ECONOMIC AND BUDGET ISSUE BRIEF

Trade-Offs in Allocating Allowances for CO2 Emissions

Overview

In light of scientific evidence about the potential damages 

from climate change, the Congress is considering legislation that would impose a “cap-and-trade” program to 

reduce U.S. emissions of greenhouse gases, including 

carbon dioxide (CO2) from the burning of coal, oil, and 

natural gas. The merit of a cap-and-trade program is that, 

like a tax on CO2 emissions, it could motivate businesses 

and households to reduce emissions in the least costly 

way. Such programs have been used successfully in the 

United States to limit the cost of reducing emissions of 

other air pollutants, such as lead in gasoline and nitrogen 

oxides and sulfur dioxide from electricity generators. 

Under a cap-and-trade program for carbon dioxide emissions, policymakers would set a limit on the total amount 

of CO2 that could be emitted in a given period—the 

“cap”—and would issue rights, or allowances, corresponding to that level of emissions. Entities that were 

subject to the cap (such as coal mines, oil importers, 

refineries, or electric utilities, depending on the proposal) 

would be required to hold allowances for their CO2 emissions. After the allowances were initially distributed, entities would be free to buy and sell them—the “trade” part 

of the program—and the price of allowances would 

adjust to reflect the cost of meeting the emission cap. 

This brief examines how policymakers’ decisions about 

allocating the allowances would affect the total cost of the 

policy to the U.S. economy, as well as the distribution of 

that cost among households in their various roles as 

workers, consumers, and investors. Although cap-andtrade programs could cover all greenhouse gases, this brief 

focuses on a program for CO2 emissions.

By capping thoseemissions, policymakers would create a 

new commodity: the right to emit carbon dioxide. The 

emission allowances (each of which would represent the 

right to emit, say, 1 ton of CO2) would have substantial 

value—perhaps totaling tens of billions or even hundreds 

of billions of dollars per year. Who received that value 

would depend on how the allowances were allocated. 

One option would be to have the government capture 

their value by selling the emission allowances, as it does 

for licenses to use the electromagnetic spectrum. Another 

possibility would be to give the allowances to energy producers or some energy users at no charge—the approach 

that the U.S. government adopted in the sulfur dioxide 

program and that the European Union has used since 

2005 in its cap-and-trade program for CO2 emissions. 

Regardless of how the allowances were distributed, most 

of the cost of meeting a cap on CO2 emissions would be 

borne by consumers, who would face persistently higher 

prices for products such as electricity and gasoline. Those 

price increases would be regressive in that poorer households would bear a larger burden relative to their income 

than wealthier households would. In addition, workers 

and investors in parts of the energy sector—such as the 

coal industry—and in various energy-intensive industries 

would be likely to experience losses as the economy 

adjusted to the emission cap and production of those 

industries’ goods declined. Such losses would probably 

be limited to current workers and investors. Job losses in 

those industries would be likely to impose a fairly large 

burden on a relatively small number of households; 

CBO A series of issue summaries from

the Congressional Budget Office

APRIL 25, 2007

This brief was prepared by Terry Dinan and is based 

on various CBO publications, including Shifting the 

Cost Burden of a Carbon Cap-and-Trade Program

(July 2003), An Evaluation of Cap-and-Trade Programs for Reducing U.S. Carbon Emissions (June 

2001), and Who Gains and Who Pays Under CarbonAllowance Trading? The Distributional Effects of Alternative Policy Designs (June 2000). Those and other 

reports about policy choices associated with climate 

change are available on CBO’s Web site at www.cbo.

gov/publications/collections/climatechange.cfm.

Peter R. Orszag

Director
2 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Table 1.

Annual Increase in Households’ 

Costs from a 15 Percent Cut in 

Carbon Dioxide Emissions

Source: Congressional Budget Office.

Note: These numbers reflect data on each quintile’s cash consumption and estimates of cash income. (A quintile contains 

one-fifth of U.S. households arrayed by income.) Because of 

data limitations, the numbers should be viewed as illustrative and broadly supportive of the conclusions in this analysis rather than as precise estimates.

CBO assumed that the full cost of cutting emissions would 

be passed along to consumers in the form of higher prices 

and that the price increase for a given product would be proportional to the amount of carbon dioxide emitted from the 

fossil fuels used in its production.

a. The cost increases are equivalent to percentage declines in 

households’ after-tax income.

investors’ losses, by contrast, would tend to impose a 

smaller burden on a much larger number of households 

(because, typically, investors hold diversified portfolios). 

In allocating allowances, policymakers would face a tradeoff between reducing the overall cost of the emission cap 

to the economy or reducing specific sectors’ or households’ economic burdens. Selling the allowances and 

using the proceeds either to cut taxes on earnings from 

labor or capital or to decrease the budget deficit would 

strengthen the economy and substantially lessen the total 

economic cost of the cap-and-trade policy. Depending on 

the stringency of the cap and the type of tax cut, such an 

approach could reduce the economywide cost by roughly 

50 percent, or perhaps substantially more, some researchers suggest. However, it would not significantly mitigate 

the costs imposed on certain firms or workers or on lowincome households. 

An alternative approach of giving away allowances (or the 

proceeds from selling allowances) to certain parties would 

lower their costs, but at the expense of missing the opportunity to greatly reduce the total cost to the economy. 

Because most of the cost of the cap would ultimately be 

borne by consumers, giving away nearly all of the allowances to affected energy producers would mean that the 

value of the allowances they received would far exceed the 

costs they would bear. As a result, that allocation strategy 

would increase producers’ profits without lessening consumers’ costs. In essence, such a strategy would transfer 

income from energy consumers—among whom lowerincome households would bear disproportionately large 

burdens—to shareholders of energy companies, who are 

disproportionately higher-income households. 

In the face of those trade-offs, policymakers would not 

have to distribute all of the allowances in the same way. 

For instance, they could give a limited amount to producers for free and sell the rest. The free distribution could be 

phased out over time, since existing shareholders would 

incur losses but future shareholders would not. 

Where Would Costs Be Felt Under a 

Cap-and-Trade Program?

A cap on U.S. carbon dioxide emissions would impose 

costs on the economy by restricting the use of fossil 

fuels—particularly coal, which has the highest carbon 

content. Profits and employment would decline for some 

existing fossil-fuel suppliers. In addition, the restriction 

would raise fossil-fuel prices and increase production 

costs for firms that rely heavily on those fuels, creating 

an incentive for them to decrease their use of fossil fuels. 

Consumers, in turn, would face higher prices for energy 

and for goods and services that require substantial 

amounts of energy to produce, which would give them 

an incentive to reduce their consumption as well. 

Besides imposing costs on the economy, a cap-and-trade 

program would transfer income from some people to others. The right to emit CO2 would become valuable, with 

the value depending on how low the cap on total emissions was set and how costly regulated entities found it to 

reduce their emissions. A review of the existing literature 

and of the range of CO2 policies now being debated suggests that the value of emission allowances might total 

between $50 billion and $300 billion per year (in 2007 

dollars) by 2020. The actual value would depend on 

various factors, including the stringency of the cap, the 

possibility of offsetting CO2 emissions through carbon

Lowest Second Middle Fourth Highest

560 730 960 1,240 1,800

Income 3.3 2.9 2.8 2.7 1.7 a

Average for Income Quintile

Cost Increase in

2000 Dollars

a Percentage of

Cost Increase as
ECONOMIC AND BUDGET ISSUE BRIEF

TRADE-OFFS IN ALLOCATING ALLOWANCES FOR CO2 EMISSIONS 3

sequestration or international trading, and other features 

of the specific policy selected.1

If policymakers chose to sell allowances, such as through 

an auction, the government would capture that value. If 

they opted to give allowances away to firms that produce 

or use energy, recipients could sell them for income or 

use the allowances themselves. Obtaining allowances (or 

taking steps to reduce emissions) would become a cost 

of doing business for firms that were subject to the cap. 

However, those firms would not ultimately bear the bulk 

of the cost of the allowances: The ultimate distribution of 

that cost would be determined by market forces.2

Consumers Would Be Likely to Bear 

Most of the Cost Burden

Researchers conclude that much or all of the allowance 

cost would be passed on to consumers in the form of 

higher prices.3

 Those price increases would disproportionately affect people at the bottom of the income scale. 

For example, the Congressional Budget Office (CBO) 

estimated that the price rises resulting from a 15 percent 

cut in CO2 emissions would cost the average household 

in the lowest one-fifth (quintile) of the income distribution about 3.3 percent of its average income. By comparison, a household in the top quintile would pay about 

1.7 percent of its average income (see Table 1).4 That 

regressivity occurs because lower-income households tend 

to spend a larger fraction of their income than wealthier 

households do and because energy products account for a 

bigger share of their spending. The price increases resulting from a cap on CO2 emissions would persist as long as 

the cap remained in place, affecting both current and 

future consumers.

Producers and Workers Would Bear 

Transitional Costs

As some parts of the energy sector and various energyintensive industries adjusted to a decline in demand for 

their goods, current workers and investors in those industries would experience costs in the form of lower wages, 

job losses, and reduced stock values. Over time, as workers and investors left those industries, wages and stock 

values would tend to return to their initial levels. Thus, 

investors and workers who entered those industries after 

the policy took effect (or was anticipated) would not 

experience such losses. Policymakers could limit the costs 

facing current investors and workers by announcing the 

emission cap well in advance or by phasing the policy in 

gradually, giving people more time to adapt. 

Producers’ Losses. Over the long term, producers in 

industries with high CO2 emissions would adjust to lower 

levels of demand by leaving the industry or by expanding 

less. In the near term, however, expectations about earnings on existing capital in those sectors would fall, resulting in losses to shareholders and owners. One study concluded that a cap that cut carbon emissions by 23 percent 

would lower stock values by 54 percent for companies in 

the coal sector, by 20 percent for firms in the oil and natural gas sector, and by roughly 4 percent for electric and 

natural gas utilities.5

Although those declines are large in percentage terms, 

in dollar terms they are modest compared with the total 

value of the allowances and with the total allowance costs 

that would be borne by consumers (discussed below). 

Furthermore, stock losses in affected industries would 

tend to be widely dispersed among investors, because 

1. “Sequestration” refers to the capture and long-term storage of shareholders typically have diversified portfolios.

CO2 emissions. For example, emissions could be captured from 

smokestacks and stored in the ground (geological sequestration) or 

absorbed by and stored within trees (biological sequestration). 

2. The distribution of costs would be largely similar whether the 

requirement to hold emission allowances was placed “upstream” 

(on fossil-fuel suppliers) or “downstream” (on users). See Congressional Budget Office, Issues in the Design of a Cap-and-Trade Program for Carbon Emissions (November 25, 2003).

3. A survey of economic models suggests that if a cap was announced 

10 years in advance, consumers would initially bear between 94 

percent and 96 percent of the allowance costs. See Mark Lasky, 

The Economic Costs of Reducing Emissions of Greenhouse Gases: A 

Survey of Economic Models, CBO Technical Paper 2004-4 (May 

2003).

4. See Congressional Budget Office, Who Gains and Who Pays Under 

Carbon-Allowance Trading? The Distributional Effects of Alternative 

Policy Designs (June 2000). That analysis assumed that all of the 

costs of the cap would be passed on to consumers in the form of 

higher prices. The degree of regressivity would be smaller if some 

of the costs were absorbed by shareholders in affected industries or 

if the costs were compared with lifetime measures of households’ 

consumption and income rather than with annual measures.

5. See Lawrence H. Goulder, Mitigating the Adverse Impacts of CO2

Abatement Policies on Energy-Intensive Industries, Discussion Paper 

02-22 (Washington, D.C.: Resources for the Future, March 

2002), Table 3, available at www.rff.org/rff/documents/rff-dp02-22.pdf.
4 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Workers’ Losses. Any policy that reduced U.S. emissions 

of carbon dioxide would inevitably create costs for existing workers. Job losses could occur throughout the economy but would probably be especially large (in percentage terms) in industries associated with high-carbon fuels. 

For example, the study cited above estimated that a 

23 percent cut in CO2 emissions would cause U.S. coal 

production to decline by roughly 40 percent in the long 

run.6

 In that case, the unemployment-related costs of a 

CO2 cap would fall disproportionately on the approximately 80,000 people who work in the coal-mining 

industry.7 Unlike the costs borne by producers, which 

would be spread among investors, the costs borne by 

existing workers would probably be concentrated on 

relatively few households and, by extension, their 

communities.

Pressure on the Federal Budget Would 

Increase as Well

A cap-and-trade program for CO2 emissions would tend 

to increase government spending and decrease revenues. 

Like other consumers, the government would face higher 

prices for energy and other carbon-intensive goods and 

services. In addition, by leading to a decline in the production of such goods and services, the cap would cause 

a decline in the taxes collected on corporate profits. If the 

government wanted to provide the same level of services 

without increasing the budget deficit, it would have to 

either raise taxes or use part of the value of the allowances 

to cover the changes in federal outlays and revenues. 

Selling Allowances Could Significantly 

Reduce Overall Costs

Selling emission allowances could raise sizable revenues 

that lawmakers could use for various purposes, some of 

which would lower the cap’s total cost to the economy. 

For instance, the government could use the revenues to 

reduce existing taxes that dampen economic activity—

primarily taxes on labor, capital, or personal income, such 

as payroll taxes and individual or corporate income taxes. 

Research indicates that a CO2 cap would worsen the negative effects of those taxes: The higher prices caused by 

the cap would lower real (inflation-adjusted) wages and 

real returns on capital, indirectly raising marginal tax 

rates on those sources of income. Using the allowance 

value to reduce existing taxes could help mitigate that 

adverse effect of the cap.

The decision about whether to sell the allowances and use 

the proceeds in ways that would benefit the economy 

could have a major impact. For example, one study estimated that a 23 percent cut in CO2 emissions could cost 

the economy nearly twice as much if allowances were 

given away than if they were sold and the revenues used 

to cut taxes.8 Another study found that the economywide 

cost of reducing emissions by 10 percent would vary by a 

factor of three, depending on how the allowance value 

was used.9 Some researchers even suggest that relatively 

modest cuts in CO2 emissions could provide net gains to 

the economy (in addition to the benefits from emitting 

less carbon dioxide) if the allowances were sold and the 

revenues used to reduce individual income taxes.10

Using the proceeds from allowance sales to reduce the 

economic cost of cutting emissions would have to compete with other aims. For example, policymakers might 

want to use the revenues to compensate various producers, workers, or consumers for some of the costs they 

would incur because of the program or devote part of the 

revenues to funding research and development (R&D) 

on technologies that could help curb the growth of CO2

emissions.11

6. Goulder, Mitigating the Adverse Impacts of CO2 Abatement Policies 

on Energy-Intensive Industries, Table 2.

7. That figure, which is for employment in the industry in 2005, 

comes from Department of Energy, Energy Information Administration, Annual Coal Report 2005 (October 2006), Table 18, 

available at www.eia.doe.gov/cneaf/coal/page/acr/table18.html. 

Although many of those workers would eventually find employment elsewhere, some might not, and some might need to take 

lower-paying jobs.

8. See Goulder, Mitigating the Adverse Impacts of CO2 Abatement 

Policies on Energy-Intensive Industries.

9. See Ian W.H. Parry, “Fiscal Interactions and the Case for Carbon 

Taxes,” in Dieter Helm, ed., Climate Change Policy (New York: 

Oxford University Press, 2005), Figure 3. The less stringent the 

cap, the larger would be the economic consequences of the decision about how to use the allowance value.

10. See Ian W.H. Parry and Antonio M. Bento, “Tax Deductions, 

Environmental Policy, and the ‘Double Dividend’ Hypothesis,” 

Journal of Environmental Economics and Management, vol. 39, 

no. 1 (January 2000), pp. 67-95. That conclusion takes into 

account the distortions that individual income taxes make in 

people’s decisions about consumption, working, and investing.

11. Decisions about what level of R&D funding would be economically efficient rest on available information about the costs and 

expected payoffs of such funding and need not be tied to the 

specific amount of revenues raised by selling CO2 allowances.
ECONOMIC AND BUDGET ISSUE BRIEF

TRADE-OFFS IN ALLOCATING ALLOWANCES FOR CO2 EMISSIONS 5

Distributing Allowances for Free 

Could Compensate Some Parties

Proposals to cap carbon dioxide emissions have typically 

included provisions to give most of the allowances to producers in the energy sector and in energy-intensive industries, as the U.S. government has done in its cap-andtrade program for sulfur dioxide and the European Union 

has done in its program for CO2 emissions. Free allocation is meant to compensate shareholders in those companies for any declines in stock value they might experience because of the cap. However, available evidence 

indicates that only a small fraction of the CO2 allowances 

would be needed to provide such compensation under 

a U.S. cap-and-trade program. Researchers generally 

conclude that less than 15 percent of the allowance value 

would be necessary to offset net losses in stock values in 

both “upstream” industries (such as suppliers of coal, natural gas, and petroleum) and energy-intensive “downstream” industries (such as electricity generators, petroleum refiners, and metal and machinery manufacturers). 

The reason is that the cost of holding the allowances 

would generally be reflected in the prices that producers 

charged, regardless of whether those producers had to 

buy the allowances or were given them for free.12

A common misconception is that freely distributing 

emission allowances to producers would prevent consumer prices from rising as a result of the cap. Although 

producers would not bear out-of-pocket costs for allowances they were given, using those allowances would create an “opportunity cost” for them because it would 

mean forgoing the income that they could earn by selling 

the allowances. Producers would pass that opportunity 

cost on to their customers in the same way that they 

would pass along actual expenses.13 That result was 

borne out in the cap-and-trade programs for sulfur dioxide in the United States and for CO2 in Europe, where 

consumer prices rose even though producers were given 

allowances for free.

Thus, giving away allowances could yield windfall profits 

for the producers that received them by effectively transferring income from consumers to firms’ owners and 

shareholders. The study of the hypothetical 23 percent 

cut in CO2 emissions concluded, for example, that if all 

of the allowances were distributed for free to producers in 

the oil, natural gas, and coal sectors, stock values would 

double for oil and gas producers and increase more than 

sevenfold for coal producers, compared with projected 

values in the absence of a cap.14

In addition, some firms in the energy sector would benefit from a cap-and-trade program regardless of how emission allowances were allocated. For example, electricity 

generators that use nuclear energy or hydropower could 

see their profits rise as a result of the program because 

they would benefit from higher electricity prices but 

would not face higher production costs. The compensation estimate described above—less than 15 percent of 

the total allowance value—represents net changes in 

stock values for key sectors because of the cap, including 

both losses and gains by firms in those sectors. If policymakers wished to offset the losses experienced by individual firms in a sector without taking into account offsetting gains by other firms, additional compensation would 

be necessary.15 However, estimating firm-level losses 

would be considerably more difficult than estimating the 

overall change in stock values for a sector as a whole. 

12. See, for example, Goulder, Mitigating the Adverse Impacts of CO2

Abatement Policies on Energy-Intensive Industries; and Anne E. 

Smith, Martin T. Ross, and W. David Montgomery, Implications 

of Trading Implementation Design for Equity–Efficiency Trade-Offs 

in Carbon Permit Allocations, working paper (Boston: Charles 

River Associates, December 2002). The estimate of less than 15 

percent assumes that firms would receive compensation in the 

form of a permanent stream of free allowances. Smith, Ross, and 

Montgomery demonstrate that the share would have to be much 

larger in the initial years of a cap-and-trade program if firms were 

to be compensated for their losses over a shorter period.

13. One exception is if allowances were given to electricity generators 

whose rates were set by regulators. In that case, regulators might 

prevent generators from passing the opportunity cost of holding 

an allowance along to consumers. For a discussion of that issue, 

see Congressional Budget Office, Shifting the Cost Burden of a 

Carbon Cap-and-Trade Program (July 2003).

14. See Goulder, Mitigating the Adverse Impacts of CO2 Abatement 

Policies on Energy-Intensive Industries, Table 3.

15. A study that examined a proposed regional cap on greenhouse-gas 

emissions from electricity generators in the northeastern United 

States concluded that the total profits of generators affected by the 

policy would actually rise. Thus, sector-level measures would suggest no need for compensation. But the study also concluded that 

fully compensating the firms that would experience losses (ignoring the firms that would earn higher profits because of the cap) 

would require roughly one-third of the total value of the allowances. See Karen Palmer, Dallas Burtraw, and Danny Kahn, 

“Simple Rules for Targeting CO2 Allowance Allocations to Compensate Firms,” Climate Policy, vol. 6, no. 4 (2006), pp. 477-493. 
6 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Figure 1.

Effects on Household Income and GDP from a 15 Percent Cut in C02 Emissions in 

2010, with Allowances Sold and the Revenues Used in Alternative Ways

(Percentage change)

Sources: Congressional Budget Office (top panel); Terry M. Dinan and Diane Lim Rogers (bottom panel), “Distributional Effects of Carbon 

Allowance Trading: How Government Decisions Determine Winners and Losers,” National Tax Journal, vol. 55, no. 2 (June 2002).

Note: The policy examined in this figure is a cap-and-trade program designed to reduce carbon dioxide (CO2) emissions by 15 percent in 

2010. In the top panel, the program’s costs are shown as decreases in household income, measured as a percentage of after-tax 

income before the policy change. Those numbers reflect data on each quintile’s cash consumption and estimates of cash income. 

(A quintile contains one-fifth of U.S. households arrayed by income.) Because of data limitations, those numbers should be viewed 

as illustrative and broadly supportive of the conclusions in this analysis rather than as precise estimates.

a. This estimate by Dinan and Rogers does not distinguish between the gains in economic efficiency associated with reducing corporate 

taxes and the gains associated with reducing payroll taxes. It implicitly assumes that capital and labor respond similarly to changes in the 

taxes on them and that increases in marginal tax rates on capital and labor have similar costs to the economy.

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

-0.34

-0.13

0

-4

-3

-2

-1

0

1

2

3

4

1.8

0.7

-0.1

-0.6 -0.7

-3.0

-1.9 -1.7 -1.5

1.6

-2.6

-1.3

-0.7

0

0.4

Lowest Quintile Second Quintile Middle Quintile Fourth Quintile Highest Quintile

Effect on Average After-Tax Household Income, by Income Quintile

Revenues from Allowance Sales

Used to Provide Equal Lump-Sum

Rebates to Households

Revenues from Allowance Sales

Used to Cut Corporate Taxes

Revenues from Allowance Sales

Used to Cut Payroll Taxes

Effect on Gross Domestic Product

a

Revenues from Allowance Sales

Used to Provide Equal Lump-Sum

Rebates to Households

Revenues from Allowance Sales

Used to Cut Corporate or Payroll Taxes
ECONOMIC AND BUDGET ISSUE BRIEF

TRADE-OFFS IN ALLOCATING ALLOWANCES FOR CO2 EMISSIONS 7

Figure 2.

Effects on Household Income and GDP from a 15 Percent Cut in C02 Emissions in 

2010, with Allowances Given Away and the Government’s Share of Their Value 

Used in Alternative Ways

(Percentage change)

Sources: Congressional Budget Office (top panel); Terry M. Dinan and Diane Lim Rogers (bottom panel), “Distributional Effects of Carbon 

Allowance Trading: How Government Decisions Determine Winners and Losers,” National Tax Journal, vol. 55, no. 2 (June 2002).

Note: The policy examined in this figure is a cap-and-trade program designed to reduce carbon dioxide (CO2) emissions by 15 percent in 

2010. The government is assumed to distribute emission allowances for free but to regain some of their value by taxing the additional 

corporate profits resulting from free distribution. In the top panel, the program’s costs are shown as decreases in household income, 

measured as a percentage of after-tax income before the policy change. Those numbers reflect data on each quintile’s cash consumption and estimates of cash income. (A quintile contains one-fifth of U.S. households arrayed by income.) Because of data limitations, 

those numbers should be viewed as illustrative and broadly supportive of the conclusions in this analysis rather than precise estimates. 

a. This estimate by Dinan and Rogers does not distinguish between the gains in economic efficiency associated with reducing corporate 

taxes and the gains associated with reducing payroll taxes. It implicitly assumes that capital and labor respond similarly to changes in the 

taxes on them and that increases in marginal tax rates on capital and labor have similar costs to the economy.

-4

-3

-2

-1

0

1

2

3

4

-2.0

-1.6 -1.7 -1.7

1.4

-3.0

-2.1 -2.0 -1.8

1.9

-3.0

-2.0 -1.8

-1.4

1.7

Lowest Quintile Second Quintile Middle Quintile Fourth Quintile Highest Quintile

Effect on Average After-Tax Household Income, by Income Quintile

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

-0.34

-0.28

0

Government's Share of Allowance

Value Used to Provide Equal

Lump-Sum Rebates to Households

Government's Share of

Allowance Value Used

to Cut Corporate Taxes

Government's Share of

Allowance Value Used

to Cut Payroll Taxes

Efficiency Cost as a Percentage of Gross Domestic Product

Government's Share of Allowance

Value Used to Provide Equal

Lump-Sum Rebates to Households

Government's Share of Allowance

Value Used to Cut

Corporate or Payroll Taxes a
8 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Fairness and Efficiency Implications of 

Different Allocation Strategies 

Policymakers’ decisions about how to allocate allowances 

could either offset or intensify the regressive effects of the 

price increases caused by a cap (shown in Table 1), as well 

as alter the cap’s total cost to the economy. CBO has 

examined the ultimate distributional effects of a cap-andtrade program that would reduce U.S. CO2 emissions by 

15 percent in 2010, including the impact of the initial 

price increases and the allowance allocation.16 That analysis considered a few illustrative ways in which policymakers might allocate allowances and use any revenues 

they received because of the program. (The results of the 

analysis, which are described below, focus solely on the 

cost of the cap-and-trade mechanism and how the value 

of the allowances is allocated; they do not incorporate the 

potential benefits of reducing emissions and thus mitigating the economic and environmental costs associated 

with global climate change.)

In one scenario, CBO assumed that policymakers would 

sell the allowances and use the resulting revenues to pay 

all households an equal lump-sum rebate. Such a strategy 

would increase average income for households in the lowest quintile by 1.8 percent in 2010, CBO estimated, 

while decreasing average income for households in the 

highest quintile by 0.7 percent (see the top panel of Figure 1 on page 6). However, because it would not use any 

of the allowance value to lower existing tax rates, that 

approach would not reduce the net economic cost of the 

CO2 cap. In a follow-up paper based on CBO’s analysis, 

researchers concluded that such a strategy would decrease 

the economywide efficiency cost (as a percentage of gross 

domestic product) in 2010 by more than 0.3 percent (see 

the bottom panel of Figure 1).17

In contrast, if the government sold allowances and used 

the revenues to cut corporate taxes, the program would 

have a more regressive effect than the cap-induced price 

increases alone, lowering the average income of households in the bottom quintile by 3.0 percent but raising 

the average income of households in the top quintile by 

1.6 percent. However, such a strategy would reduce the 

efficiency cost by roughly 62 percent compared with 

devoting the revenues to lump-sum rebates, researchers 

estimate. Using the revenues to cut payroll taxes rather 

than corporate taxes would be less regressive, but 

researchers suggest that it could produce a similar reduction in the economywide cost of the program.

Freely distributing all of the allowances to producers 

would be likely to increase profits and ultimately benefit 

shareholders, although the government would regain part 

of the allowance value through taxes on higher profits. 

Giving away all of the allowances and using the government’s regained share of their value to reduce corporate 

tax rates would be the most regressive of the strategies 

that CBO examined. In that scenario, average household 

income would fall by 3.0 percent for the lowest quintile 

and rise by 1.9 percent for the highest quintile (see the 

top panel of Figure 2 on page 7). The free-distribution 

strategy would be regressive even if the government used 

its portion of the allowance value to make lump-sum 

payments to households. That combination of policies 

would also reduce the economywide cost by more than 

0.3 percent in 2010, researchers suggest (see the bottom 

panel of Figure 2). That net cost would be 18 percent 

less, however, if the government used its share of the 

allowance value to cut corporate or payroll taxes.18

Those examples show some of the trade-offs that policymakers would face in deciding how to allocate emission 

allowances. Strategies that reduced net economic costs 

would often disproportionately benefit higher-income 

households, whereas the costs of the cap would tend to 

fall disproportionately on lower-income households. Giving allowances to energy producers could generate windfall profits and would forgo using the allowance value to 

offset the regressivity of the cap-induced price increases, 

provide compensation for dislocated workers, or reduce 

total costs to the economy. If policymakers opted to give 

some of the allowances to producers to compensate them 

for lower returns on existing capital, such allocations 

could be phased out over time, because producers’ losses 

16. Congressional Budget Office, Who Gains and Who Pays Under (unlike those of consumers) would mostly be transitional.

Carbon-Allowance Trading?

17. Terry M. Dinan and Diane Lim Rogers, “Distributional Effects of 

Carbon Allowance Trading: How Government Decisions Determine Winners and Losers,” National Tax Journal, vol. 55, no. 2 

(June 2002).

18. A more recent study reached conclusions that were consistent with 

CBO’s analysis. See Ian W.H. Parry, “Are Emissions Permits 

Regressive?” Journal of Environmental Economics and Management,

vol. 47, no. 2 (March 2004), pp. 364-387.