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Commentary Climate Change

Leading Economists Offer 5 Carbon Tax Recommendations: 3 1/2 are Basic Principles of Economics

A group of 45 economists released a statement declaring the need for immediate national action on climate change. The statement endorses a “carbon dividends” policy, which is a price on carbon dioxide emissions with all revenues returned to Americans in the form of equal rebates. This commentary describes the support in the economic literature (or lack thereof) for the five policy recommendations contained in the statement.      

Each of the signatories is (or was) a Nobel Laureate, a Federal Reserve Chair, a Chairman of the Council of Economic Advisors, or a U.S Treasury Security. They span a wide range of ideologies, political affiliations, and academic specialties. Given that it is notoriously difficult to find consensus among economists, their willingness to lend public support to a large and specific policy change reinforces the truly remarkable nature of this document.

Three of the recommendations are principles firmly grounded in economic literature. One of the recommendations is a more subjective policy judgment informed by economic analysis. One is a combination of economic principle and policy judgment.     

The purpose of categorizing the recommendations in this way is to highlight the issues on which these economists are uniquely qualified to weigh in. Indeed, there is little to no disagreement among economists about the 3 1/2 recommendations that reflect basic principles of economics applied to climate policy.      

Pointing out that some of the recommendations are subjective policy judgments is not intended as a criticism of the economists or the judgments. In fact, given that each of these economists held a senior position in the U.S. government, they are very well qualified to make subjective policy judgments based on economic analysis. Nevertheless, on these recommendations, expert (economists and otherwise) opinions differ.

The five recommendations in the letter are as follows:

A carbon tax offers the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary. By correcting a well- known market failure, a carbon tax will send a powerful price signal that harnesses the invisible hand of the marketplace to steer economic actors towards a low-carbon future.

This is an economic principle. A carbon tax is a cost-effective way to reduce emissions because it encourages low-cost emissions reductions and low-carbon innovation across the economy.

The statement refers to a “powerful price signal,” which is contingent on the details of the carbon tax policy. Studies released by the Columbia University Center on Global Energy Policy (CGEP) and our partners have shown that a federal economy-wide carbon tax could lead to a dramatic reduction in U.S. emissions. For example, a carbon tax starting at $50 per ton in 2020 and increasing at 2 percent per year could reduce emissions to 39 to 46 percent below 2005 levels by 2030, which would put the US on a pace to exceed its emissions commitments under the Paris agreement.

A carbon tax should increase every year until emissions reductions goals are met and be revenue neutral to avoid debates over the size of government. A consistently rising carbon price will encourage technological innovation and large-scale infrastructure development. It will also accelerate the diffusion of carbon-efficient goods and services.

This is partially an economic principle, partially a policy judgment. Economic studies provide various reasons to support a trajectory of carbon tax rates that steadily increases over time. One example: an increasing carbon tax enables the combination of a high long-term price signal to drive investments with a relatively low near-term price to avoid economic disruption.   

Interestingly, this recommendation implies that the objective of the carbon tax policy should be “emissions reductions goals.” This is a notable sea change because economists have traditionally supported a carbon tax set at a rate that balances the costs of emissions reductions and the benefits of avoided climate damages (at the “social cost of carbon”). Setting carbon tax rates to achieve an emissions target has various advantages over an SCC-based approach that I describe in this CGEP commentary.  

Also included is a recommendation for a carbon tax that is revenue neutral, meaning it does not increase government spending. As an alternative, under a “revenue positive” policy, carbon tax revenues could be used for priorities like transportation infrastructure or economic development in transitioning fossil fuel communities. Assuming these are not wasteful investments, the economic literature provides little evidence to suggest whether some portion of the carbon tax revenue should be used for productive government spending. After all, the “optimal” use of carbon tax revenue is similar to the optimal use of any other government revenue, a topic on which economists do not agree. The endorsement of revenue neutrality in this recommendation reflects an explicit attempt to avoid this unresolvable argument over the optimal size of government.

A sufficiently robust and gradually rising carbon tax will replace the need for various carbon regulations that are less efficient. Substituting a price signal for cumbersome regulations will promote economic growth and provide the regulatory certainty companies need for long-term investment in clean-energy alternatives.

This is an economic principle. While reasonable people can argue over whether regulations are “cumbersome,” there is little doubt that a sufficiently robust carbon tax would make certain regulations fully or partially redundant. For example, regulations of power plants under the existing Clean Air Act authority may reduce the flexibility of the response to the carbon tax (and thus its cost-effectiveness) without providing any additional emissions reductions.     

Many other regulations are well-suited to exist alongside a carbon tax, and Recommendation #3 appropriately does not suggest that most or all regulations should be changed or eliminated.   

To prevent carbon leakage and to protect U.S. competitiveness, a border carbon adjustment system should be established. This system would enhance the competitiveness of American firms that are more energy- efficient than their global competitors. It would also create an incentive for other nations to adopt similar carbon pricing.

This is an economic principle. A carbon tax could put manufacturers of carbon-intensive products at a disadvantage compared to competitors in countries without a comparably stringent policy. Some manufacturers could respond to the carbon tax by moving their operations overseas, negating the benefits of domestic emissions reductions.

An ideal solution to these adverse impacts is a border carbon adjustment (BCA) that requires importers of carbon-intensive goods to pay a tax and provides a rebate to exporters of the same products. To the extent that the BCA is designed to apply only to countries without comparably stringent climate policies, it can serve as an incentive for countries to adopt climate policies to avoid the tax on its exports to the United States.

To maximize the fairness and political viability of a rising carbon tax, all the revenue should be returned directly to U.S. citizens through equal lump-sum rebates. The majority of American families, including the most vulnerable, will benefit financially by receiving more in “carbon dividends” than they pay in increased energy prices.

This is a policy judgment. The recommendation to use all carbon tax revenues for lump-sum rebates is a judgment grounded in concerns over the fairness and popularity of a carbon tax. Economic studies show that the majority of households would receive more in rebates than they pay in additional taxes, including low-income households. The rebate checks could create an important constituency of support for the policy while offsetting adverse effects of energy price increases on vulnerable households.  

However, using all carbon tax revenues for rebates sacrifice opportunities to use revenues in ways that can produce better macroeconomic outcomes or government services. Other experts (economists and otherwise) therefore prefer revenue uses aside from lump-sum rebates. For example, many economists support using the revenue to reduce other taxes, because economic studies almost universally show that the overall economy fares better when revenues are used to lower other distortionary taxes compared to using revenues for rebates. It is notable that in the judgment of this group of economists, the fairness and political benefits of a lump-sum rebate approach outweighs the potential benefits of other revenue uses.

One final note: the five recommendations in this statement do not comprise a comprehensive policy. Arguably the two most consequential decisions policymakers need to make when designing a carbon tax are missing from this statement – the annual tax rates and specific decisions about which other policies to add, change or eliminate upon the implementation of a carbon tax. Columbia University’s Center on Global Energy Policy will be releasing reports on both of these topics later this year.



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Commentary Climate Change

Leading Economists Offer 5 Carbon Tax Recommendations: 3 1/2 are Basic Principles of Economics