**Tax Reform and the Environment:**

*Paying for Fundamental Tax Reform*

Prof. Gilbert E. Metcalf

Department of Economics

Tufts University

Medford, MA 02155

\(617\) 627-3685

gilbert.metcalf@tufts.edu

June 6, 2005

*Executive Summary*

I would like to encourage the President\'s Advisory Panel on Federal Tax
Reform to consider the use of environmental taxes in general and a
carbon tax in particular as part of its mix of instruments to contribute
to an improved federal tax system.

-   A carbon tax beginning at \$15 per metric ton of carbon and
    gradually rising to roughly \$23 per metric ton over the next ten
    years would raise sufficient revenues to finance corporate tax
    integration.

-   Employing environmental taxes need not put the United States at a
    competitive disadvantage internationally. Currently the United
    States relies less on environmental taxes (3.3 percent of federal,
    state, and local tax revenues) than any other country in the OECD.

-   In addition to a carbon tax, the Panel should consider the
    possibility of a *permit emissions tax* to capture some of the rents
    accruing to electric utilities from the tradable permits under the
    1990 Clean Air Act Amendments\' SO~2~ trading program having been
    given away rather than sold.

**Tax Reform and the Environment**

With the exception of comments submitted by Duke Energy, it appears that
no one has suggested how environmental taxes could help the Advisory
Panel achieve its goals of simplification and greater rationality in the
U.S. tax code. I have two points to make in these comments. First, the
United States lags behind most other developed countries in its use of
environmental taxes and charges as a component of its fiscal system.
Second, our failure to avail ourselves of environmental taxes and
charges means we are missing revenue opportunities which could help us
tackle important fiscal issues in our federal budget.

**Environmental Charges: an Underutilized Resource**

The first point to make is that the United States collects little in the
way of revenue from environmental charges (including taxes) and what
little we do collect is collected in an inefficient manner.[^1] Even if
we include taxes on motor fuels (which are -- strictly speaking -- not
an environmental tax), environmental tax collections are trivial in the
federal budget. Less than 4 percent of federal revenues came from excise
taxes in 2004 roughly two-thirds of which could loosely be described as
environmental in nature. How does the United States compare with other
developed nations? Considering environmental taxes at all levels
(federal, state, and local), environmental taxes in the United States
comprised 3.3 percent of total tax revenues in 2001.[^2] By contrast,
OECD countries as a whole collected 4.9 percent of taxes through
environmental taxes. Germany\'s environmental tax share, for example,
was 7.1 percent; the United Kingdom\'s was 7.5 percent; Denmark\'s was
10 percent. No country\'s environmental tax share in 2001 was lower than
the United States\' share.

In short, the United States is at the very bottom of the distribution in
terms of the fraction of government revenue collected through
environmental taxes and charges and an increase in our reliance on
environmental taxes should not put us at a competitive disadvantage
relative to our trading partners in the OECD. Let me next turn to how we
might use a green tax shift in the United States.

**Green Tax Shifts: Some Possibilities**

I\'d like to discuss three examples of green tax shifts to illustrate
how the Panel might use environmental tax revenues to help us achieve
important fiscal policy goals.

*1. Carbon tax to finance corporate tax integration*

A study that Kevin Hassett of the American Enterprise Institute and I
did a few years ago explored instituting a carbon tax to finance
corporate tax integration (Hassett and Metcalf (2001)). The idea of a
carbon tax combined with a reduction in existing taxes has been
extensively studied.[^3] The focus on a carbon tax is a natural one
given rising concerns about global warming. Emissions of carbon dioxide
(CO~2~) in 2002 totaled 1,581 million metric tons, according to the most
recent report on greenhouse gas emissions from the Energy Information
Administration (2004). A carbon tax is an obvious policy tool to help
reduce carbon emissions. The Congressional Budget Office estimates that
the ten year cost of reducing the double taxation of corporate income by
excluding dividends and capital gains from taxation at the personal
level is \$266 billion. Based on CBO estimates, I calculate that a
carbon tax starting at about \$15 per metric ton and gradually rising to
\$23 per ton over a ten year period could finance this reform. The
research that Hassett and I did indicates that such a reform would have
little impact on the equity values of the affected industries and could
in fact lead to increases in equity valuations for many industries.

*2. Environmental taxes to help achieve distributional objectives*

The President\'s Advisory Panel on Federal Tax Reform is charged with
thinking about ways to simplify tax collections and enhance efficiency
in a revenue neutral context. The discussion above illustrates how
environmental taxes could help us achieve considerable efficiency gains
through capital income tax relief. My next example illustrates how
environmental taxes can be used to achieve distributional objectives.

A study I undertook a few years ago asked how we might carry out a
revenue *and* distributionally neutral green tax reform. I hypothesized
a green tax shift equal to ten percent of federal revenues in 1994.[^4]
I modeled a new carbon tax, an increase in the motor fuels excise tax,
new taxes on air pollution (or alternatively the federal sale of
tradable permits giving firms the right to emit air pollution -- as
currently occurs under the SO~2~ trading system for electric utilities
and as proposed under the Bush Administration\'s Clear Skies Initiative.
Finally I modeled a tax on unrecovered waste, a so called virgin
materials tax.

The specific tax rates and amounts collected are not that important for
our current consideration. Rather I\'d like to emphasize that a common
concern with environmental taxes is that they are regressive -- that is
they fall disproportionately on low-income individuals and households.
My analysis confirmed this result when looking at the environmental
taxes in isolation. I then modeled three tax reductions financed by the
new (or increased) environmental taxes. First, I exempted from the OASDI
payroll tax the first \$5,000 of tax base for each worker (real \$1996).
Next, I implemented a refundable \$150 tax credit for each exemption
taken in the personal income tax. Finally, I modeled an across the board
income tax cut of 4 percent.

The net result was an essentially distributionally neutral green tax
shift. The point of this exercise was not to make a case for this
particular reform. Rather it was to emphasize the key point that while
environmental taxes may be regressive, an environmental tax reform can
have whatever degree of progressivity policy makers choose. Any
regressivity in the environmental tax can be offset by progressivity in
the tax reductions financed by the new revenues.

The broader point in the context of the Advisory Panel\'s work on tax
reform is that environmental taxes provide an additional instrument to
help achieve whatever goals the panel has, whether they be related to
efficiency, distribution, or some combination of the two.

*3. Emission trading permit exercise tax*

As my last example of an environmental tax, I turn to cap and trade
programs like the SO~2~ trading program for electric utilities
implemented in the 1990 Clean Air Act Amendments or the various cap and
trade programs such as proposed in the Clear Skies Initiative. Cap and
trade programs such as the SO~2~ program have a number of attractive
features as recently documented in the 2004 *Economic Report of the
President*. How permits are allocated is an important issue in their
design. The SO~2~ trading program grandfathered firms allocating permits
to utilities on the basis of historic pollution levels. Grandfathering
may make permit programs more palatable to affected industries but it
means the government foregoes valuable revenue it could collect by
selling permits to firms, revenue that comes without the deadweight loss
generally associated with taxes.

Economists have long argued that the government should sell rather than
give away emissions permits in order to raise revenue to finance cuts in
distortionary taxes. While this is good advice for future trading
programs, it would be difficult to retroactively begin selling permits
from the current SO~2~ trading system given the banking and forward
purchase of permits that has occurred.

The Panel could, however, propose a *permit exercise tax*. This would be
a tax levied on any firm that used a permit under the current program in
order to emit sulfur dioxide. In other words, this is a tax on the right
to exercise the permit. In 2003 electric utilities emitted 10.6 million
tons of SO~2~ emissions.[^5] A permit exercise tax of \$250 per ton
would raise \$2.6 billion annually. Such a tax would capture a
significant fraction of the economic rents generated by giving the
permits to utilities in the first place.

**Conclusion**

Summing up, I strongly urge the Advisory Panel to consider adding
environmental taxes in general and a carbon tax in particular to the
list of tax reforms under consideration. These taxes would give greater
flexibility to achieve important fiscal reforms elsewhere in the tax
code while preserving revenue neutrality and contributing to a cleaner
environment. I would be happy to provide additional information if the
Panel wishes.

**Bibliography**

**Bovenberg, A. Lans and Goulder, Lawrence H.** \"Optimal Environmental
Taxation in the Presence of Other Taxes: General Equilibrium Analyses.\"
*American Economic Review*, 1996, *86*, pp. 985-1000.

**Burtraw, Dallas; Evans, David A.; Krupnick, Alan; Palmer, Karen and
Toth, Russell.** \"Economics of Pollution Trading for So~2~ and No~x~,\"
*RFF Discussion Paper.* Washington, DC: Resources for the Future, 2005.

**Energy Information Administration.** \"Annual Energy Review 2003,\"
Washington, DC: Energy Information Administration, 2004.

**Francis, Brian.** \"Federal Excise Taxes, Including the Slow Death of
Expired Taxes.\" *Statistics of Income Bulletin*, 1999, (Summer), pp.
185-89.

**Fullerton, Don.** \"Why Have Separate Environmental Taxes?,\" J. M.
Poterba ed., *Tax Policy and the Economy.* Volume 10. Cambridge: MIT
Press for the National Bureau of Economic Research, 1996, 33-70.

**Hassett, Kevin and Metcalf, Gilbert E.** \"Environmental Taxes to
Finance Capital Tax Reform,\" *Accurate Prices Program.* Oakland, CA:
Redefining Progress, 2001.

**Metcalf, Gilbert E.** \"A Distributional Analysis of Green Tax
Reforms.\" *National Tax Journal*, 1999, *52*(4), pp. 655-81.

[^1]: See Fullerton (1996) for an overview of environmental tax policy
    and the high costs of collection. Francis (1999) notes the decreased
    use of some environmental taxes in the 1990s.

[^2]: The source for these and subsequent tax share numbers is the OECD
    Economic Instruments Database.

[^3]: See, for example, Bovenberg and Goulder (1996) who consider cuts
    in the personal income tax financed by a carbon tax.

[^4]: This is an ambitious goal and would represent new environmental
    taxes of roughly \$200 billion in the current fiscal year. I am
    reporting the research in Metcalf (1999) here.

[^5]: Burtraw, Evans, Krupnick, Palmer and Toth (2005)