The Magazine

The Exploding Carbon Tax

The costs imposed by the cap and trade system are equivalent to raising a family of four's income tax by 50 percent.

Jun 22, 2009, Vol. 14, No. 38 • By MARTIN FELDSTEIN
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The cap and trade legislation supported by the Obama administration is a stealth strategy for a massive long-term tax increase. It is a large tax on all American households, and the tax burden rises in future years without any need for further legislation. It will evolve into an enormous new source of tax revenue for the government.

A cap and trade system is supposed to reduce carbon dioxide (CO2) emissions by raising the price of CO2-intensive goods and services like gasoline, electricity, and a wide range of industrial products. This, in theory, will induce consumers to shift their spending to services and products that involve lower levels of CO2 emissions. It achieves these price increases by requiring firms that create CO2 in their production process, or sell goods like gasoline that create CO2 when used, to have a permit per ton of CO2 emission.

The Congressional Budget Office estimates that reducing the level of CO2 to 15 percent less than the total level of U.S. emissions in 2005 would require permit prices that would increase the cost of living of a typical household by $1,600 a year. To put that $1,600 carbon tax in perspective, a typical family of four with earnings of $50,000 now pays an income tax of about $3,000. The tax imposed by the cap and trade system is therefore equivalent to raising the family's income tax by about 50 percent. (Some advocates of a cap and trade program argue that the cost to households could be much less than $1,600 if the government uses the tax revenue to finance transfers to low income households and tax cuts to others, but since there is no way to know how the future revenue would actually be used, the only number we have to consider is the $1,600 direct increase in the burden on households.)

The Waxman-Markey bill that recently passed the House Energy and Commerce Committee would cause an even greater initial rise in the cost of living by its requirement to cut CO2 emissions to 17 percent less than the 2005 level of emissions rather than the 15 percent reduction assumed in the CBO estimates. (European officials are, moreover, calling for the United States to agree to a much bigger initial cut--20 percent less than the U.S. emission level in 1990.)

As the legislated CO2 reduction increases automatically after 2020, the price of the permits would rise to further limit consumers' demand for CO2-intensive goods and services. The Waxman-Markey legislation requires the CO2 level in 2050 to be an amazing 83 percent less than it was in 2005, and a study by the EPA estimates that the price of the permit would rise from about $20 a ton in 2020 to more than $75 a ton in 2050. The higher permit costs would be reflected in the prices that households would pay for CO2-intensive goods and services.

Rises in the cost of living would be greater for households that use more energy and CO2-intensive goods and services. The implied rate of the cap and trade carbon tax would therefore rise with income. In that way it would act like an income tax--reducing the reward for additional effort by putting a tax wedge between the individuals' additional work effort and the resulting increase in their standard of living. But while it would collect more tax from higher income households, the cap and trade tax would be a relatively heavier burden on lower-income and middle-income households. The Congressional Budget Office estimates that spending on "carbon based energy" is 21.4 percent of income among households in the lowest income quintile but only 4.1 percent of income in the highest income quintile.

Although the cap and trade plan that President Obama proposed during the campaign called for auctioning all of the CO2 permits, members of Congress in heavily industrialized states and in states that use coal to generate electricity refused to support the plan unless the auction process was eliminated. To get their support, Waxman and Markey agreed to a fundamental change in the structure of the program. Instead of auctioning the permits, about 85 percent of them would initially be given away to a variety of firms. (Since a firm that had excess permits would be able to sell them to other firms, the price of the permit would still be determined by what firms were willing to pay for excess permits, just as it would be in an auction system.) Electricity distributors would get the largest amount--more than 30 percent of the total permits. If electricity regulators required these distributors to pass along the benefit of the free permits to consumers in the form of lower electricity prices, this source of CO2 would not be reduced. That would require raising the cost of other CO2-intensive products to achieve the required overall reduction in CO2.