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 proposed cap and trade plan also provides an escape hatch for firms that emit CO2. Instead of reducing their own emissions or buying permits at auction or from other firms, they could pay others to take actions that reduce global CO2 emission. They could, for example, pay for the planting of trees to absorb CO2 emissions from the atmosphere or pay firms in other countries that are not covered by CO2 caps to reduce their CO2 emissions. The Financial Times estimates that the regulated European market for such carbon offset credits will increase to more than $60 billion next year. Such offset activities are obviously difficult to monitor. It is even more difficult to judge the extent to which these extra CO2 reductions would have occurred without the financial inducements.

The Waxman-Markey legislation provides that the annual giveaway of permits would eventually phase down so that more than half of all permits would be auctioned after 2050. This would create a massive rise in tax revenue that could finance new government spending without the need for any new tax legislation. The Hamilton Project at the Brookings Institution estimates that just stabilizing CO2 emissions at the current level could produce revenue of more than $470 billion a year (in today's prices) by 2050. They estimate it would be a 9 percent increase in total non-CO2 federal tax revenue, an amount equivalent to $200 billion a year in today's economy.

The rise in the prices of U.S. goods would make them less competitive. American firms would suffer in export markets and domestically in competition with goods imported from countries that do not impose such a high implicit tax on CO2 emissions. There would no doubt be pressure to impose tariffs on imports from other countries that have lower carbon costs. This might be welcomed by the unions that now seek to use foreign labor practices as an excuse for tariffs on imports, but countervailing tariffs based on carbon content would hurt American consumers and threaten our global trading system.

And, despite the high cost to American households and the economy, the proposed cap and trade plan would do little to deal with concerns about global warming. Although there is a broad scientific consensus that the increasing level of total global CO2 emissions is raising temperatures, which could have significant adverse long-term effects, the potential U.S. reduction of CO2 would not be enough to prevent those adverse effects unless China, India, and other rapidly industrializing countries also agreed to major reductions in their CO2 emissions.

The proponents of enacting a U.S. cap and trade program at the present time "to show U.S. leadership" so that other countries will follow are naïve to think that China and India will agree to major CO2 reductions without financial inducements. The Chinese and Indians have stressed their opposition to any major reduction in their CO2 emissions and have given no indication that their position would change if we enacted limits on our CO2 emissions. It would be a big mistake to enact legislation before the international meeting in Copenhagen in December where these issues can be discussed and a negotiation could begin.

The initial shift from an auction process to giving away permits is just one of many departures the Waxman-Markey bill makes from the type of pure cap and trade system that appeals to many economists. They favor cap and trade over administrative regulations like automobile mileage standards and smokestack scrubber requirements because the uniform price of permits allows every amount of CO2 reduction to be achieved at the least cost to the economy. The 900-page Waxman-Markey bill imposes a wide array of costly administrative regulations that should be unnecessary if CO2 is limited by a cap and trade plan. Fifteen percent of electricity must be produced with renewable technologies, including wind, solar, and biofuels. Household appliances must meet various efficiency standards. The Obama administration has added a 39-mile-per-gallon fleet efficiency standard for new automobiles. To the extent that these rules restrict behavior, the result will be a more expensive way of reducing CO2 than a pure cap and trade arrangement.