Can a carbon tax replace the Green New Deal?

The idea of a carbon tax appears to be gaining traction in the US, in the form of a “tax-and-dividend” scheme from the Climate Leadership Council. Last week, the Financial Times reported that the proposal – in which tax revenue is recycled to households – has support from Wall Street and bipartisan support in the US Congress. In part, FT writes, that’s because the Council is “deliberately presenting these ideas as an antidote to the left’s Green New Deal ideas, using Trump-friendly rhetoric.”

But can it truly replace a Green New Deal?

A carbon tax would undoubtedly be a step forward. But the Climate Leadership Council contends that it is the solution. To get companies to agree to the tax, other kinds of regulation would be taken off the table. The council argues that those other regulations will be unnecessary, because they will duplicate what the tax will already be doing.

While that may be true to a certain extent, it is at least questionable. More to the point, very little in the Green New Deal resolution is about regulation. Quite a lot is about how to expand the range of low-carbon technologies available, and the bulk of the resolution is about fairness. In this aspect, the council’s proposal falls well short of what the Green New Deal is trying to achieve. To understand why, we need to talk about carbon taxes.

What does a carbon tax do?

By definition, businesses make profits by setting prices higher than costs. Most businesses continually work both the revenue and cost side of that equation, raising prices when they can and lowering costs when they can. The result, as I have argued in a pair of papers (one covering the general case and one focusing on energy) is that different categories of costs – labor, energy, etc. – tend to settle at fixed shares of a business’ total costs over time.

Let’s apply this concept to carbon dioxide emissions. A business emits carbon dioxide directly through its vehicle fleet, running engines, using blast furnaces, and so on. It also has indirect “embedded” emissions in the goods and services it buys from other businesses. A business’s carbon-intensive activities already cost them some money, and adding a carbon tax would increase those costs. The business would thus work to eliminate that extra cost, by reducing the carbon intensity of its activities. Their ability to do so is constrained by the available technology, which is why the Green New Deal resolution pays so much attention to R&D.

How fast could emissions fall? Well, to keep the cost share constant, carbon emissions intensity –emissions per unit of output – should fall at the rate that the price is rising. However, that does not mean that carbon emissions themselves will fall. If the economy grows faster than intensity falls, then carbon emissions will rise. So, when the constant-cost-share rule applies, the speed of reduction is roughly equal to the rate of increase in the price minus the growth rate of the economy.

The Climate Leadership Council proposes that the carbon tax should rise at 5% per year, after correcting for inflation. That isn’t the same as the rise in the cost to business – more on that below – but let’s assume for the moment that it is close. If the economy is growing at, say, 2% per year on average over the next 15 years (close to the US average over the past 20 years after correcting for inflation), then between 2020 and 2035, total emissions will fall by roughly 36%. Emissions in the US were already declining, so that translates to a nearly 45% drop between 2005 and 2035, close to the 50% drop the council claims on its website. They point out that this far exceeds our Paris commitment, which is true, but they neglect to mention that it is quite a bit less ambitious than the Green New Deal.

Aside from the question of ambition, an important caveat applies to this scheme. Suppose the tax starts at $40 per ton. A barrel of oil, if completely burned, would release about 0.4 tons of carbon dioxide, so the tax on a barrel of oil would be about $16. Crude oil has been trading at close to $50 a barrel, so adding the tax would amount to a roughly 32% one-time increase. That’s quite a jump for the first year and would likely be challenging for some businesses. But after that initial jump, the growth in the price would be very slow under the council’s proposal. After 15 years of 5% annual growth, the tax on a barrel of oil will be $33. If crude oil is still $50 a barrel, then the growth in the price comes out to only 1.5% per year on average, which is actually slower than GDP growth! That is a very weak incentive for businesses to reduce fossil fuel consumption, and if the constant-cost-share rule applies, then emissions would actually rise under this plan.

While a well-designed carbon tax can be a useful tool in the policy toolkit, it is not clear to me that this is a well-designed price. Moreover, the claim that a carbon tax can replace direct regulation of carbon-intensive business activities needs careful scrutiny. But I’ll focus on a different problem with the plan that cuts to the heart of the Green New Deal – households do not behave like businesses.

Households are not businesses

The Climate Leadership Council’s website says that a carbon tax would send a “powerful price signal” to both businesses and consumers. That’s where the trouble starts. Households – where the consumers live – face very different constraints and have to make very different decisions from those of a business. Many costs in our society have a floor under them that it is nearly impossible to go below. The most challenging categories are housing and transportation.

For low and moderate income households, housing and transportation costs are unavoidable burdens. Household choices are largely dictated by where people are employed, and employment possibilities depend strongly on education – another expense with a high floor. These costs are such strong constraints that it can be a struggle to pay bills each month, and an unexpected cost, such as a medical emergency, can drive a family into debt or even put them out on the street.

What about the household dividend? If it is sent back to households, then it will help cover some of the rising costs from a carbon tax. But without supporting policies, the dividend income by itself might not be enough to pay for a new car. What is more, most low and moderate income households rent, and they are likely to keep paying high fuel bills because there is no incentive for them or their landlords to make energy-efficiency improvements. The dividend certainly helps, and should definitely be part of any carbon tax policy, but it cannot be assumed that the dividend alone would meet the needs of low and moderate income households or of other “frontline and vulnerable communities” listed in the Green New Deal resolution.

The resolution proposes to provide “all people of the United States with high-quality health care; affordable, safe, and adequate housing; economic security; and clean water, clean air, healthy and affordable food, and access to nature.” A carbon tax by itself, even with a dividend, is very unlikely to deliver on these goals.

So what is fair?

Businesses can handle changes to their costs. What they do not like is regulatory uncertainty. Asking for greater certainty is a reasonable request, as long as businesses see themselves as part of the effort to meet the climate challenge and are willing to share the effort fairly. While it is unlikely to fully replace direct regulation, and must drive actual business costs at a quick enough pace, a predictably rising carbon tax is a simple and reliable way to let businesses build climate mitigation into their everyday decision-making.

So far, so good. But the same logic does not apply to households. Many households cannot handle changes to their costs, which may already be very high compared to their income. A dividend scheme, while necessary, is far from adequate to ensure that low and moderate income households, in particular, won’t face additional hardship.

Addressing the climate challenge is daunting. But, whether through mitigation or adaptation, we must face it, and we must all play a part. Sharing the effort in a way that seems fair to all will take dialogue, serious compromise, creativity, and mutual respect. No single policy instrument will magically deliver a fair solution.

So let us welcome the willingness of Wall Street to support a carbon tax. It’s a step in the right direction. But let’s be clear: it’s not an “antidote” to the Green New Deal. It is one small policy tool in what must be a voluminous Green New Deal toolkit.