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The debate is heating up: Impose a nationwide carbon tax or implement a cap-and-trade system to curb carbon dioxide emissions?
Reforming America’s energy policies has become a major concern for businesses and the public alike. With economic and environmental factors at play, finding a comprehensive strategy may seem like a daunting task. Currently, the two prevailing options are either a cap-and-trade system, such as the one currently favored by the European Union, or a carbon emissions tax. Both raise the price for carbon and provide economic incentives to lower emission rates, but supporters of each policy seem deadlocked by opposing arguments.
Unraveling the debate may be more important than ever before, as United States energy policy approaches a critical fork in the road.
The cap-and-trade strategy is considered a more market-driven approach to handling America’s carbon dioxide output. As the Environmental Protection Agency (EPA) explains, under this system the government sets an overall emissions cap while creating allowances that enable businesses to emit a given amount. The allowances can be traded, so companies that reduce their emissions can sell surplus allowances to those who would have to pay to comply. In theory, this method allows companies to achieve their maximum allowable output at the lowest cost.
This approach has gained support in Congress and from the Obama administration, with cap-and-trade provisions appearing in the latest federal budget proposal.
Under President Barack Obama’s 2010 budget plan, the government would auction off all emission credits, generating as much as $650 billion in cumulative government revenue between 2012 and 2020, both the New York Times and the Wall Street Journal report (subscription required). The government would then allocate $65 billion from the auction revenue for emission credits toward middle-income tax cuts, as well as $15 billion in funding for “clean air” technologies.
The value of these allowances has spawned further debate over the percentage that should be auctioned and the best distribution policy for auction revenues.
Supporters of the cap-and-trade system, such as Carter Bales and Richard Duke at McKinsey & Company, claim it 1) provides greater investor certainty by enabling businesses to estimate allowance prices needed for their work, 2) offers greater environmental benefits by placing a fixed cap on emissions and 3) may create a “useful economic shock absorber” because carbon allowance prices could be adjusted according to changing economic conditions.
But will an emissions cap hinder U.S. businesses in competing in the global marketplace? In the Bulletin of the Atomic Scientists, Gernot Wagner and Nathaniel Keohane argue that a cap-and-trade system “could promote broad international participation.”
Developing countries would most likely become sellers in a global carbon allowances market and could expect to earn substantial profits. “Meanwhile, because advanced economies such as the United States and European Union can set the terms of access to their own markets, they would have considerable leverage to persuade those other countries to take on binding emissions targets,” Wagner and Keohane note.
Similarly, the Environmental Defense Fund (EDF) emphasizes the positive effects of linking environmental controls with market forces because “this system creates tangible financial rewards for environmental performance.” The EDF claims that turning pollution reduction into marketable assets will also encourage technological and process innovations, citing the success of the acid rain cap-and-trade program of the 1990s to support the new policy.
However, the acid rain cap-and-trade program of the Clean Air Act of the ’90s functioned on a much smaller scale than would a nationwide carbon dioxide cap, so its success may not be indicative of the newly proposed policy.
Some critics of cap and trade believe it will have negative consequences for consumers by creating a commodity out of the right to emit carbon dioxide. “Putting a price on carbon is regressive by definition because poor and middle-income households spend more of their paychecks on things like gas to drive to work, groceries or home heating,” a Wall Street Journal op-ed claims (subscription required).
The Wall Street Journal piece estimates that the price increases from a carbon cap would cost roughly 3.3 percent of after-tax earnings for lower-income families and 2.7 percent to 2.9 percent for middle-income households. In addition, reductions in employment and output could result in “corporate welfare for carbon-heavy businesses.”
The creation of a global carbon allowances market may also produce financial speculation. A carbon tax, by contrast, is a less complex option that involves having carbon dioxide emitters pay a tax for every ton of pollution they produce. The revenue could be used to reduce payroll taxes or lower other tax rates.
According to Gregg Easterbrook at McKinsey’s The Debate Zone: Carbon Tax v. Cap and Trade, “If carbon is taxed, individuals not government will make the decisions about greenhouse-gas reduction strategies. Individuals have a much better track record at economic decision-making than government does.”
Proponents of the carbon tax argue it offers a direct profit incentive for the development of emission-reduction technology and encourages scaling back carbon pollution. Part of this is due to the system’s reliance on only two elements, direct participants and the Internal Revenue Service (IRS), rather than abstract market forces, traders and external regulatory agencies.
“The taxpayers may pass the cost of the tax on down the chain of purchasers, and the behavioral effect of the tax will depend on how the price signals influence decisions by the taxpayers and subsequent purchasers, but the mechanism itself is implemented directly just between taxpayers and the IRS,” says Janet Milne in the Bulletin of the Atomic Scientists.
Concerns remain about whether a carbon tax would actually reduce emissions or if companies would simply pay the tax and continue to produce the same amount of carbon dioxide. However, as Gregg Easterbrook notes, “[t]his is possible, but unlikely: experience shows that individuals and firms change behavior to reduce taxation.”
According to carbon tax proponent the Carbon Tax Center, a first-year tax rate of $15 per ton of carbon dioxide coupled with incremental rate increases of $10 per ton each year would lower emissions to 25 percent below 2005 levels by 2022. These figures reflect a new carbon tax bill recently introduced to Congress.
However, many people have voiced serious doubts about the feasibility of a carbon tax program. “If you were a pure economist, the most logical thing is taxation. It is the simplest. But ‘taxation’ is a word that makes people choke in normal times. And these are not normal times,” the director of the United Nations’ climate change program recently told the New York Times.
In addition to the widespread reluctance for additional taxation (in the midst of a recession, no less), critics argue that a carbon tax would not foster international participation due to the difficulty of coordinating global taxation efforts. For a carbon tax to work, Wagner and Keohane argue, “it would be necessary to achieve a harmonized tax structure across countries.”
Of the two strategies, cap and trade has greater backing in Washington, while the carbon tax garners most of its support from economists and academics.
The debate boils down to a preference for a market-driven solution emphasizing self-interest via cap and trade, or a direct incentive system that guards against financial manipulation through a carbon tax. Although some argue that both options represent impractical measures, the time has come for choosing between one or the other, as picking neither is no longer on the nation’s agenda.
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