Carbon Taxes that Fund a Carbon Dividend

In early February, two widely respected former Reagan administration luminaries, George P. Shultz and James A. Baker III, provided Wall Street Journal readers with “A Conservative Answer to Climate Change.”^[1] They put forth a bewitching, but not necessarily persuasive, proposal for reversing more than 40 years of U.S. environmental policy. They want to scrap command-and-control regulation as applied to carbon emissions and replace it with a tax.

Schultz and Baker accept the notion of climate change and that something should be done about it. “The extent to which climate change is due to man-made causes can be questioned,” they write. “But the risks associated with future warming are so severe that they should be hedged.” Their proposal has three parts. The first, taken alone, is a really old idea: place a tax on U.S. firms that emit carbon dioxide when producing goods and services, and let the power of tax avoidance drive firms toward cost-effective pollution control. The carbon tax would replace the Environmental Protection Agency’s controversial Clean Power Plan, along with other complex, one-suit-fits-all engineering standards. Just that idea alone is enough to make the proposal worthy of debate.

But the second and most bewitching part of the proposal relates to what to do with the carbon tax revenues. Under the plan, the revenues collected from the tax will be returned quarterly to the American people, to each and everyone who has a Social Security number. How much? Shultz and Baker assume a $40 per ton tax, which, based on U.S. carbon dioxide emission estimates, would yield $2,000 per year for a family of four—surely enough to catch the attention of most Americans. The $40 tax is close to the Obama White House estimate of $37 as the social cost of carbon.^[2]

Arthur Cecil Pigou Rides Again

Placing a charge on emissions or other unwanted activity is called a Pigouvian Tax, named for Arthur Cecil Pigou, the Cambridge don who devised and first promoted the idea in 1920.^[3] Pigou had the idea that when, for example, a polluter’s emissions impose a cost to society and the polluter receives no bill for doing so, then that society gets too much of the polluter’s product, along with too much pollution. By setting a tax equal to the pollution’s social cost, the polluter reduces his unwanted action, and everyone is made better off. After describing a list of possibilities for reducing unwanted activities, Pigou wrote:

It is, however, possible for the State, if it so chooses, to remove the divergence in any field by “extraordinary encouragements” or “extraordinary restraints” upon investments in that field. The most obvious forms which these encouragements and restraints may assume are, of course, those of bounties and taxes.^[4]

The Shultz-Baker plan is not the first time that a national emission tax has been floated for the United States. President Nixon called for sulfur dioxide taxes, without success, and the Clinton administration pushed implementation of a national energy tax, an idea that went nowhere. But the logic underlying emission fees or taxes is compelling on purely theoretical grounds, especially when considered in an economics classroom. Put a price on something undesirable being done and less of that something will occur. Want less? Raise the price. As Shultz and Baker explained, a carbon tax is a cost-effective way to reduce emissions, and “unlike the current cumbersome regulatory approach, a levy on emissions would free companies to find the most efficient way to reduce their carbon footprint.”

Once away from the classroom, the trick, of course, is how to get a political body to set the right price at the outset and then, having done so, to make adjustments only when changes in fundamental conditions call for revisions. After all, politicians are prone to prefer more revenue to less, and American families would likewise prefer larger quarterly carbon dividend checks.^[5] Recognizing this, Shultz and Baker recommend that the initial tax rate be set for five years and that a “blue ribbon” committee then be convened to determine on the basis of scientific literature if the rate should be changed.

It was this very problem that caused Pigou to decide his plan could never work. Writing much later, after considering typical behavior of members of Parliament, Pigou wrote:

For we cannot expect that any public authority will attain, or even wholeheartedly seek that ideal (the optimal tax). Such authorities are liable alike to ignorance, to sectional pressure and to personal corruption by private interest. A loud-voice part of their constituents, if organized for votes, may easily outweigh the whole.^[6]

Let’s remember Pigou’s warning.

While never a part of U.S. environmental policy, carbon emission taxes have been implemented in some 40 countries that include Ireland, Australia, Chile, and Sweden.^[7] Other emission fees have been used for decades by river basin authorities to manage water quality in France and in parts of Germany for more than a hundred years. Let’s face it: pollution taxation can work. Raise the price, pollution goes down.

So far so good…maybe. But the plan has a third pillar to consider, and this one gets a bit complicated and troublesome. Along with fees and dividends, the proposed solution calls for special treatment of exports and imports. The proposal goes like this: When American emission-fee-paying firms ship goods to countries that have no carbon tax, the firms would receive a rebate for the emission fees paid on those goods. This would keep U.S. producers competitive, but on the other hand, it appears that U.S. production of goods shipped across borders is not as climate sensitive as otherwise. All else equal, the quarterly dividend check received by American families could fall when exports rise.

When producers from other countries—who have paid no emission taxes—ship to us, they would pay the U.S. the appropriate amount of emission fees on the carbon content of their shipments. Of course, the consumer prices of those goods would tend to rise by the amount of the fee, but those fee revenues would also be returned to citizens as part of the quarterly carbon dividend. This sounds like a rebated border tax, doesn’t it? The larger the flow of imports relative to exports, the larger the quarterly dividend. The general public, especially those who do not buy the affected goods in question, might say “Hooray for imports”! However, consumers of the higher-priced imported goods would not celebrate as much. There are some winners and losers, aren’t there?

Will this Proposal Walk the Walk in Washington?

Now, let’s back away a bit and consider the political economy of the proposal. Will this beast walk in Washington? And is it, on balance, a move in the right direction?

Here, I make a broad political feasibility evaluation by considering the proposal’s Bootlegger/Baptist appeal.^[8] Remember, a strong coalition of bootlegger and Baptist interest groups is a sure sign that a proposed law or regulation might pass muster. After all, politicians who step out to support the carbon tax proposal must be able to appeal to the public interest and more specifically to high human motivation. To the extent that environmental organizations accept the logic that higher fees on carbon will reduce carbon emissions, they may play the Baptist role and join the politicians who march in favor of the fee. These environmental Baptists, however, may not be rock solid in their support. Some may tarry for a while with command-and-control regulation, the regime they have fought for and supported for decades. Maybe some will prefer the certainty of the status quo to the uncertainty of a new carbon fee regime.

What about other Baptists? We might think of that wonderful mass of unorganized American carbon-dividend lovers as Baptists, too. The idea of lower income families receiving $2,000 annually in carbon emission money should appeal to those who worry about families who have not seen a raise in pay in a decade. In fact, Shultz and Baker indicate that a U.S. Treasury study shows that 70 percent of American families would receive an income boost from the dividend, after taking their consumption of higher priced goods into account. Describing the beneficiaries of a program that works against climate change could give politicians even more to talk about.

Are there other possible bootleggers who might quietly lend support? Perhaps large industrial exporters who like the rebate they receive for fees they pay, something their domestic non-exporters do not get, would qualify. Broader bootlegger support could come from industries that face costly technology-based, command-and-control regulation under current carbon control schemes.

At first blush, It appears a shaky Bootlegger/Baptist parade could form. But before hiring the band and drum majors, we must ask about the bootleggers who long ago supported command-and-control regulation because of the differential standards it contained for new versus old sources of pollution. The regulation Shultz and Baker want to replace is exactly the stuff that cartelized existing industries and enabled them to command higher prices and profits due to blocked or delayed competitive entry. Will they suffer in silence? I am not sure.

We Should Support a Vigorous Debate of the Plan

Although there are unanswered questions about how the carbon tax proposal would actually work and whether or not special interest group politics would poison it, we should still support debate that may ensue regarding the Shultz-Baker plan. We should compare a system of flexible, market-friendly emission fees with more rigid and costly command-and-control regulation that was designed for the 1970s smokestack economy. If we are serious about reducing carbon emissions, then a system of emission fees determined by sensors, managed by smart computers, and refunded to the American people seems to be more compatible with America’s high-technology advanced-manufacturing economy than our more ancient one-suit-fits-all pollution control system. And if the fee approach can work for carbon dioxide, why not use it for other emissions?

But before getting carried away with the Shultz-Baker emission fee-based climate change proposal, let’s remember that it is possible that our politicians might just be so persuaded by the logic of the argument that they would place a system of emission fees on top of the current command-and-control regulation and use the resulting revenues to fund additional federal programs.

It is critically important to remember A.C. Pigou’s warning.