would return $182 billion to households in 2020, the first year of the proposal. (see Table 2) The proposed revenue return includes:

• A guarantee that 11 percent of the carbon tax revenues will go ratably to households with annual incomes below $25,000.
• A flat percentage, refundable labor tax cut for households with combined wage and nonwage incomes from $25,000 to $150,000.
• An additional lump sum supplement for households with combined wage and nonwage incomes of less than $100,000. Specifically, CAP proposes providing annual lump sum payments of an additional $115 per household for those making less than $25,000; $350 per household for those making from $25,000 to $75,000; and $175 per household for those making from $75,000 to $100,000.

The hybrid approach has four primary benefits.

1. All households making less than $150,000 are protected from increases in direct energy and consumer costs

Under a carbon tax, prices for higher-carbon-emitting goods, such as electricity generated by a coal-fired power plant or gasoline, would rise to reflect the cost of carbon pollution to society. As Chad Stone from the Center on Budget and Policy Priorities explains, low- and middle-income households “feel the squeeze the most” from higher energy prices, “both because energy-related expenditures constitute a larger share of their budgets and because they have less ability to make investments needed to adapt to higher energy prices (such as buying new, more energy-efficient appliances or home-heating systems) than better-off households.”²¹ A well-designed carbon tax can generate and distribute enough revenue to offset or mitigate the impact of higher energy costs on low- and middle-income households.

The hybrid approach outlined above returns enough revenue to households to compensate for any increase in direct energy costs and prices of other consumer goods. All households making less than $150,000 per year would receive a labor tax cut and/or a lump sum payment that more than covers new household costs arising from the carbon tax. As shown in Table 3, the revenue return constitutes a higher percentage of income for households on the lower end of the income scale than for those higher up. This revenue return approach is more progressive and counteracts the inherently regressive nature of consumer price increases.

The revenue return succeeds because price changes for the household consumption bundles—the individual quantities of all the goods and services a household buys—are slight. Modeling completed by RTI International for the authors shows that energy expenditures are a relatively small percentage of the consumption bundle—about 5 percent.²² Table 4 shows how a carbon tax would affect prices for household consumption bundles, averaged over the 2020–2040 period, by income group. Higher-income households would experience a slightly lower percentage increase, since they spend a smaller fraction of their income on energy and energy-intensive goods relative to lower-income households. For all households, regardless of income group, consumption bundle prices will rise by less than 1 percent.

2. It protects the poorest households from the burden of other indirect costs and mitigates the impact for other households

As noted above, a carbon tax could increase energy and consumer prices as industry internalizes the costs of climate change. The revenue return more than compensates for these higher direct costs, as reflected in the consumption bundle prices. But economists often talk about other indirect welfare costs that households could experience as well. These indirect costs—which households would not see on an electricity bill or on their receipt at the grocery store—are harder to quantify with precision, as they are not reflected in the price of consumer goods and services.

To use a noncarbon example: Some cities are served by two airports, one closer to downtown but with more expensive flights and another cheaper but more remote. Losing access to the nearby airport—say, if an airline stopped servicing that airport—would make many travelers worse off, even if they took every trip they otherwise would have and did so at lower costs. Modelers use equivalent variation to estimate how much these consumers would be willing to pay to bring back service at the nearby airport. To apply that concept to carbon taxation, the indirect welfare effect of a carbon tax reflects the monetized value of what a household would pay to return to the pre-carbon tax state.

The labor tax cut and lump sum payment, which households would see reflected in their paychecks and bank accounts, would mitigate—but would not entirely negate—the indirect costs of a carbon tax for all households. Importantly, this equation, while including the direct and indirect costs of a carbon tax, does not include the indirect benefits of a carbon tax. For every ton of carbon pollution averted, the world sees a $36 benefit in the form of damages avoided—such as diminished agricultural productivity, property damage from extreme weather and sea level rise, and effects on human health—according to SCC estimates for 2015.²³

Table 5 shows the net welfare effect of the carbon tax after factoring in direct and indirect costs and the revenue return to households. Notably, it does not include a quantification of the general societal benefit of mitigating climate change. Households in the lowest quintile experience a positive welfare impact or no impact at all. For households in the remaining income brackets, the net welfare impact never exceeds 1 percent of household income, and each year, the societal benefits of stemming climate change would further reduce that impact.

3. Effective tax rates on middle-income households will be lower

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