A consensus has formed among economists, climate wonks, and progressives that a carbon tax is the best way to address climate change. In some quarters, rhetorical support for a carbon tax is seen as a litmus test for whether policymakers are serious about climate change.
In my last post, I questioned the premise that a carbon tax is always and everywhere the "first best" climate policy.
In this post, I'm going to do something different: I'm going to accept the premise. Let's assume that a carbon tax, equal to the social cost of carbon, is the ideal climate policy — the most efficient and cost-effective way to reduce carbon emissions. Let's stipulate that it is our ultimate goal.
Now, how do we get there?
To answer that question, we have to go beyond economics to political economy: institutional structures, power, and influence. We have to grapple with the political constraints on carbon pricing and think about how they can be overcome.
This is not a topic on which the more fervent carbon tax advocates have showered themselves with glory. Their schemes are comprehensive. Their dreams are deeply felt. But their engagement with politics ranges from naive to disdainful. It's time for a better, more grounded conversation about what's possible for carbon pricing.
Proof of political constraints is in the pudding
Carbon prices, where they exist, are too low. That is to say, they fall short of the social cost of carbon (SCC), as estimated by economists.
The graph below is based on a working paper by MIT's Jesse Jenkins and Valerie Karplus. On the left is the range of estimates for the social cost of carbon. On the right are existing carbon prices, as set by taxes and cap-and-trade programs around the world.
As you can see, more than half of existing carbon prices in the world are below even the 33rd percentile of SCC estimates, $15. All of them, save Sweden's, are below the 50th percentile, $75.
And these SCC estimates are from a 2011 paper by Richard Tol (albeit updated to 2015 dollars). Many economists have argued more recently that the true social cost of carbon is much higher than most conventional estimates.
(A side note on the social cost of carbon: It is an estimate of how much a single ton of carbon emissions imposes in social costs, through climate damages. Most of those damages are in the future, so they are discounted and expressed in terms of today's dollars. There are reasons to doubt that the kind of modeling exercises that produce the SCC actually tell us anything worthwhile, but that's a subject for another post.)
The point is, carbon prices, where they exist, are too low. Why?
The obvious answer is that carbon pricing faces various political constraints, which prevent the carbon price from rising to the proper (high) level.
The political constraints on carbon pricing
Unfortunately, these political constraints are not nearly as well-understood as the economic dynamics of carbon pricing. Among climate economists and wonks, the hunches, pet theories, and ritual invocations of "political will" too often are substitutes for deeper, systemic political analysis.
The Jenkins-Karplus paper is an attempt to make some progress on that score. It sets out to model carbon pricing scenarios, seeking to determine which policy design leads to the greatest aggregate social welfare under various political constraints.
To do that, it had to develop a framework/taxonomy for those constraints, so it could model them separately. There are three main buckets:
1) Concerns about distributional impacts.
A carbon tax, all things being equal, is regressive: It raises the cost of energy, and lower income households spend a higher percentage of their budget on energy, so it hits low-income households harder.
Those regressive distributional impacts have been used as a political weapon against virtually every energy tax ever proposed. Leah Stokes and Matto Mildenberger of UC Santa Barbara have a good essay on this, which goes over some of the history, including Bill Clinton's ill-fated BTU tax.
In the modeling, this operates as a constraint on the final price of energy.
2) Willingness to pay.
There's a limit to how much US households and businesses are willing to pay to combat climate change. In this 2013 blog post, Jenkins reviewed some of that research and summarizes the conclusion: "a majority of citizens are likely to oppose climate mitigation policies with expected annual household costs on the order of $150-200 per household."
I have some quibbles with this sort of research, but let's accept that it's roughly true. That means a $10-per-ton carbon tax, well below the SCC, would be pushing the political limits in most of the US.
In modeling terms, this operates as a constraint on the "decrease in energy consumer surplus," i.e., how much more consumers — both residential and commercial consumers of fossil fuel energy — have to pay, on net, under the carbon pricing system.
3) Opposition from fossil fuel interests.
Fossil fuel companies are big, wealthy, and powerful, and they will be hardest hit by carbon pricing, so they tend to oppose it. In modeling terms, this operates as a constraint on the "decrease in fossil producer surplus," i.e., how much more fossil fuel producers have to pay, on net.
These constraints add up to what Jenkins and Karplus call "direct political constraints," which they model separately as a constraint on the final cost of carbon under the system.
This is not an exhaustive list of constraints, obviously, but it captures things in rough and ready terms.
Jenkins and Karplus model various ways of designing a carbon pricing system to test how they perform under these political constraints. Before getting to their results, though, a more general discussion is in order.
It's all about the revenue
How can these restraints be overcome? One obvious place to seek an answer is on the other side of the carbon pricing ledger: the revenue.
(It's easiest to talk about this in terms of revenue from a carbon tax; all the same considerations, more or less, apply to the value of carbon permits under a cap-and-trade system.)
A carbon tax raises money. What should be done with it? This is the central issue in carbon policy design.
On its own, a tax will face tight political constraints and be held low, well beneath the SCC. Taxes just aren't very popular. The National Surveys on Energy and Environment, conducted by the University of Michigan and the Muhlenberg College Institute of Public Opinion, found in 2014 that support for a carbon tax, when no purpose for the revenue is specified, is quite small.
That's where the revenue comes in.
Depending on how it's deployed, the revenue can hold energy prices down, either by funding RD&D or by directly compensating low-income consumers. It can compensate consumers or fossil-fuel producers for their welfare losses through direct payments.
More broadly, as long as the tax is beneath the SCC, alternative uses of the revenue can a) achieve cost-effective emission reductions beyond what the tax achieves on its own, and/or b) loosen political constraints, allowing the carbon price to rise. So revenue is not a side issue. It's the whole enchilada.
The most fundamental choice to be made about the revenue is whether to allow the government discretion over how to spend (some or all of) it.
Schemes that would return the revenue in various prescribed ways are known as revenue neutral, because they result in the government receiving no net revenue from the system. All the revenue is automatically "recycled" back into the economy.
Revenue neutrality has been a hot topic lately, so it's worth addressing the two revenue-neutral schemes with the most vocal constituencies.
Tax shift: using the revenue to reduce taxes
Many conventional economists, along with some of the few conservatives who take climate policy seriously, favor a "tax shift": using the carbon tax revenue to reduce other taxes, preferably "distortionary" taxes like payroll or income.
The idea is that you double your impact: You get less of what you don't want (carbon) and more of what you do want (work) — more efficient markets on both sides. Harvard economist Greg Mankiw is a big proponent of this perspective, as is Bob Inglis, one of the few conservatives actively working on climate change policy.
The main thing to note about tax-shift schemes is that they address few of the political barriers facing carbon pricing.
A carbon/income tax swap would be doubly regressive — raising a regressive tax to lower a progressive one. Reducing payroll taxes might have a net progressive effect, but it is very difficult to imagine the politics working. Fossil fuel and other carbon-intensive industries would balk. Every consumer would see the rise in prices. And those who benefited through an incremental decline in their payroll taxes are unlikely even to notice it.
British Columbia is one of the few places to have instituted a revenue-neutral carbon tax, using the revenue to reduce income and corporate taxes. The tax has been a success on its own terms — fuel consumption is down slightly and the economy is still growing — but a) it only covers about three-quarters of the economy, b) some of the revenue has started to be funneled to specific industries, and c) it remains capped at $30, too little to fully capture the SCC or drive a green industrial revolution. It may or may not be raised again after 2018; in the meantime, BC emissions are rising again.
Nowhere else has the tax-shift idea proven able to rally a sufficient political coalition.
Greg Mankiw singles out for praise a group in Washington seeking to put a revenue-neutral carbon tax on the ballot (I-732). But that group's own polling shows that an alternative tax proposal, which would use the revenue for investments in green energy and pollution reduction, polled better.
Tax (or cap) and dividend: using the revenue to pay back consumers
Meanwhile, many climate wonks and activists have seized on a different scheme: tax-and-dividend (or I guess we're supposed to call it "fee-and-dividend").
The idea here is to return the revenue as equal per-capita shares (dividends) to every US citizen, in the form of annual checks. This is how the Alaska Permanent Fund works with the state's oil revenue.
(An alternative is cap-and-dividend, which would have similar overall effects, but specify the amount of carbon allowed rather than the level of the tax.)
To a certain subset of climate hawks, most notably climate scientist James Hansen, tax-and-dividend become something of fixation. It directly addresses constraint #2, which is the net welfare impact on consumers (or at least the roughly 1/3 of energy consumption that's residential as opposed to commercial); it is thought that removing that constraint will unleash a wave of support that will crush other restraints.
In a set of papers on carbon pricing released last week by the Scholars Strategy Network (which is what triggered all this), two of the scholars, economist James K. Boyce of the University of Massachusetts Amherst and Michael Howard of the University of Maine, argue for tax-and-dividend.
The case boils down to the contention that dividends are the key to political acceptance of an ever-rising carbon tax. Boyce says that dividends are "essential to build durable public support." Howard says that "the dividend is key to the political success and durability of the entire carbon pricing effort."
It makes sense in the abstract. Who wouldn't love getting checks? But the real world offers no examples of dividends being used to successfully muster support for a carbon tax. Boyce and Howard both call for a grassroots movement (the underpants gnome of all dividend arguments), but there is, to my knowledge, no evidence that dividend schemes would elicit much public support, much less a movement.
What little polling evidence exists seems to point to the opposite direction:
As noted earlier, on the 2014 National Surveys on Energy and Environment, a carbon tax with no specified revenue use polled poorly. But things changed when different uses of the revenue were offered alongside the tax.
USA Today describes the results:
[A] different picture emerges when survey participants are asked about three possible uses of the tax revenue. If used to fund programs for renewable power like solar and wind, 60% back the tax overall, including 51% of Republicans, 54% of Independents and 70% of Democrats.
A smaller majority supports a tax if the revenue is returned to them via a rebate check. While 56% overall favor this idea, support ranges from 43% for Republicans to 52% for Independents and 65% for Democrats.
The third option -- using the tax revenue to reduce the massive U.S. fiscal deficit -- is not popular with any political group. It is opposed by the majority in each.
Investing in renewables outpolls dividends all along the political spectrum, including Republicans. Why? More research is needed to answer this question, or to see whether the pattern holds over time.
But at the very least tax-and-dividend proponents should temper their claims that dividends are the skeleton key to climate policy until there is more, or at least some, evidence. It's a big scheme that mainly moves money around. It's going to require a lot of calm explanation and a lot of trust in government, neither of which are abundant in US politics these days.
Also, no one has any idea how to conjure up a grassroots movement around an abstract policy idea. Which brings me to a something that has nagged at me for years.
The anti-politics of revenue neutrality
I have struggled to understand in the past what has put some climate wonks and activists on the side of neoclassical economists and conservatives on this question of revenue neutrality.
The common thread, it often seems to me, is a kind of anti-politics. It's not just a libertarian suspicion of government spending. There's also an underlying note of disdain for the compromises and trade-offs that come with policy in a fractious democracy.
That's where the pining for a grassroots movement comes from. It's imagined as a way to circumvent the ugly process of horse-trading that takes place in actual legislatures.
As it happens, we saw what the process of building support for carbon pricing looks like in the US Congress, when Henry Waxman navigated a cap-and-trade bill through the House in 2009. He made deals and compromises, just enough to get it over the finish line.
The very same people who are so messianic about carbon pricing today were unanimous in their scorn for the process. (Boyce calls it "cap-and-giveaway.") All that compromising. Why didn't Obama and Dems just … not compromise?
No one indulges in anti-politics more than Hansen, who has called Obama's Clean Power Plan "practically worthless" and the Paris climate agreement "a fraud really, a fake." Everything is judged against the perfect policy cloud castle he's constructed in his head, the one that requires no concessions, no political sacrifices — and everything is found wanting.
But purism doesn't get policies passed. If carbon taxes as high as economists want ever arrive, they will evolve out of compromised, suboptimal beginnings, like every other major policy ever.
Political constraints have implications for policy design
So, given everything discussed above, it seems to me that carbon pricing strategy discussions should begin by accepting two premises. First, a new carbon pricing system, where it is possible at all, will begin with a relatively low price. And second, sweeping wonk systems for revenue neutrality will not do much to overcome political resistance, especially in the early stages.
All the polling I've seen indicates that clean energy is extremely popular. Using carbon tax revenue for clean energy R&D is the only thing that found majority support across the spectrum in the NSEE:
That's only one poll, but polling has been remarkably consistent on this for years. Americans love wind and solar power. More broadly, they respond to positive, forward-looking messages focused on reducing pollution and building a better future. And not just Americans. Here's a focus group study from Norway demonstrating that most participants "express a very strong preference for earmarking the revenues for environmental purposes."
Tying the revenue from a dirty-energy tax to clean-energy investments is intuitively appealing; it is a use of revenue tied tightly to the justification for the tax, reducing the level of explanation and trust needed to make sense of it.
What's more, the modeling done by Jenkins and Karplus shows that investments in clean energy RD&D work well to boost the social benefit of a tax. As long as the tax is beneath the SCC, clean-energy investments can secure additional cost-effective emission reductions and reduce energy bills by spurring technology development. (Reduced energy bills means reduced political resistance.)
Clean-energy investments also have another key advantage: If deployed strategically, they can help create constituencies that support stronger policy.
The proof that clean energy regulations and investments are more politically feasible than carbon prices lies in the simple fact that more of them have been passed, and they've done more work, even where carbon prices exist. This is from an excellent essay on the subject by Mark Jaccard of Simon Fraser University:
When asked which climate policy in Canada reduced the most CO2 emissions over the last decade, many people guess BC’s well-publicized carbon tax. They’re wrong. It was Ontario’s ban on coal-fired power, which reduced annual emissions by 25 megatonnes (MT). Surely, then, BC’s carbon tax must have caused the most reductions in that province. Wrong again. The 2007 "clean electricity" regulation forced BC Hydro to cancel two private coal plants and its own gas plant. This cut BC’s projected annual emissions in 2020 by 12 to 18 MT. The carbon tax is slated to reduce 2020 annual emissions by 3 to 5 MT.
It’s the same in any jurisdiction that has significantly reduced emissions. Experts show that the carbon pricing policy in California, which Quebec has now joined, will have almost no effect by 2020. Ninety percent of that state’s current and projected reductions are attributed to innovative, flexible regulations on electricity, fuels, vehicles, buildings, appliances, equipment and land use. Even Scandinavian countries, famous for two decades of carbon taxes, mostly used regulations to reduce emissions. For example, the greatest CO2 reductions in Sweden happened when publicly owned district heat providers were forced to switch fuels.
Clean-energy regulations and investments work because they imply a very high "implicit carbon price" — the level at which carbon would have to be taxed to achieve the same effect. Those implicit prices are higher than any politically practicable explicit carbon tax.
This bothers economists, who believe that carbon prices should be uniform across the economy, but as Jaccard says, that's politically daft. If we can't get to the carbon price we need explicitly, why not do it implicitly, where we can? Voters certainly seem more amenable to it.
Of course regulations and investments can be done badly. There are plenty of risks involved in proactive government — regulatory capture, waste, extended partisan and internecine warfare, economic inefficiency. But as Jaccard says, there are better and worse regulations, better and worse investments. Economists could help with the task of making them better.
But in the end, these are just the risks of trying to do big things in a fractious democracy. No grand wonk scheme can wave them away. The only way past politics is through.
In practice, carbon pricing programs never devote all their revenue to a single purpose. Real-world programs involve some mix of clean-energy investments, protection for low-income households and trade-exposed businesses, tax reductions, and direct payments or dividends. Getting the mix right requires close attention to the political economy of particular jurisdictions.
For an example of how to thoughtfully determine the right mix, see this report from Canada's Ecofiscal Commission. It begins by acknowledging that each province will have its own needs and priorities, which will mean a different set of uses for carbon tax revenue:
This is the kind of close analysis that's required to get the mix of revenue uses right. But getting the mix right is what allows a carbon price to pass at all, remain politically secure, and rise over time. Revenue is not an afterthought; it's the key.
How to sell this thing
A final thought.
There's been an unspoken premise in the carbon pricing discussion: If carbon pricing is the best policy, then it ought to be the headline policy. The approach to the public ought to go like this:
First: We want to raise taxes, more and more every year, indefinitely.
Then: But wait, here's why you shouldn't oppose this tax like you reflexively oppose most taxes.
This kind of political kamikaze run might be justified if the tax were the overwhelmingly most important element of the policy package. But remember, carbon prices are likely to begin at relatively low levels, well short of the SCC. At those low levels, they will have mostly marginal background effects.
In the early years, the programs and investments funded by the revenue will be more visible and salient to voters. And as a bonus, most uses of the revenue are more politically popular than a tax.
Which leads to a question: Why lead with the tax? Why not lead with the popular stuff? An approach more like this:
First: We want to accelerate the technological development, early market commercialization, and wide deployment of clean, renewable energy, so that America can innovate, create jobs in some of the 21st century's most promising industries, and spur economic development. We'll also set aside some money to make sure no one is left behind or left out of the new energy economy.
Then: Oh, and guess what: It's paid for, entirely funded by a tax on fossil fuel energy.
That's still a tough case to make, particularly in a time of political polarization and budgetary austerity. But it's easer than leading with a regressive tax.
And it taps into a belief in the power of active government that is more in line with where young progressives are headed these days. It's not punitive, eat-your-vegetables sacrifice. It's optimistic, ambitious, and forward-looking, a bet that we can still do big things together — not just wait for markets to do them for us.