A Question of Balance: Finding the Optimal Carbon Tax Rate

Guest Post by James Handley

Economists are virtually unanimous: Raising the price to emit carbon is essential for reducing greenhouse gas emissions and staving off climate disaster. But how high should that price be set? And how steep a trajectory should be chosen to get there? Here, we look at what several leading economists have said about carbon tax rates, as well as their preferences for the use of carbon tax revenues.

One of the most forceful and respected advocates of carbon taxation is Yale economist William Nordhaus. In his new book, A Question of Balance, Weighing the Options on Global Warming Policies, Nordhaus employs a complex model of the U.S. economy to determine the "optimal" carbon tax rate – the rate that would cost the economy no more in reduced productivity than the climate damage it would prevent. He writes:

According to our estimates, efficient emissions reductions follow a "policy ramp" [with] modest rates of emissions reductions in the near term, followed by sharp reductions in the medium and long terms. Our estimate of the optimal emissions-reduction rate for CO2 relative to the baseline is 15 percent in the first policy period, increasing to 25 percent by 2050 and 45 percent by 2100. This path reduces CO2 concentrations, and the increase in global mean temperature relative to 1900 is reduced to 2.6°C for 2100 and 3.4°C for 2200." (p. 14)

Nordhaus assumes that, at least in the near term, Earth’s climate system will respond predictably to rising levels of greenhouse gases. He thus distances himself from the more aggressive stance of Al Gore and Sir Nicholas Stern who advocate steeper carbon pricing policies to avoid triggering irreversible "tipping points" in the climate system. Nordhaus also assumes a far higher "discount rate" than Stern, which leads to greater emphasis on present costs than distant benefits. With these assumptions, Nordhaus concludes that a carbon tax starting at $7.40/ton of CO2 is optimal, so long as it increases by 2-3% a year in real terms (after inflation) until 2050, with steeper increases after that.

Nordhaus suggests revenues "be used to soften the economic impacts on lower-income households, to fund necessary research on low-carbon energy, and to help poor countries move away from high-carbon fuels." (p. 24) He calls internationally "harmonized" carbon prices the most efficient way to induce emissions reductions worldwide.

Another forceful advocate of carbon taxes is Gilbert Metcalf of Tufts University. In his paper, A Green Employment Tax Swap: Using A Carbon Tax to Finance Payroll Tax Relief, published jointly by the Brookings Institution and the World Resources Institute, Metcalf recommends a carbon tax just under $17/ton of CO2. This would nearly double coal’s price, reducing its use by 32%, while petroleum products would increase in price by nearly 13% and natural gas by just under 7%. Metcalf also advocates dedicating carbon tax revenues to eliminate the payroll tax on the first $3,660 earned by each worker. He calculates that this equates to an average 11% reduction in payroll taxes, with greater percentage reductions for the lowest-paid workers.

Metcalf’s rationale for reducing payroll taxes is simple:

"In general, taxes on labor supply discourage labor and create economic losses to workers over and above any taxes collected. Workers forego opportunities to work longer hours or engage in training that increases their productivity and wages. Moreover, workers may choose not to enter the labor force in response to taxes on wage income. Tax reductions can encourage additional labor supply either on the intensive margin (hours worked) or the extensive margin (the decision to enter the labor force). The Green Employment Tax Swap encourages additional labor supply on the extensive margin." (p. 2)

Greg Mankiw, Harvard economist and former economic advisor to President Bush, has written in the New York Times in support of Metcalf’s proposal.

A third prominent carbon tax advocate is Robert Shapiro, former undersecretary of Commerce in the Clinton Administration and now head of SonEcon a Washington, DC consulting firm, and co-chair of the U.S. Climate Task Force. In his recent report, Addressing Climate Change Without Impairing the U.S. Economy, Shapiro begins with the science:

"…a range of scientific studies has concluded that the world’s current climatic conditions can be sustained if atmospheric CO2 concentrations do not exceed a general range of 450 to 550 ppm over the long term. Stabilizing carbon dioxide concentrations at those levels will require sharp reductions in net global emissions of CO2 for the next several decades." (p. 2)

Shapiro’s optimal carbon tax would

reduce carbon emissions at the rate and levels required to move to a path that will stabilize future atmospheric concentrations of CO2, so they do not produce destructive climatic changes, and in ways that impose the least marginal social and economic costs. Because climate science is still developing, scientists cannot say with certainty what the marginal cost of CO2 emissions is today, and consequently at what precise point a carbon-based tax — or the cap in a cap-and-trade program — would achieve this goal.

Shapiro continues:

One of the most comprehensive surveys of these issues, conducted by a leading European expert, Dr. Richard S.J. Tol, assessed 103 published estimates of the marginal costs of CO2, including 43 studies published in peer-reviewed journals. Among these more rigorous analyses, the average or mean value of this measure was $50 per metric ton of carbon or $13.64 per metric ton of CO2." (p.15)

Shapiro accepts this figure and uses the U.S. Energy Department’s NEMS model to predict the effects of gradually increasing to that carbon tax level. He concludes:

… Americans’ use of the least carbon-intensive forms of energy, renewable fuels, would rise sharply (up 220 percent by 2030) while the use of coal, the most carbon intensive fuel, would fall correspondingly (down 54 percent by 2030). Much of this shift would occur in the fuels used to produce electrical power. By 2030, these shifts would drive down U.S. annual CO2 emissions by about 30 percent, compared to what they would be without a climate change program, or about 6 percent less than current emissions." (p. 18)

Shapiro recommends recycling 90% of the carbon tax revenue, with the balance dedicated to research and development of low-carbon energy:

This policy then would return to workers, businesses or households nearly $3.6 trillion of the $4 trillion collected by the tax. These recycled revenues would be sufficient to reduce, on average, the annual payroll tax rate for workers and businesses by two percentage points, or exempt from payroll tax the first $10,066 in a worker’s earnings (or exempt the first $5,033 from the payroll taxes paid by both workers and their employers), or provide every working person a rebate payment of $1,080 each. [Alternatively,] these revenues also could be returned as flat payments to every household averaging $1,275 per year, per household, from 2010 to 2030. These payments would more than offset the direct tax related costs for the majority of American households, since the $1,563 in direct costs applies to the "average-income" household. (p. 21)

The Carbon Tax Center advocates establishing a $10/ton CO2 tax and increasing it at that rate each year for at least a decade. Using a simple but transparent model, CTC estimates that this more aggressive approach would reduce U.S. CO2 emissions relative to their expected growth curve by a third, if ramped up for 10 years and then held constant, and by almost half if the incrementing is extended over a second decade. This would put the U.S. on a trajectory to meet the recommendations of the Fourth Assessment by the Intergovernmental Panel on Climate Change to reduce emissions by 80% from projected "business as usual" levels by 2050.  As for use of carbon tax revenues, CTC is agnostic between tax-shifting and pro-rata "dividends," provided the tax is kept revenue-neutral.

The table below summarizes the four sets of carbon tax recommendations:

Source	Initial tax, $/tonCO2	Annual Tax Increment	Tax Rate in 10 yrs	Tax Rate in 20 yrs	Revenue treatment
Nordhaus	$7.40	2 – 3%	$9 – 11	$11-13	offsets for poor, low-carbon energy R&D, assistance for LDCs
Metcalf	$16.60	0	$16.6	16.6	payroll tax shift
Shapiro	$15	$2	$35	$55	payroll tax shift
Carbon Tax Center	$10	$10	$100	$100-200	payroll tax shift/dividend

All four sources propose starting with modest carbon taxes. CTC recommends predictable, step-wise increases to create clear expectations, while two others recommend gradual increases but concede that adjustments in carbon tax rates may be needed to meet emissions targets.

Two recommend that a fraction of carbon tax revenue be devoted to research and development of low-carbon energy. All recommend "recycling" most or all carbon tax revenue over targeted subsidies to energy industries, because price signals would more effectively spur individuals and firms to develop and implement conservation and alternative energy technologies. "Revenue recycling" would improve the overall efficiency of the economy and provide stimulus that could more than offset income effects of a carbon tax on middle- and low-income families, always a salient point but particularly now, as a deep recession looms.