CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

STUDY

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WHO GAINS AND WHO PAYS

UNDER CARBON-ALLOWANCE TRADING?

THE DISTRIBUTIONAL EFFECTS

OF ALTERNATIVE POLICY DESIGNS

The Congress of the United States

Congressional Budget Office
NOTES

Numbers in the text and tables of this study may not add up to totals because of rounding.

Cover photo ©The Stock Market/George B. Diebold.
Preface

Although scientists have long known thatrising concentrations ofcarbon dioxide in the

atmosphere affect the Earth's climate, considerable disagreement exists about what,

if anything, should be done to reduce carbon emissions caused by human actions.

One general area of agreement, however, is that ifsteps are taken to reduce emissions, they

should achieve those reductions at the lowest possible cost. For that reason, policymakers

and analysts have expressed interest in using economic incentives, such as a trading program

for carbon-emission allowances.

This Congressional Budget Office (CBO) study examines how the potential costs of a

carbon-allowance program would be distributed among U.S. households of different incomes. Those distributional effects could vary widely depending on the government's decisions about how to allocate the allowances and how to use any revenue that it received as a

result of the policy. The analysis was done at the request ofthe Ranking Minority Member

of the House" Committee on Commerce.

Terry Dinan ofCBO's Microeconomic and Financial Studies Division and Diane Lim

Rogers, formerly of CBO's Tax Analysis Division, wrote the study. CBO staff members

Mark Booth, Robert Dennis, Pamela Greene, Roger Hitchner, Mark Lasky, Robert

McClelland, John Sabelhaus, Robert Shackleton, John Sturrock, David Weiner, Roberten

Williams, and Thomas Woodward provided valuable comments and assistance, as did Suzi

Kerr of Motu Economic and Public Policy Research in New Zealand, Gilbert Metcalf of

Tufts University, and Ian Parry and Margaret Walls of Resources for the Future.

Chris Spoor edited the study, and Christine Bogusz proofread it. Rae Wiseman typed

the drafts and produced the preliminary versions ofthe tables. Kathryn Quattrone prepared

the study for publication, and Laurie Brown prepared the electronic versions for CBO's

World Wide Web site.

Dan L. Crippen

Director

June 2000

This study and other CBO publications

are available at CBO's Web site:

www.cbo.gov
Contents

SUMMARY Vll

ONE INTRODUCTION

Efforts to Prevent Climate Change /

Trading Programs for Emission Allowances 4/

Methods for Allocating Emission Allowances 4

TWO THE OVERALL ECONOMIC EFFECTS

OF A CARBON TRADING PROGRAM

THREE

Effects Under Domestic Trading 7

Effects Under International Trading 14

DISTRIBUTING THE OVERALL ECONOMIC

EFFECTS AMONG U.S. HOUSEHOLDS 17

Data and Methods 17

Results of the Analysis 20

Limitations of the Analysis 28

Conclusions 28
vi WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

TABLES

S-l.

1.

3.

4.

7.

The Distributional Effects and Potential for Efficiency Gains

of Various Scenarios for Allocating Carbon Allowances and

Recycling the Government's Revenue

Comparison of Domestic and International Carbon-Allowance

Trading Assuming a 15 Percent Cut in Emissions

Price Increases for Various Consumer Goods Assuming

a $100 Price per Carbon Allowance

Households' Patterns of Consumption, by Income Group, 1998

Increase in Average Household Costs Because of

Allowance Costs and Substitution Costs

Change in Average After-Tax Household Income Under

Various Allowance-Allocation and Revenue-Recycling

Scenarios, with Domestic Trading Only

Change in Average After-Tax Household Income Under

Various Allowance-Allocation and Revenue-Recycling

Scenarios, with International Trading

Change in Average After-Tax Household Income When

Domestic Trading Is Replaced by International Trading

IX

10

18

21

22

24

25

FIGURES

1.

2.

Composition of Total U.S. Emissions of Greenhouse Gases, 1995 2

Sources of U.S. Emissions of Carbon Dioxide, 1998 3

BOXES

1.

2.

3.

4.

Key Assumptions Underlying the Estimates of Total Costs

Considerations About International Trading of Allowances

Offsetting the Additional Costs to Low-Income Households

How a General-Equilibrium Analysis Might Change

the Distributional Effects

12

15

23

26
Summary

Scientists have known for more than a century

that rising concentrations of carbon dioxide

(C02) in the atmosphere affect the Earth's climate. Nevertheless, agreement on whether to reduce

man-made COz emissions—which are caused mainly

by the combustion of fossil fuels—has been elusive

because of uncertainty about the potential size and

effects of climate change, the costs associated with

lowering emissions, and the distribution ofthose costs.

This study focuses on the last issue: how the costs of

U.S. government policies to reduce C02 emissions

(referred to here as carbon emissions) would ultimately be distributed among U.S. households.

If the government decided to curb carbon emissions, one cost-effective way to achieve that goal

might be through an allowance-trading policy. Under

such a policy, ratherthan mandating specific pollution

limits for each source of carbon in the nation, the government could set an overall limit on emissions and

require U.S. firms to hold rights (or allowances) to

those emissions. Some analysts advocate an "upstream" program, in which producers and importers of

fossil fuels would be required to hold allowances.

Such a design would probably be easier to implement

than a "downstream" program, in which the requirement was placed on the millions of users of fossil

fuels. After an initial distribution, companies would

be free to buy and sell allowances. Similar trading

programs have been used for U.S. emissions of sulfur

dioxide, which contributes to acid rain; for lead in

leaded gasoline; and for various chemicals that are

thought to deplete the ozone layer of the atmosphere.

The ultimate distributional effects of a trading

program for carbon allowances would depend on two

key decisions that the government would need to make

in designing the program: how to allocate the allowances and how to use the additional revenue itreceived

as a result.

Scenarios for CarbonAllowance Trading

The government would have two primary methods of

allocating carbon allowances:

o Selling them through an auction, or

o Giving them away (as past pollution-rights trading programs have done).

Either way, the government would receive at least

some ofthe value ofthe allowances in the form offederal revenue. If it auctioned off allowances, it would

receive theirtotal value, which would equal the selling

price multiplied by the number of allowances issued.

If it gave allowances away, the fossil-fuel-producing

or -importing companies that received them would

have higher profits than would otherwise be the case.

In that situation, the rise in profits would reflect the

value of the allowances. The government would receive approximately 45 percent of that value through

taxes on those profits (including state and local as well
viii WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

as federal taxes). The other 55 percent of the allowances' value would ultimately benefit the U.S. households that were shareholders of those companies.

For this analysis, the Congressional Budget Office (CBO) assumes that the government would either

give all of the allowances away or sell all of them

through an auction. In reality, the government could

use a combination of those methods. Likewise, it

could allocate the allowances to users of fossil fuels

rather than to producers and importers, as assumed

here.

In addition to the method of allocation, the distributional effects of a carbon-allowance policy would

hinge on how the government used the resulting revenue—what this study calls the "revenue-recycling"

strategy. The government would need part ofthat revenue to cover higher costs that would result from the

policy (such as the higher prices it would have to pay

for energy and other goods). The remaining share

could be returned to U.S. households in various ways.

This analysis considers two revenue-recycling

methods that the government might use:

o Reducing corporate taxes, or

o Providing each household with an identical lumpsum rebate.

Of course, the government could use that revenue in

many other ways, such as paying down the national

debt, spending more on government programs, or decreasing certain taxes that discourage economic activity. CBO chose the alternatives above because they

illustrate a wide range of distributional effects that

might result from an allowance-trading policy.

The total cost of a carbon-allowance program

would depend on two additional factors: how extensively the government tried to reduce total carbon

emissions and whether the trading program was international (involving the buying and selling of allowances with other countries) or limited to the United

States. This analysis assumes that the government

would cut U.S. carbon emissions by 15 percent. That

figure is a hypothetical limit that was chosen because

it lies between the cuts proposed by various policy

groups. The analysis looks at effects under both domestic allowance trading (outlined below) and international trading (discussed later).

Distributional Effects of

Carbon-Allowance Trading

Although the government might impose the allowance

requirements on companies, the costs of the policy

would ultimately fall on households. Companies

would be likely to pass the costs associated with those

requirements on to households by raising the prices of

consumer products. The price increase for a product

would be proportional to its "carbon content," the

amount of carbon emitted from the fossil fuels used in

its production. Those increases would be regressive

—that is, they would place a relatively greater burden

on lower-income households than on higher-income

households—for two reasons. First, lower-income

households generally consume a larger share of their

income than higher-income households do, and second,

a greater percentage oftheir income is spent on energy

products (such as gasoline, electricity, and fuel for

heating and cooking), which are the most carbonintensive goods.

Like the policy costs, the value of the carbon allowances would also accrue to households. Ifthe government gave allowances away, a large share of their

value would go to households that were shareholders

of the firms that received the allowances. Those

households have disproportionately higher income.

Likewise, if the government used its share of the allowances' value to reduce corporate taxes, households

that owned capital (also disproportionately highincome households, though not to as great an extent as

shareholders) would gain. If the government converted its share into lump-sum payments, all households would benefit.

CBO analyzed four allowance-trading scenarios,

each incorporating one of the two allocation methods

and one of the two revenue-recycling strategies described above. The analysis looked at how each scenario would affect average household income in five
SUMMARY

quintiles—categories that each contain one-fifth of all

U.S. households, ranked by income.

Results of the Analysis

Of the four scenarios, the free distribution of allowances combined with a cut in corporate taxes would be

the most regressive. Average annual household income in the highest quintile would increase by $ 1,810,

or 1.8 percent, under that scenario, whereas average

household income in the lowest quintile would fall by

$530, or 3.1 percent (see Summary Table 1). Lowerincome households would incur losses because they

would pay higher prices for goods but would receive

little of the allowances' value.

By contrast, auctioning off allowances and using

the revenue to provide households with lump-sum

rebates would have a progressive distributional effect,

in that households in the highest income quintile would

bear the greatest share of the policy costs. Average

household income in that quintile would decline by

$940, or 0.9 percent, a year. At the other end of the

distribution, average household income in the lowest

quintile would increase by $310, or 1.8 percent. Thus,

if the government chose to auction off carbon allowances, it would have enough revenue to fully offset the

regressivity of the policy-induced price increases by

issuing lump-sum payments.

If the government instead gave the allowances

away, it would have less revenue available to offset

the negative effects on low-income householdsthrough

lump-sum payments. In addition, the share of allowance value that would accrue to firms receiving the

allowances would tend to benefit high-income households. Thus, the ultimate effects of that scenario

would be regressive (though not as regressive as the

scenario that would combine free distribution with a

cut in corporate taxes). Households in the highest

quintile would be better off as a result ofthose policies

(with average annual income increasing by $1,250, or

1.2 percent), but households in lower quintiles would

tend to be worse off (with average income decreasing

by $340, or 2 percent, in the bottom quintile).

Auctioning off the allowances and using all of

their value to cut corporate taxes would have a slightly

Summary Table 1.

The Distributional Effects and Potential for Efficiency Gains of Various Scenarios for Allocating

Carbon Allowances and Recycling the Government's Revenue

Allowance-Allocation/Revenue-Recycling Scenario

Chanae in Real Annual Income for Potential for

Lowest Quintile Hiqhest

Dollars

Quintile

Percent

Gains in

Economic

Dollars Percent Efficiency

-530 -3.1 1,810 1.8 Some

-510 -3.0 1,510 1.5 Greatest

-340 -2.0 1,250 1.2 None

310 1.8 -940 -0.9 None

Free Distribution/Decrease in Corporate Taxes

Auction/Decrease in Corporate Taxes

Free Distribution/Lump-Sum Rebate

Auction/Lump-Sum Rebate

SOURCE: Congressional Budget Office.

NOTE: Quintiles are categories that each contain one-fifth of U .S. households ranked by real (inflation-adjusted) annual income. The numbers in this

table derive from data on each quintile's cash consumption and estimates of cash income. More complete measures of income and

consumption would include in-kind items, such as employer-paid health benefits or food stamps, and thus could yield somewhat different

findings. Data limitations preclude such measures, however. Consequently, these numbers should be viewed as illustrative and broadly

supportive of the conclusions in this analysis rather than as exact figures.
x WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

less regressive effect than giving the allowances away

and using the government's share of their value to decrease corporate taxes. Average annual household

income in the top quintile would rise by $ 1,510, or 1.5

percent, and average household income in the bottom

quintile would fall by $510, or 3 percent.

Limitations of the Analysis

Those distributional effects of a trading policy for carbon allowances should be viewed as illustrative rather

than exact. Although the general pattern of gainers

and losers and the relative regressivity ofthe four scenarios would be unlikely to change, shortcomings in

the data available for this analysis cast doubt on the

exact income figures. In addition, the results given

here represent average national effects; the impact on

any particular household or region could differ.

The available data on households' consumption

and income make it difficult to precisely measure how

regressive the costs of a carbon-allowance program

would be. The Consumer Expenditure Survey (CEX)

produced by the Bureau of Labor Statistics provides

the best information about what households buy, but

available data on income (from the Census Bureau's

Current Population Survey and the Internal Revenue

Service's Statistics of Income database) appear to understate the resources that some households have

available. That understatement is particularly important at the bottom end of the income distribution,

where unreported income and private transfers (such

as gifts from family members) may constitute a larger

share of households' resources. When income is understated, consumption can look unreasonably large

compared with income. For example, according to the

reported expenditure and income data, the average

household in the lowest quintile spent more than twice

its after-tax income (135 percent more) in 1998. If

that ratio is higher than actually occurred, the policy

costs of a carbon-allowance program—which depend

on households' levels of consumption—will appear

more regressive than they really would be.

Data on net worth (assets minus liabilities) rather

than income yield a very different picture of

consumption-to-income ratios. Changes in net worth

can be used to infer saving rates and, by extension,

both consumption and consumption-to-income ratios.

That approach suggests that the average household in

the lowest quintile spentjust 17 percent more—rather

than 135 percent more—than its income in 1998.

For this analysis, CBO used the consumption

data reported in the CEX and adjusted the income estimates for lower-income households upward so that

consumption-to-income ratios matched those obtained

from data about net worth. If the resulting ratios understate low-income households' true consumption relative to their income, all four policy scenarios analyzed in this study would be more regressive than

CBO estimated. But if the consumption-to-income

ratios are overstated, all ofthe scenarios would be less

regressive than estimated.

Effects of Carbon-Allowance

Trading on Economic

Efficiency

One reason that some policy analysts favor auctioning

off allowances is that the government could use auction revenue to reduce the costs that a cut in carbon

emissions would impose on the economy. Such cost

reduction could occur ifthe government used the revenue to lower taxes that discourage economic activity

by discouraging labor and investment (such as taxes

on capital, labor, and personal income). By decreasing those taxes, the government would provide an incentive for households to save, invest, or work more.

That would increase the supply of capital and labor

and in turn generate efficiency gains—that is, lead to a

higher level of economic activity. Measuring the potential efficiency gains associated with different

allowance-allocation and revenue-recycling strategies

is beyond the scope of this analysis, but some general

conclusions are possible.

Not all ofthe policies that CBO examined would

produce gains in economic efficiency. Recycling allowance revenue through lump-sum rebates to households would not encourage additional work, saving, or

investment by households. Decreasing corporate taxes

could produce such gains, but the potential for gains

would be greater if the government auctioned off al-
SUMMARY

lowances rather than gave them away. For one thing,

an auction would yield more revenue for the government, so the decrease in corporate taxes could be

larger. And for another, the share of allowance value

that would accrue to households that held stock in

companies receiving free allowances would not produce any efficiency gains. Thus, combining an allowance auction with a corporate tax cut would create

both a more efficient and a more equitable outcome

than combining free distribution of allowances with

such a tax cut would.

International trading would make U.S. households better off overall, but that benefit would not be

distributed uniformly. Households that would lose

income under a particular allowance-allocation and

revenue-recycling scenario with domestic trading

would be better off with international trading. But

households that would experience an income gain under a given domestic scenario would be relatively

worse off with international trading.

Distributional Effects of

International Allowance

Trading

Because temperature levels are affected by the total

amount ofC02 in the atmosphere, and because carbon

emissions are subject to international agreements (such

as the 1997 Kyoto Protocol), some policy analysts

have suggested that carbon allowances be traded internationally. How would such trading change the distributional effects of the various policy scenarios that

CBO examined? If the U.S. government issued the

same number of allowances (corresponding to a 15

percent cut in carbon emissions) but domestic firms

were allowed to buy additional foreign allowances, the

worldwide price ofallowances would fall and the level

of U.S. carbon emissions would rise. The reason is

that some foreign companies might be able to reduce

their emissions at a lower cost than U.S. companies

could, which would give them an incentive to sell their

excess allowances in the United States. (The additional allowances would let U.S. companies emit more

carbon.) At the same time, the availability oflow-cost

foreign allowances would reduce the price, and thus

the value, of all allowances.

Conclusions

If the government gave away carbon allowances to

U.S. firms, the ultimate effects on U.S. households

would be regressive in their distribution. That would

be true even if the government tried to offset the

regressivity of the resulting price increases by using

the share of the allowances' value that it received

through taxes (and did not need to cover higher costs

itself) to give households lump-sum rebates.

If the government sold carbon allowances

through an auction, by contrast, the ultimate distributional effects would depend on how the government

chose to use the auction revenue. If it made a uniform

lump-sum payment to all households, the effects

would be progressive, with the costs of the policy

borne primarily by high-income households. Ifinstead

the government used that revenue to decrease corporate taxes, the effects would be regressive.

Thus, the ultimate distributional effects (or incidence) of a carbon trading program are largely a function of how the program is designed. Specifically, the

incidence depends on how the government decides to

allocate the allowances and to use its share of the allowances' total value. The distributional implications

of those decisions are an important consideration for

policymakers because the amount ofwealth that would

be redistributed by a U.S. carbon trading policy could

reach into the tens or hundreds of billions of dollars.
Chapter One

Introduction

Since the 19th century, scientists have known that

concentrations of carbon dioxide (C02) in the

atmosphere affect temperatures. Changes in

those concentrations have raised concern about the

impact that human actions may be having on the

Earth's climate. But uncertainty about the science and

effects of climate change and about the potential cost

of reducing COz emissions has thwarted efforts to

agree on what actions, if any, should be taken.

One area that is subject to general agreement is

that any actions to reduce C02 emissions (referred to

in this study as carbon emissions) should be costeffective; in other words, they should achieve the desired reduction at the lowest possible cost. That desire

has sparked interest in a trading program for carbon

emissions. Under such a program, the U.S. government would set an overall limit on domestic carbon

emissions—perhaps as part of an international agreement—and U.S. firms would determine the manner in

which to meet that limit. They would make that determination through buying and selling rights (or allowances) to emit a certain amount of carbon. Trading in

allowances could be limited to U.S. allowances or

could include those of other countries. (In addition,

gases besides C02 that have been shown to affect temperatures could be included in a trading program. The

wider scope of such a program, however, would make

monitoring and enforcement more complicated.)

A growing body of research has looked at how

the design of a trading program for carbon allowances

would affect economic efficiency—that is, the overall

level of economic activity. This study touches on that

topic but focuses mainly on how the economic effects

would be distributed among U.S. households at different income levels. It examines four policy scenarios,

each including one of two methods for allocating allowances (free distribution or an auction) and one of

two strategies for using the additional governmentrevenue that would result (cutting corporate taxes or paying a uniform rebate to all U.S. households).

Efforts to Prevent

Climate Change

Carbon dioxide in the atmosphere affectstemperatures

by retaining heat from the sun. It is produced by

(among other things) burning any fuel that contains

carbon, such as coal, oil, or natural gas. As a result,

man-made carbon emissions increased greatly during

the industrial revolution when use of fossil fuels

surged.1

For many years, scientists assumed that manmade carbon emissions were being absorbed by the

oceans. But that assumption changed in the late 1950s

when scientists took measurements in Hawaii and

found that atmospheric concentrations of C02 were

rising steadily. Later research revealed that other

For a more detailed discussion of the science and politics of climate

change, see J.W. Anderson, The Kyoto Protocol on Climate Change:

Background, Unresolved Issues and Next Steps (Washington, D.C.:

Resources for the Future, January 1998). Much ofthis discussion was

drawn from that report.
2 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

Figure 1.

Composition of Total U.S. Emissions of Greenhouse Gases, 1995 (In percent)

M

Carbon Dioxide

(83.7)

Sulfur Hexafluoride

(0.5)

Perfluorinated Carbons

(0.5)

Hydrofluorocarbons

(1.3)

Nitrous Oxide

(2.6)

Methane

(11.4)

^1

SOURCE: Congressional Budget Office based on information from Department of State, Climate Action Report (1997), p. 57.

common gases, such as methane and nitrous oxide,

could also affect climate. Because the process by

which such gases trap heat in the atmosphere is sometimes called the greenhouse effect, the gases are

known as greenhouse gases.

By the late 1980s, climate change had emerged

as a major political issue transcending national boundaries. In December 1988, the U.N. General Assembly

established the Intergovernmental Panel on Climate

Change (IPCC) to review scientific data on the subject. The most recent IPCC report, issued in 1996,

concluded that statistical evidence "now points towards a discernible human influence on global climate."2 However, that report highlighted the difficulties ofdetermining the magnitude ofhuman effects and

distinguishing between human and natural effects on

climate. In addition, public understanding of the potential severity and impact ofclimate change continues

to evolve. Some recent research has focused on the

possible benefits of global warming as well as the potential harm.3

In December 1997, officials from nearly every

nation met in Kyoto, Japan, to discuss climate change.

The outcome ofthat meeting was the Kyoto Protocol,

which set specific targets by which each country

should reduce its emissions of greenhouse gases.

Those targets would be in effect from 2008 through

2012. Together, they would cut emissions from industrialized countries by 5.2 percent from the 1990 level.4

(Targets vary between countries, but the total level of

A review draft of the latest IPCC report was released in April 2000,

but the final report is not scheduled to be issued until early 2001.

For a review ofthat research, see Robert Mendelsohn, The Greening

ofGlobal Warming (Washington, D.C.: American Enterprise Institute

for Public Policy Research, 1999).

More specifically, the emissions from countries that agreed to binding

limits under the Kyoto Protocol are expected to fall by 5.2 percent.

Those countries include most developed nations and the transitional

economies of the former Soviet bloc.
CHAPTER ONE INTRODUCTION 3

worldwide emissions is the key consideration because

the geographic distribution of greenhouse gas emissions does not affect the potential for global warming.)

The Kyoto Protocol would require the United States to

reduce its emissions of greenhouse gases by 7 percent

from the 1990 level. That would correspond to a cut

of approximately 30 percent from the level otherwise

expected to occur during the 2008-2012 period.

The protocol covers six greenhouse gases. Of

those, carbon dioxide accounted for nearly 84 percent

of U.S. greenhouse gas emissions in 1995 (see Figure

1). Virtually all U.S. carbon emissions result from

combustion of fossil fuels. Petroleum was the largest

source in 1998, followed by coal and natural gas (see

Figure 2). Of those three, coal emits the most carbon

per amount of heat generated and natural gas the least.

For example, carbon emissions would be 77 percent

higher if a given amount of heat was generated by coal

rather than by natural gas and 20 percent higher if it

was generated by petroleum rather than by natural

gas. Any attempt to achieve large reductions in U.S.

emissions would require shifting fromcarbon-intensive

fossil fuels such as coal to less-carbon-intensive ones

such as natural gas. Switching to renewable sources

of energy (such as hydropower or nuclear power) or

reducing energy use would also decrease emissions.

As ofJanuary 13, 2000, the Kyoto Protocol had

been signed by 84 countries and ratified by 22.5 The

agreement is intended to take effect 90 days after the

55th government ratifies it, assuming that those 55

countries accounted for at least 55 percent of the carbon emissions of developed countries in 1990.

The Kyoto Protocol has not yet gone to the U.S.

Senate for a vote on ratification. Some difficult issues

must be resolved first, including whether large developing countries—such as China, Mexico, and South

Korea—will agree to limits on their emissions. Reducing greenhouse gases would be relatively inexpensive in those countries, where fossil fuel is used inefficiently. Thus, the cost of meeting its own emission

target would be significantly lower ifthe United States

could do so in part by financing low-cost emission

Figure 2.

Sources of U.S. Emissions of Carbon Dioxide,

1998 (In percent)

SOURCE: Congressional BudgetOffice based on information from

Department of Energy, Energy Information Administration.

reductions in developing countries.6 But developing

countries fear that limits on emissions could impede

their growth.

Uncertainty about the severity and effects of climate change and the cost of cutting emissions—along

with numerous complications involved in coordinating

with other countries—has prevented agreement about

how much the United States should reduce its greenhouse gas emissions. If reductions are undertaken,

however, most people would agree that they should be

achieved at the lowest possible cost to the U.S. economy. For that reason, analysts and government officials have focused on the use of economic incentives

rather than one-size-fits-all regulations to cut emissions. A carbon trading program is one form of economic incentive under consideration. Such a program

could be launched in the context of an international

agreement, such as the Kyoto Protocol, or on a unilateral basis.

5. See United Nations Framework Convention on Climate Change,

"Kyoto Protocol Status of Ratification" (January 13,2000), available

atwww.unfccc.de/resource/kpstats.pdf

Global temperature levels are affected by the total amount of C02 in

the atmosphere, so foreign emission reductions should bejust as effective as U.S. emission reductions. If international trading of carbon

allowances occurred, the United States could receive credit toward its

domestic limit by purchasing low-cost foreign emission reductions.
4 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

Trading Programs for

Emission Allowances

The concept of trading in pollution rights—what this

study calls emission allowances—first appeared in the

academic literature in 1968. Trading programs can be

attractive alternatives to more traditional approaches

that mandate specific pollution limits for all sources.

Their primary advantage is that they can lower the

cost of achieving an environmental goal by giving participants some flexibility.

Trading programs have been used to achieve a

variety of environmental objectives in the United

States. A federal program for sulfur dioxide (S02)

emissions began in 1995 in order to reduce damage

from acid rain. Major electricity-generating units received an allocation of tradable allowances, each permitting the discharge of one ton of S02. Taken together, those allowances corresponded to a specific

level of S02 allowed for those electricity-generating

units during the 1995-1999 period. Firms that wished

to emit more S02 than their allowed level (that is,

more than the amount they were entitled to by the

number of allowances they were given) could buy allowances fromcompanies that had reduced their emissions below their allowed levels.

Besidesthe S02 program, the federal government

has successfully used trading programs to gradually

lower the amount of lead in gasoline and to phase out

the use of ozone-depleting chemicals.7 More recently,

the Environmental Protection Agency (EPA) issued a

rule that would require 22 eastern states and the District ofColumbia to reduce their emissions of nitrogen

oxides, the principal component of smog.8

then distribute allowances for those emissions. One

allowance would permit the emission ofone metric ton

of carbon dioxide. Because different fuels release different amounts of carbon when they burn, the number

of allowances required for a given amount of heat output would vary among fuels. For example, the

amount of carbon released per million British thermal

units (MBTU) of coal is 1.8 times the amount released

per MBTU of natural gas. Thus, the number of allowances required per MBTU of coal used would be 1.8

times greater than the number required per MBTU of

natural gas. Some sources of energy, such as solar

and nuclear, do not result in the release of any carbon,

so no allowances would be required for their use. The

difference in allowance requirements among fuels

would result in price increases that would give companies and households an economic incentive to use lesscarbon-intensive fuels and to use fuels more efficiently.

Methods for Allocating

Emission Allowances

An important decision in designing a trading program

is how to allocate allowances. Among its primary allocation methods, the federal government could give

allowances to companies or sell the allowances

through an auction. The government has distributed

allowances for free in its past environmental trading

programs. For example, allowances for S02 and

ozone-depleting chemicals were issued on the basis of

previous production levels.9In the lead program, refiners "earned" rights to the use of lead by producing

leaded gasoline—that is, each gallon of gasoline they

made entitled them to a certain number oflead credits.

Under a carbon trading program, the government

would set a limit on total U.S. carbon emissions and

For an overview ofthe wide variety ofstate and federal environmental

trading programs, see Robert C. Anderson and Andrew Q. Lohof, The

United States' Experience with Economic Incentives in Environmental Pollution Control Policy (report prepared for the Environmental

Protection Agency by the Environmental Law Institute, August 1997).

For more information about that program, see Congressional Budget

Office, Factors Affecting the Relative Success of EPA's NOx Capand-Trade Program, CBO Paper (June 1998).

About 1.7 percent ofthe 8.69 million sulfur dioxide allowances issued

in 1995 were auctioned off by the EPA; see A. Denny Ellerman and

others, Emissions Trading Under the U.S. Acid Rain Program:

Evaluation of Compliance Costs and Allowance Market Performance (Cambridge, Mass.: MIT Center for Energy and Environmental Policy Research, October 1997), p. 12. The purpose of those auctions was to ensure a supply of allowances for new utilities and, for

early auctions, to provide a price signal for allowances in a nascent

market; see Renee Rico, "The U.S. Allowance Trading System for

Sulfur Dioxide: An Update on Market Experience," Environmental

and Resource Economics, vol. 5, no. 2 (1995), p.125.
CHAPTER ONE INTRODUCTION 5

They could use those credits themselves orsell themto

other refiners.10

ulated community and would thus be unavailable to

cut existing taxes.

Distributing allowances for free could make a

limit on carbon emissions more acceptable to the companies involved. The value of an individual allowance

is represented by the price at which it can be sold. If

allowances were auctioned, the federal government

would receive virtually all ofthat value. In contrast, if

allowances were freely distributed, the majority ofthat

value would go to the recipient firms—who would

have higher profits as a result—and would ultimately

benefit their shareholders.11

Although giving away allowances could make a

trading program more acceptable to the regulated entities, distributing allowances through an auction could

also have benefits. The revenue raised from an auction could be used to cut existing taxes that cause distortions in the economy. For example, taxes on capital

discourage investment and saving, and taxes on labor

can discourage people from working more and employers from using more labor. If the revenue raised

by auctioning off emission allowances was used to cut

taxes on capital and labor, those adverse incentives

would be reduced. But if allowances were given

away, a large share of their value would go to the regie The EPA allowed refiners and importers to sell lead credits beginning

in 1983. Those companies generated credits forsale iftheir individual

quarterly average for actual lead used in their leaded gasoline was less

than the regulatory limit for the lead content of leaded gasoline. That

limit was decreased over time until lead was completely phased out of

11. The trading program for ozone-depleting chemicals was accompanied

by a tax on those chemicals. The tax was intended to accelerate the

phaseout of the chemicals, raise revenue for the federal government,

and capture some ofthe windfall revenues that the producers ofozonedepleting chemicals received when the cap on those chemicals led to

higher prices.

Decisions about how to allocate allowances and

how to use the government's share oftheir value would

affect households in different income brackets differently. In other words, each policy would have unique

distributional effects. Some people argue that carbon

allowances should be auctioned off and the resulting

revenue should be used to make the trading program

more equitable. For example, the Corporation for Enterprise Development has proposed that the revenue

from a carbon auction be put into a "Sky Trust."12

The bulk ofthat fund would be issued as uniform payments to each U.S. citizen. That proposal is predicated on the idea that everyone owns the "rights" to the

sky and that each person should receive an equal

amount of the revenue generated by selling those

rights.

Analysts at Resources for the Future have also

proposed that carbon allowances be auctioned off and

the revenues returned to households in a way that

makes the policy more equitable.13 They argue that

since a limit on carbon emissions would increase energy prices, a trading programwould be equitable only

ifit compensated households forthose price increases.

They propose that 75 percent of auction proceeds fund

a direct payment to all U.S. households (based on legal residency). The remaining 25 percent would be

given to states on the basis of how much energy their

low-income households use and how vulnerable their

industries are to higher energy costs.

12. See Peter Barnes and Gabriel Wishik, "Who Will Own the Sky?"

Journal ofEnvironmental Economics (forthcoming).

13. See Raymond Kopp and others, "A Proposal for Credible Early Action

in U.S. Climate Policy" (Resources forthe Future, Washington, D.C.),

available at www.weathervane.rff.org/features/feature060.html
Chapter Two

The Overall Economic Effects

of a Carbon Trading Program

One ofthe first steps in designing a trading program for pollution allowances is to determine

the desired limit on emissions. This study assumes that U.S. emissions of carbon dioxide would be

cut by 15 percent. That figure was chosen arbitrarily

because it lies between the limits in other carbonrestriction proposals. (The Kyoto Protocol, for example, would compel the United States to reduce carbon

emissions by approximately 30 percent from the average level in 2008 through 2012. The proposal by Resources for the Future described in the previous chapter would decrease carbon emissions gradually, froma

10 percent cut by 2002 to a 20 percent cut by 2008.)

The distributional effects described in this study would

change roughly proportionately with larger or smaller

limits on emissions.

After setting its limit, the government would distribute carbon allowances, with each allowance permitting the emission of one metric ton of carbon dioxide. Some analysts advocate using an "upstream"

trading program that would require producers and importers of fossil fuels to hold an allowance for each

metric ton of carbon that was emitted when their fuel

was burned.1 That design would limit the number of

entities that would need to be monitored and minimize

the costs of implementing the policy. This analysis

For a discussion ofthe advantages of an upstream trading design, see

Carolyn Fischer, Suzi Kerr, and Michael Toman, "Using Emissions

Tradingto Regulate U.S. Greenhouse Gas Emissions: An Overview of

Policy Design and Implementation Issues," National Tax Journal,

vol. 51, no. 3 (September 1998).

assumes such a design. However, because firms

would be free to buy and sell allowances after the initial distribution, the government could distribute the

allowances either to the upstream firms that were required to hold them or to "downstream" firms, such as

utilities and industrial boilers.

The overall economic effects of the carbon trading programwould differ depending on whether allowances were traded only within the United States or internationally. In the case of an international trading

program, the availability of carbon allowances from

other countries would lowerthe total cost to the United

States of achieving its limit on carbon emissions.

Effects Under

Domestic Trading

In a domestic trading program, the level of U.S. carbon emissions would be limited to the number of allowances issued by the U.S. government. This study

uses 1998 emissions as a policy baseline (to be consistent with the consumer expenditure data and tax return

data used later in the analysis). U.S. carbon emissions

totaled 1.5 billion metric tons in 1998, so a 15 percent

reduction would limit total emissions to 1.28 billion

metric tons (see Table 1). Thus, in this analysis, the

federal government would issue 1.28 billion allowances.
8 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

Table 1.

Comparison of Domestic and International Carbon-Allowance Trading

Assuming a 15 Percent Cut in Emissions

Domestic Trading International Trading

1.50

1.28

1.35

60

77

81

4

Carbon Dioxide Emissions (Billions of metric tons)

U.S. Emissions in 1998 (Prepolicy baseline) 1.50

Level of Emissions for Which Allowances Would Be Issued 1.28

U.S. Emissions After Policy Change 1.28

Price per Allowance (1998 dollars)

Price3100

Total Costs and Allowance Value (Billions of 1998 dollars)

Value of U.S. Allowances Issued 128

U.S. Spending on Allowances (Allowance costs) 128

Substitution Costs" 11

Share of Total Costs and Allowance Value Borne by Various Parties (Percent)

Value of U.S. Allowances Issued

Government share under free distribution

Government share under auction

U.S. Spending on Allowances (Allowance costs)

Private share

Government share

Substitution Costs

Private share

Government share

SOURCE: Congressional Budget Office.

NOTE: The cost estimates in this table are based on various assumptions, which are outlined in Box 1 on pages 12 and 13.

a. Based on 1998 prepolicy carbon emissions, a prepolicy price of $307 per metric ton of carbon emitted, and a price-responsiveness estimate of

-0.57.

b. Based on the price per allowance, the change in carbon emissions, a prepolicy price of $307 per metric ton of carbon emitted, and a priceresponsiveness estimate of -0.57.

45 45

100 100

87 87

13 13

87 87

13 13

The price at which allowances would be bought

and sold would be determined by the size ofthe carbon

limit and the cost of reducing carbon emissions. The

bigger the limit on emissions and the harder it was for

households and intermediate producers (such as utilities) to reduce their use of fossil fuels, the more the

allowances would cost. The price per allowance

would reflect the economy's relative ease or difficulty

in adjusting to a lower level of carbon emissions; that

price would be the same regardless of whether the

government initially gave the allowances to firms or

sold them through an auction.2 Based on empirical

2. That statement assumes efficient trading of allowances following the

initial distribution. It also assumes that the incentives for innovation

(and, hence, the price of an allowance) would not be affected by the
CHAPTER TWO THE OVERALL ECONOMIC EFFECTS OF A CARBON TRADING PROGRAM 9

studies ofthe extent to which carbon emissions would

decrease as the price of emitting carbon increased, the

Congressional Budget Office (CBO) estimates that a

15 percent cut in emissions would correspond to an

allowance price of $100.3

Policy Costs

Under an allowance-trading program, obtaining allowances would become a cost of doing business. In the

long run, producers and importers of fossil fuels

would pass that cost on to households in the form of

higher prices.4The price that users paid for fossil

fuels would rise in proportion to the fuels' carbon

emissions, and the price of all goods would rise in proportion to their "carbon content"—the carbon emissions generated by the fossil fuels used in their production. For example, given an allowance price of

$100, the price of electricity would rise by 34 percent

and the price of gasoline and oil would rise by 33 percent (see Table 2).

CBO estimates that an allowance price of $100

would cause a 2.8 percent increase in the general price

level. That rise would produce automatic increases in

income for households that receive transfer payments

from the federal government (such as Social Security

method of distribution. Further, it does not account for any potential

changes in the allowance price that might result from the efficiency

gains obtained when revenue was used to cut existing taxes.

3. CBO estimated that price using a responsiveness estimate of -0.57,

which was found by geometrically averaging the results of nine models that empirically estimated the responsiveness of carbon emissions

to carbon prices. Those nine models were the Second Generation

Model used by Batelle Laboratory and the Clinton Administration; the

Multi-Sector, Multi-Regional Trade Model ofCharles Rivers Associates and the University of Colorado; the National Energy Modeling

System ofthe Department ofEnergy's Energy Information Administration; the Model for Evaluating Regional and Global Effects of Greenhouse Gas Reduction Policies used by the Electric Power Research

Institute and Stanford University; the Jorgenson-Wilcoxen-Slesnick

Model; the Emissions Prediction and Policy Analysis Model of the

Massachusetts Institute of Technology; and models by Data Resources, Inc., Oxford Economic Forecasting, and WEFA, Inc. The

estimates from those nine models range from a high of -1.30 to a low

of-0.41, although six of the estimates lie between -0.50 and -0.41.

4. Fossil-fuel prices would rise even if the federal government gave allowances away. Since the allowances have value, firms that received

one would have the option of forgoing production and selling the allowance. For them to be willing to hold on to the allowance and continue to produce, the price of the fossil fuel would need to rise by the

price of the allowance.

benefits) that are indexed to the price level. This study

accounts for that effect by indexing federal pensions

and Social Security and Supplemental Security Income payments to the increase in the general price

level.

The rise in consumer prices resulting from a carbon trading policy would impose two types of costs on

households: substitution costs and allowance costs.

Substitution Costs. Higher prices would encourage

households and intermediate producers to decrease

their consumption of goods with a high carbon content. Substitution costs are the costs that households

would bear as a result of those efforts. They could

include inconvenience costs (for example, fromhouseholds' driving less) as well as higher prices that households would pay to intermediate producers that had

reduced their carbon consumption (for example, higher

electricity prices to finance utilities that had replaced

coal with lower-carbon-emitting fuels, such as natural

gas or renewable energy sources).

CBO estimates that the substitution costs resulting from a 15 percent cut in emissions would total $11

billion under domestic allowance trading (see Table

l).5Such costs represent a cost to the U.S. economy

as a whole rather than a transfer of income within the

economy. Thus, $11 billion is the cost that the United

States would bear to decrease its carbon consumption.

The environmental benefits of reducing carbon emissions may or may not exceed that cost; however, such

5. That estimate is based on the price per allowance, the change in carbon emissions, a price-responsiveness estimate of -0.57, and a

prepolicy price of $307 per metric ton of carbon emitted. Note that

the price increases caused by the limit on emissions would lower real

wages and real returns on capital. Those reductions would tend to

reduce furtherthe level ofemployment and investment in the economy

and thereby add to the distortions created by the tax system. That

result is called the "tax-interaction effect." Some economists argue

that the tax-interaction effect could be very large; see Ian Parry,

Roberten C. Williams, and Lawrence Goulder, "When Can Carbon

Abatement Policies Increase Welfare? The Fundamental Role of Distorted Factor Markets," Journal of Environmental Economics and

Management, vol. 37 (1999). For example, based on a model that

includes only labor, Parry, Williams, and Goulder find that the total

cost of reducing carbon emissions by 15 percent would more than

double because ofthe tax-interaction effect. Estimating themagnitude

ofthat effect is beyond the scope ofthis study. However, their results

suggest that the tax interaction could more than double the substitution

costs in this analysis. The tax-interaction effect would be reduced ifthe

revenue collected as a result ofthe allowance policy was used to offset

existing distortionary taxes, such as those on capital and labor.
10 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

Table 2.

Price Increases for Various Consumer Goods Assuming a $100 Price per Carbon Allowance

Increase in Price

(Percent)

Food

Consumed off premises 2.6

Consumed on premises 1.4

Furnished to employees 2.8

Tobacco Products 1.1

Alcohol

Consumed off premises 2.3

Consumed on premises 1.4

Clothing and Related Items

Clothing and shoes 2.3

Clothing services 1.4

Jewelry and watches 2.0

Toilet articles and preparations 2.3

Barbershop, beauty parlor, and health club services 1.4

Housing and Related Items

Rent for tenant-occupied nonfarm dwellings 0.6

Rent for other lodgings 1.4

Furniture and durable household equipment 2.3

Nondurable household supplies and equipment 0

Electricity 34.2

Natural gas 55.9

Water, sewer, and other sanitary services 1.7

Fuel oil and coal

Telephone and telegraph

Domestic service and other household operations

Medical Care

Business Services

Expense of Handling Life Insurance

Automotive and Related Items

New and used motor vehicles

Tires, tubes, accessories, and other parts

Repair, greasing, washing, parking, storage, and rental

Gasoline and oil

Bridge, tunnel, ferry, and road tolls

Automobile insurance

Other Transportation

Mass transit systems

Taxicab, railway, bus, and other travel expenses

Airline fares

Recreation

Books and maps

Magazines, newspapers, and nondurable toys

Recreation and sports equipment

Other recreation services

Net receipts from pari-mutuel betting

Education

Higher education

Nursery, elementary, and secondary education

Other education services

Religious and Welfare Activities

34.5

0.9

2.8

1.4

0.9

0.9

2.3

2.6

1.4

33.1

1.7

0.9

5.4

5.4

5.4

2.0

2.3

2.0

1.4

1.4

1.4

1.4

1.4

1.4

SOURCE: Congressional Budget Office based on Gilbert E. Metcalf, 'A Distributional Analysis of Green Tax Reforms," National Tax Journal,

vol. 52, no. 4 (December 1999), pp. 655-681.
CHAPTER TWO THE OVERALL ECONOMIC EFFECTS OF A CARBON TRADING PROGRAM 11

an assessment is beyond the scope of this analysis.6

That cost estimate and the others in Table 1 rely on

several key assumptions (see Box 1). Ifthose assumptions did not hold, the total costs of the policy would

be different from the substitution costs used in this

analysis.

CBO's estimate of substitution costs does not

include the transitional losses that would occur as the

economy adjusted to the new level of fossil-fuel consumption. For example, some coal mines could shut

down, causing job displacement and a loss of the specialized capital that was invested in those mines. Such

losses are important, but they are not estimated in this

analysis. This study takes a long-term perspective in

which resources have had time to adjust to the new

consumption level.

Allowance Costs. Besides the costs associated with

reducing consumption of carbon-intensive goods,

households would also bear the costs of continuing to

consume some of those goods. By CBO's estimate,

those allowance costs would total $ 128 billion (reflecting the 1.28 billion allowances issued and the $100

price per allowance). Unlike substitution costs, allowance costs would not be a cost to the U.S. economy as

a whole. Rather, they represent a transfer of income

from households that would pay more because of the

allowance policy to households that would receive the

value of the allowances.7

6. That assessment would compare the benefits ofreducing carbon emissions with the total costs ofthe limit on emissions, including substitution costs and the increased distortion in labor and capital markets that

the policy might create (the tax-interaction effect described in the previous footnote).

7. If a carbon trading program would reduce the overall welfare of U.S.

citizens (because the total costs of the program would be greater than

the total benefits), some researchers would argue that the lobbying

costs associated with firms' attempts to obtain allowances should be

included in the real cost of the policy; see Gordon Tullock, "Rent

Seeking and Tax Reform," Contemporary Policy Issues, vol. 6, no. 4

(October 1988). Further, some researchers argue that under those

same circumstances, the true cost of the policy must account for the

cost of other inefficient policies that were tied to it through vote trading among legislators; see Gordon Tullock, "Where Is the Rectangle?"

Public Choice, vol. 91, no. 2 (September 1998). Finally, other researchers point out that inefficient policies resulting from special interests' attempts to gain at the expense of society as a whole (called rent

seeking) could be a necessary part of the process of passing laws that

enhance the welfare of society; see Gordon C. Rausser, "Predatory

Versus Productive Government: The Case of U.S. Agricultural Policies," Journal of Economic Perspectives, vol. 6, no. 3 (Summer

1992). Determining whether a carbon trading program would increase or decrease overall welfare and whether rent-seeking activities

Allowance costs would ultimately fall on households in the form of higher prices, with price increases

reflecting the carbon content of each good. The cost

that any individual household bore would be determined by what quantity of carbon-intensive goods it

purchased.

This study treats government consumption of

carbon differently than private-sector consumption.

The government accounted for approximately 13 percent of total carbon consumption in 1998, CBO estimates.8 Thus, it would bear 13 percent of both allowance costs and substitution costs. Unlike privatesector cost increases, government cost increases would

probably not be passed on to households in proportion

to their consumption of carbon-intensive goods. Instead, this study assumes that the government would

pay for its increased costs with the share ofthe allowances' value that it received through taxes on corporate

profits or auction revenue. (It would pay in the same

way for the increase in transfer payments, such as Social Security, that resulted from the general price increase.)

Allowance Value

A carbon trading program would redistribute income

fromhouseholdsthat ultimately pay forthe allowances

(through higher prices) to households that ultimately

receive the value of the allowances. In this analysis,

the trading program would transfer $128 billion of

income within the U.S. economy—more than 10 times

what it would cost the economy as a whole (through

substitution costs) to cut carbon emissions.

How that $128 billion in allowance value was

distributed among households would depend on two

decisions by the government: how it allocated allowances and how it used the share of the allowances'

value that it would receive under a given method of

allocation.

would increase the cost ofthe policy is beyond the scope ofthis analysis.

That estimate includesthe government's direct and indirect demand for

carbon. The direct demand was obtained by examining the government's consumption of coal, oil, gas, and electricity. Its indirect demand was based on its share of total spending on goods and services

(after adjusting for government payroll costs and capital depreciation).
12 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

Boxl.

Key Assumptions Underlying the Estimates of Total Costs

This study assumes that a carbon trading program

would cover all potential sources of fossil-fuel-based

carbon and would result in the least costly mix of

emission reductions. Those are best-case assumptions; to the extent that they did not prove true, the

cost of achieving a 15 percent cut in carbon emissions

would be higher than this study estimates.

The Trading Program Would Include All

Fossil-Fuel-Based Carbon

A program of economic incentives that covered all

sources of fossil-fuel-based carbon emissions would

have the greatest chance of minimizing the cost of

meeting a limit on emissions. By contrast, a program

that focused on carbon emissions in just one sector,

such as the utility industry, could overlook potentially

cheaper reductions in other sectors, such as transportation. The United States has millions of individual

sources of carbon emissions, including power plants,

motor vehicles, and lawn mowers. Thus, a trading

program would have the greatest potential to capture

all sources of carbon if it was implemented "upstream," covering suppliers of fossil fuels rather than

users. This analysis assumes such a trading program.

Trading Would Result in the Least Costly Mix

of Emission Reductions

The estimates of total costs used in this analysis

(which are shown in Table 1) are based on the assumption that the restriction on emissions would be

met at the lowest possible cost. In other words, allowance trading would occur until there were no more

possible changes in the pattern of emission reductions

that would lower the overall cost of meeting the restriction. Achieving that ideal in the real world is not

always possible, however.1

Various uncertainties make projecting the cost

of meeting a particular carbon restriction difficult.

The estimates of total costs in this study rely on available empirical estimates of how responsive carbon

emissions would be to changes in the price of a carbon allowance. Those price-responsiveness estimates

in turn depend on many assumptions, including predictions about what technologies would be available

to reduce the use of carbon-intensive fuels (such as

technologies for saving energy and for using renewable energy sources); the cost of those technologies;

and the willingness of residential, commercial, and

industrial users to adopt them. To the extent that this

study's estimates of price responsiveness overestimate

or underestimate actual behavioral responses, the actual costs of achieving a 15 percent decrease in carbon emissions would be greater or less than the costs

shown in Table 1.

In an upstream trading system, fossil-fuel suppliers would need to determine the price at which they

were willing to buy or sell allowances. Making that

determination could be difficult, particularly in the

initial period while the market for allowances developed and companies gathered information about how

For example, according to an unpublished study, the costs of

meeting the goals of the sulfur dioxide program in 1995 (its

first year of operation) were 50 percent higher than they would

have been if electric utilities had taken advantage of all potential trading opportunities. See Curtis Carlson and others, S02

Control by Electric Utilities: What Are the Gains from

Trade? (draft, Resources for the Future, Washington, D.C.,

December 1997).

First, consider the case in which the government

gives the allowances to producers and importers of

fossil fuels. Those firms would make higher profits

than they did before because the price of their fuel

would rise (based on its carbon content and the price

of the allowance) but their costs would not increase

(since they would not have to pay forthe allowances).9

The government would capture approximately 45 percent of the value of the allowances through the taxes

Allowances would be traded among firms until the most efficient allocation was achieved. That trading would result in a transfer of funds

among firms but not a cost increase for the industry as a whole. Ifthe

government were able to distribute allowances according to the most

efficient allocation, then no trading would occur.
CHAPTER TWO THE OVERALL ECONOMIC EFFECTS OF A CARBON TRADING PROGRAM 13

Boxl.

Continued

fossil-fuel production and prices were responding.

Uncertainty about those responses could lead to volatile prices—and compound the difficulties in planning

compliance—during that initial period. For example,

during early trading in a market for nitrogen oxide

allowances for 12 northeastern states, allowance

prices ranged from $1,900 per ton to $7,500 per ton

over the course of one year.2To the extent that information problems impeded trading, or that the market

for allowances did not develop as smoothly as expected, the cost of achieving a particular limit on

emissions would be higher than predicted.

To be effective in lowering the cost of restricting carbon emissions, the market for allowance trading would need to be competitive. That would be important regardless of whether allowances were distributed freely or through an auction. Concerns about

market competition would arise if one participant's

actions had the potential to influence the price of allowances, such as if the number of buyers and sellers

was small or if a few participants controlled a large

share of the market. Such concerns would be greater

in an upstream market than in a downstream market

because the number of regulated firms would be

smaller. However, some analysts argue that market

power would not be a problem in an upstream market

for carbon allowances. Based on information about

producers of oil and coal and suppliers of natural gas,

See James C. Letzelter and Marc W. Chupka, "Surviving the

SIP Call: Fossil Plant Economics Under NO, Control," Public

Utilities Fortnightly (May 1999), pp. 44-51.

they estimate that any one firm would make up less

than 6 percent of the allowance market.3

In addition, allowance trading would be active

only if transaction costs were low and enforcement

was effective. Transaction costs include the cost of

identifying potential trading partners and negotiating

trades and the cost of obtaining necessary regulatory

approval for trades.

Successful U.S. trading programs have had effective monitoring and reporting requirements.4

Those requirements enabled the government to ensure

that allowance sales were accompanied by actual reductions in pollution and that firms held the correct

number of allowances for their emissions. Thus, the

government could approve trades with minimal

oversight—keeping transaction costs low—and at the

same time ensure the integrity of the trading system.

Effective monitoring and enforcement are more likely

to be feasible in an upstream system, where the number of firms required to hold allowances is relatively

small, than in a downstream system.

See Peter Cramton and Suzi Kerr, Tradable Carbon Permit

Auctions: How and Why to Auction Not Grandfather, Discussion Paper 98-34 (Washington, D.C.: Resources forthe Future,

May 1998).

For more information about the role of transaction costs in

trading programs, see Robert W. Hahn and Gordon L. Hester,

"Marketable Permits: Lessons from Theory and Practice,"

Ecology Law Quarterly, vol. 16, no. 2 (1989); and Robert N.

Stavins, "What Can We Learn from the Grand Policy Experiment? Lessons from S02 Allowance Trading," JournalofEconomic Perspectives, vol. 12, no. 3 (Summer 1998).

that firms and their shareholders would pay as a result

ofthose higher profits.10 That percentage includes the

10. The government's share ofallowance value could be partially offset by

lower collections ofindividual income tax. The reason is that policyinduced price increases would lead to automatic indexing of parts of

the individual income tax, including the exemptions and tax brackets,

thus causing income tax revenue to fall. However, that offsetting effect would most likely be small relative to the government's share of

allowance value. (Income tax revenue would decline by the same

value captured by federal, state, and local governments. The producers and importers would retain approximately 55 percent ofthe allowances' value, which

would ultimately benefit households that were their

shareholders.

amount ifthe government auctioned off allowances instead of giving

them away.)
14 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

Alternatively, considerthe case in which the government sells the allowances to fossil-fuel producers

and importers through an auction. Again, the price of

fuel would rise, but those firms would see no increase

in profits because their costs would rise by the same

amount since they would need to buy allowances

through the auction. The government would capture

virtually all of the allowances' value in the form of

auction revenue.

In both cases—free distribution and an auction

—the government would receive at least some of the

allowances' value through increased revenue. The ultimate distribution of that value among households

would depend on the government's decision about how

to use the revenue. The government could pass it

along to households in a variety of ways: by decreasing current tax collections, spending more on various

programs, reducing the national debt, or providing a

lump-sum rebate, which would be equivalent to dividing the revenue by the number of households and giving each household the same payment.

Different uses of the revenue would benefit

households in various income brackets differently.

The next chapter examines the distributional effects

associated with two alternative strategies: reducing

collections of corporate taxes by the amount of the

revenue and providing a lump-sum rebate.11 CBO

chose those two from among the many potential uses

because they illustrate a wide range of distributional

effects that could result from an allowance-trading

policy. (Chapter 3 describes how the distributional

effects of cutting other types of existing taxes would

compare with the results of this analysis.)

Effects Under International

Trading

With international allowance trading, the U.S. government would distribute a quantity of allowances equal

to the U.S. limit on carbon emissions. That amount

would be the same as under domestic trading (in this

case, enough to cut 1998 emissions by 15 percent).

However, U.S. firms could purchase additional allowances from foreign companies that were able to reduce

their carbon emissions at a lower cost. In developing

countries, in particular, where fossil fuels are used less

efficiently, the cost of cutting carbon emissions is

lower than in the United States. Including such countries in an allowance-trading program would benefit

both foreign firms (or governments) and U.S. firms.12

Foreign companies would benefit fromgreater demand

for their carbon allowances. U.S. companies would

benefit from a greater supply of low-cost allowances.

That greater supply would decrease the price of all

allowances and let more U.S. firms buy allowances

rather than reduce their emissions.

Analysts disagree about the viability of an international trading market for carbon allowances and the

price at which foreign allowances would be available.

This study assumes that the availability of cheaper

foreign allowances would lower the worldwide price

per allowance to $60. That figure is arbitrary and

reflects CBO's estimate ofthe price necessary to bring

about a 10 percent cut in U.S. emissions; it does not

reflect CBO's assessment of the potential viability of

an international market for carbon allowances. (For a

discussion of the major concerns associated with implementing such a market, see Box 2.)

If U.S. firms could purchase allowances (including foreign ones) for $60 apiece, U.S. carbon emissions would fall by 10 percent from the baseline level

(to 1.35 billion metric tons rather than 1.28 billion

under domestic trading). Although some 70 million

more allowances would be purchased under international trading, the price of an allowance would be sufficiently lower that total spending on allowances

would fall from $ 128 billion under domestic trading to

$81 billion under international trading (see Table 1).

Substitution costs would also fall—from$ 11 billion to

about $4 billion—because of the lower allowance

price.

11. Providing each household with a lump-sum rebate would be similarto

providing a fully refundable tax credit for the same amount.

12. A great deal ofuncertainty exists about how a system ofinternational

trading would be implemented, including whether trading would take

place among firms or governments.
CHAPTER TWO THE OVERALL ECONOMIC EFFECTS OF A CARBON TRADING PROGRAM 15

Box 2.

Considerations About International Trading of Allowances

Allowance trading among governments or companies

in different nations remains in the realm of theory,

and analysts have raised numerous questions about

how it would actually work. Examining the potential

for active international trading in carbon allowances

is beyond the scope of this study. But four of the major concerns about such trading are outlined below.

First, concerns about transaction costs (such as

the costs of negotiating a trade and obtaining regulatory approval) are especially great with an international trading program. Coordinating the rules for

approving trades among participating governments,

establishing liability, and monitoring and enforcing

trades would be essential to keeping transaction costs

low. But resolving those issues for international

carbon-allowance trading would be challenging. If

high transaction costs discouraged international trading, the potential savings from such trading would not

be realized.

Second, some analysts worry about the role of

national governments in an international carbonallowance market. In that view, "national governments might try to influence the market to their

advantage, obstruct allowance trades, or otherwise

depart from the conditions of well-functioning abatement markets assumed in the estimates of cost savings."1

For example, governments could pursue strategies that favored domestic interests and that limited

international trading.

Jonathan Baert Wiener, Designing MarketsforInternational

Greenhouse Gas Control, Climate Issue Brief No. 6 (Washington, D.C.: Resources for the Future, September 1997).

A third, related concern is the issue of market

competition in an international allowance market.

Some studies indicate that in an international trading

market that included only industrialized countries,

Russia would end up being the main seller of allowances. In that case, it might be able to influence the

price of allowances, and it would have an incentive to

veto the inclusion of other potentially large suppliers

of allowances, such as China or Brazil.2

Fourth, in estimating how much a limit on carbon would cost the United States under international

trading, analysts typically assume that international

trading would minimize the cost of meeting the overall carbon limit agreed to by all participating countries. But for that to occur, all countries would need

to use tradable-allowance systems to meet their national targets and allow for international trades—

which might not actually be the case. The Kyoto Protocol, for example, allows countries to choose how

they will meet their emission targets. Some countries

have a history of using taxes to achieve environmental

goals; other countries, which have less experience

with market-based incentives, might mandate specific

reductions for each source of emissions. To the extent

that countries chose approaches other than allowance

trading, the potential to minimize global costs would

be reduced.3

2. Ibid.

3. See Robert W. Hahn and Robert N. Stavins, "What Has Kyoto

Wrought? The Real Architecture of International Tradable

Permit Markets" (draft working paper, John F. Kennedy

School of Government, Harvard University, February 25,

1999).

Under internationaltrading, the level ofU.S. carbon emissions would exceed the amount ofallowances

issued by the U.S. government. Thus, total U.S.

spending on allowances would exceed the value ofthe

allowances allocated to U.S. firms. That fact has important implications for the distribution ofthe costs of

a trading program among U.S. households—the subject of the next chapter.
Chapter Three

Distributing the Overall Economic

Effects Among U.S. Households

Acarbon trading policy would initially affect

companies, but the results would ultimately

affect households. This analysis distributes

the overall economic effects described in the previous

chapter among households in different income quintiles (categories that each contain one-fifth of U.S.

households, ranked by income). That distribution depends mainly on the design of the trading policy, particularly on how the carbon allowances are allocated

and how the government uses (or "recycles") the resulting revenue.

Data and Methods

Estimating the specific effects of a carbon trading program for each income quintile requires having detailed

data on industries and households. The sample of

households used in this study reflects the families and

demographic mix found in the Census Bureau's Current Population Survey (CPS) for calendar year 1994.

More detailed information on income and taxes from

the Internal Revenue Service's Statistics of Income

(SOI) database was merged with the CPS. The 1994

data were increased to reflect projected totals for

1998, so the analysis simulates the effects of carbonallowance trading on a 1998 economy. Data on

household consumption fromthe Bureau ofLabor Statistics' Consumer Expenditure Survey (CEX) were

merged with the household sample defined by the

CPS.

Distributing Policy Costs

The share of substitution costs and allowance costs

that any individual household would bear is determined by its consumption patterns. Households that

consumed more carbon before the limit on emissions

and the trading program took effect—for example,

those that drove a lot—would bear a larger share of

the policy's costs.1

Ratios of consumption to income play an important role in determining how large a burden the policy

would impose on households in different quintiles.

Households with high consumption-to-income ratios

would tend to bear a higher cost (relative to their income) than households with low consumption-toincome ratios would. However, shortcomings in the

available data on consumption and income make it

difficult to precisely measure how large the policy

costs would be relative to income. The CEX provides

the best information about what households buy, but

associated data on income appear to understate the

resources available to some households. That understatement is particularly important at the bottom end

The Congressional Budget Office does not have quintile-specific estimates of policy-induced changes in carbon consumption. However,

the assumption that high-carbon-consuming households will bear costs

in the form of either higher prices (for continuing their carbon consumption) or substitution costs (for decreasing their carbon consumption) seems reasonable. Therefore, both allowance costs and substitution costs are distributed among households on the basis of their

prepolicy consumption of carbon.
18 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING?

Table 3.

Households' Patterns of Consumption, by Income Group, 1998

Total Consumption as a

Percentage of After-Tax Income3

June 2000

Income Quintile

Based on

Expenditure Data

Based on

Net-Worth Data

Carbon-Intensive

Consumption as a

Percentage of

Total Consumption0

Lowest

Second

Middle

Fourth

Highest

235.1

144.3

121.3

105.4

70.5

116.9

113.4

110.4

104.6

93.7

8.4

7.4

6.8

6.3

5.5

SOURCE: Congressional Budget Office calculations based on data from the Census Bureau's Current Population Survey, the Internal Revenue

Service's Statistics of Income database, the Bureau of Labor Statistics' Consumer Expenditure Survey, and John Sabelhaus, "What Is

the Distributional Pattern of Taxing Consumption?" National Tax Journal, vol. 46, no. 3 (September 1993), pp. 331-343.

NOTE: CBO defines a household according to the Census Bureau's definitions of a family, with some modifications. For example, unrelated

individuals are included as separate households. When imputing consumption data to households, however, some unrelated individuals living

together are grouped into households.

a. After-tax income before the policy change.

b. Carbon-intensive consumption includes spending on electricity, natural gas, fuel oil, coal, gasoline, and oil.

of the income distribution, where unreported income

and private transfers (such as gifts from family members) may compose a larger share of household resources.2 A consequence of that understatement is

that consumption may look too large relative to reported income. For example, the CEX data suggest

that households in the lowest income quintile spend

more than twice their after-tax income (see Table 3).

But recent research indicates that the consumption-toincome ratios implied by the CEX data may not be

reasonable.3

Cash transfer payments from the government, such as Social Security

and Supplemental Security Income payments, are included in the measure ofincome used in this study. In-kind transfers, such as Medicaid

and Medicare benefits, are not included in the measures of income or

consumption. As a result, government transfers do not account for the

consumption-to-income ratios derived from expenditure data.

Low-income households may consume more than their annual income

iftheir "permanent," or long-term, income is greater than their annual

income. For example, a medical school student might borrow money

to finance current consumption knowing that his or her future income

would be much higher than current income. Recent research, however, indicates that the consumption-to-income ratios implied by the

CEX data are more skewed than the difference between annual and

permanent measures of income can explain. See John Sabelhaus and

Jeffrey A. Groen, "Can Permanent-Income Theory Explain CrossSection Consumption Patterns?" Review ofEconomics and Statistics

(forthcoming).

An alternative to measuring consumption directly

from the expenditure data in the CEX is to measure it

indirectly from data on net worth that can be used to

suggest saving rates and, in turn, consumption rates.4

That approach yields more reasonable consumptionto-income ratios (see Table 3). For example, the networth-based approach implies that the average household in the lowest quintile consumed 17 percent more

than its income in 1998, as opposed to the 135 percent

more implied by the expenditure approach. However,

the net-worth-based approach does not indicate why

the consumption-to-income ratios obtained from reported data are so high for low-income households. It

is unclear whether income is biased downward or consumption is biased upward, although the former seems

more likely.

This study attempts to draw on the strengths of

both approaches. Given that the CEX is designed to

elicit reliable information about households' spending,

the Congressional Budget Office uses that data to deSee John Sabelhaus, "What Is the Distributional Pattern of Taxing

Consumption?" National Tax Journal, vol. 46, no. 3 (September

1993), pp. 331-343.
CHAPTER THREE DISTRIBUTING THE OVERALL ECONOMIC EFFECTS AMONG U.S. HOUSEHOLDS 19

termine quintile-specific consumption levels. It then

uses the consumption-to-income ratios implied by the

net-worth-based approach to increase income estimates to be consistent with those consumption estimates. That adjustment is not made for the top income quintile, where understated income is less of a

problem.5

The pattern of consumption-to-income ratios resulting from the net-worth-based approach suggests

that the costs of a carbon trading policy would be

regressive—that is, they would fall more heavily on

households toward the lower end ofthe income distribution. That would occur because low-income households consume a largershare oftheir income than their

higher-income counterparts do. The degree of regressivity would be greater ifCBO used the consumptionto-income ratios that result from expenditure data

rather than those from net-worth data.

Income groups differ in the mix of consumer

goods they purchase as well as in how much of their

income they consume. Carbon-intensive consumption

—defined here as spending on electricity, natural gas,

fuel oil, coal, gasoline, and oil—makes up a larger

fraction of the total spending of lower-income households (see Table 3). That pattern means that lowerincome households would tend to bear a larger share

of policy costs—relative to their total consumption—

than higher-income households would.

Regardless ofshortcomings in the available data,

the general distributional pattern (or incidence) ofthe

costs of a carbon trading policy is clear. The substitution costs and allowance costs associated with the policy would almost certainly be regressive (since lowincome households spend more of their income than

higher-income households do and also spend more ofit

on carbon-intensive goods). Differences between the

actual pattern of quintiles' consumption-to-income ratios and the pattern used in this study (based on networth data) could mean that the actual policy costs

would be more or less regressive than this analysis

suggests. However, the general conclusion that the

policy costs would be regressive is likely to be sound.

Distributing Allowance Value

Households would ultimately receive the value of the

allowances that were distributed in a carbon trading

program. Under the various allowance-allocation and

revenue-recycling scenarios considered in this study,

households would receive that value in one of three

ways:

o By owning stock in firms that were given allowances,

o By receiving a lump-sum rebate, or

o By having their share ofthe corporate tax burden

reduced.6

Ifthe government gave allowances away, 55 percent of their value would eventually flow to households that own stock in the firms that received them.

The government could distribute the allowances to

upstream producers and importers of fossil fuels or to

downstream users of fossil fuels (such as utilities, industrial boilers, airlines, trucking companies, and so

on). Given the uncertainty about which firms the government would issue allowances to, CBO distributed

the allowances' value among all stockholders on the

basis of their observed dividend income and taxable

capital gains income (as reported in the SOI). In other

words, the distribution of dividend and capital gains

income was used as a proxy for the distribution of

stock ownership. The distributional effects associated

with a specific allocation would differ from the distributional effects in this analysis ifthe income ofshareholders in the firms that actually received the allowances differed fromthe income ofshareholders in general. (For example, the allowance value would be

more concentrated in higher income brackets than this

study estimates if the government chose to give the

allowancesto upstreamproducers and importers and if

Such an adjustment would reduce income for the highest quintile,

which would exacerbate any potential underreporting.

The tax return data in the SOI allow corporate taxes to be translated

into household effects because those data contain detailed information

about different pieces of income that are related to the ultimate incidence of various business-level taxes. CBO assigned corporate tax

liabilities to households according to their personal capital income,

based on an extensive literature on corporate tax incidence; see Congressional Budget Office, The Incidence of the Corporate Income

Tax, CBO Paper (March 1996). The corporate tax initially falls on

corporate capital, but when capital used by corporations flows into the

economy, part of that tax burden is shifted onto capital in general in

the form of reduced rates of return.
20 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

the shareholders of those firms were wealthier than

shareholders in general.)

The government would capture 45 percent ofthe

allowances' value if it gave the allowances away and

all ofthat value ifit distributed the allowances through

an auction.7If the government used its share of the

allowances' value to provide a lump-sum rebate, that

value would be distributed equally among all households. If the government used its share of the allowances' value to reduce collections of corporate taxes,

that value would be distributed among households according to their prepolicy share of the corporate tax

burden.

Results of the Analysis

This analysis measures the effects of a carbon trading

policy by the change in real (inflation-adjusted) annual

cash income that the average household in each

quintile would experience.8 An increase in households'

costs because of the policy is viewed as a decrease in

real after-tax income. Because the results presented

here are averages, the results for any particular household or geographic region could be different.

The distributional effects of carbon-allowance

trading would vary depending on what allowanceallocation and revenue-recycling methods the government chose and on whether allowance trading was domestic or international. Because of the shortcomings

in the available data on consumption and income, the

distributional results that follow must be viewed as

illustrative. Nonetheless, they provide a reasonable

picture of how different policy designs would affect

households across the income distribution. In particular, the general pattern of incidence and the relative

CBO assumes that the auction would extract the full value of the allowances. If that was not the case, the firms involved in the auction

would receive some ofthe allowance value for free. The distributional

effects associated with that share ofthe allowance value would be the

same as if the government gave the allowances to firms.

Cash income excludes in-kind transfers and accrued but still unrealized income. CBO could have presented results based on an alternative measure of income, adjusted family income, which adjusts for

family size. Using that measure would alter the quantitative results

slightly, but it would not affect the conclusions ofthis analysis in any

qualitative way.

ranking ofthe scenarios according to their regressivity

are likely to hold true regardless of the actual dollar

figures.

Results Under Domestic Trading

The total effect of a carbon trading policy on various

households isthe combined effect ofthe distribution of

the policy costs and the distribution of the allowance

value. The share oftotal policy costs that a household

will bear because of changes in prices of fossil fuels

and other goods is determined by its consumption patterns. The share oftotal allowance value that a household will receive is determined by the government's

allowance-allocation and revenue-recycling methods.

Distributional Effects. The price changes that would

result from a 15 percent cut in carbon emissions

would cost the average household in the lowest income

quintile $560 a year, or 3.3 percent of its average income (see Table 4). That policy cost includes both

allowance and substitution costs. Although households in other quintiles would face higher costs in dollar amounts, those costs would make up a smaller

share of their average annual income—1.7 percent in

the case ofthe highest quintile. Thus, the policy costs

are regressive. (Average policy costs as a share of

income were reduced by the additional Supplemental

Security Income and Social Security payments that

households would receive when the price level rose.

Such payments make up a relatively large share of

household income in the lower quintiles, making the

policy less regressive than it would appear if those

payments were not adjusted.)

For all households, on average, allowance costs

would amount to $1,210 per year. As noted earlier,

that figure represents a transfer of income within the

economy (fromhouseholdsthat pay more in additional

costs than they receive of the allowances' value to

households where the opposite is true). Substitution

costs represent the true average household costs ofthe

carbon-allowance policy, which must be weighed

against the benefits of a decrease in carbon emissions.

Those costs would average $100 per year for all

households, CBO estimates. Comparing the size of

the average household's allowance and substitution

costs shows how much is at stake in the government's
CHAPTER THREE DISTRIBUTING THE OVERALL ECONOMIC EFFECTS AMONG U.S. HOUSEHOLDS 21

decision about how to allocate allowances: the

amount ofwealth transferred by the allocation process

would dwarfthe substitution costs ofthe policy (as the

overall figures in Chapter 2 also demonstrated).

Of the four allowance-allocation and revenuerecycling scenarios that CBO analyzed, the share of

policy costs borne by households in the lowest income

quintile would be largest if the government gave allowances away and used the revenue that it received

(from taxes on the increased profits) to reduce corporate taxes. In that case, average household income for

the lowest quintile would fall by $530, or 3.1 percent

(see Table 5). Households in the highest income

quintile, by contrast, would see their average income

rise by $1,810, or 1.8 percent. That increase would

occur because those households' gains from the share

ofallowance value that they received directly (through

their stock holdings) and indirectly (as the decrease in

corporate income taxes boosted the rate of return on

their capital) would exceed their cost increases because of the policy. The estimated rise in income for

the average household in the highest quintile—and the

drop in income forthe average household in the lowest

quintile—would be larger under this scenario than under any ofthe other three that CBO examined, making

this the most regressive of the scenarios.

At the other end of the spectrum, the share of

policy costs borne by households in the highest income

quintile would be greatest if allowances were auctioned off and the revenue used to provide lump-sum

rebates to all households. In that scenario, households

in the top quintile would experience a $940, or 0.9

percent, decline in average real income, while those in

the lowest quintile would see their average income rise

by $310, or 1.8 percent. Average household income in

the lowest quintile would increase because those

households' lump-sum rebates would be larger than

their cost increases as a result of the policy. Thus,

CBO estimates, a carbon trading policy would have a

progressive distributional effect ifthe governmentsold

the allowances through an auction and divided the revenue equally among households.

A third scenario in CBO's analysis, an auction of

allowances followed by a cut in corporate taxes,

would be slightly less regressive than the most regressive scenario, free distribution and a corporate tax cut.

If the government auctioned off the allowances and

used the revenue to decrease corporate taxes, the full

value ofthe allowances would benefit households that

own all ofthe various forms of capital, including interest and rental income as well as stock-related income

(because all households with capital income are asTable 4.

Increase in Average Household Costs Because of Allowance Costs and Substitution Costs

Averaqe for Income Quintile

Average for

All Households3

Allowance

Costs

Substitution

Lowest Second Middle Fourth Highest Costs

Cost Increase

In dollars 560

As a percentage of income" 3.3

730

2.9

960

2.8

1,240

2.7

1,800

1.7

1,210

2.7

100

0.2

SOURCE: Congressional Budget Office.

NOTE: The numbers in this table derive from data on each quintile's cash consumption and estimates of cash income. More complete measures of

income and consumption would include in-kind items, such as employer-paid health benefits orfood stamps, and thus could yield somewhat

different findings. Data limitations preclude such measures, however. Consequently, those numbers should be viewed as illustrative and

broadly supportive of the conclusions in this analysis rather than as exact figures.

a. Includes the government's share of allowance and substitution costs. (The distribution ofthat share among households depends on the government's specific allowance-allocation and revenue-recycling strategies, so government costs are not included in the average costs for each quintile.)

b. The cost increases are equivalent to percentage decreases in after-tax income.
22 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

sumed to benefit from a decrease in corporate taxes).

If the government gave the allowances away, in contrast, only 45 percent of the allowance value would

benefit all capital owners (the share that the government captured through taxes and used to decrease corporate taxes). The other 55 percent would benefit

only those capital owners who held stock in firms that

received the allowances. Because stocks are more

concentrated in higher-income householdsthan capital

as a whole is, a policy that directed more benefits to

stockholders would be more regressive. Morever, the

allowance value that would flow to households

through increases in stock value under a free distribution would be concentrated in the relatively few households within each quintile that owned stock in the companies that received allowances (a difference that is

not apparent from the results presented in this study).

In contrast, the gains associated with decreasing corporate taxes would be much more widely distributed

among households within each quintile.

Table 5.

Change in Average After-Tax Household Income Under Various Allowance-Allocation and

Revenue-Recycling Scenarios, with Domestic Trading Only

Allowance-Allocation/

Revenue-Recycling

Scenario

Average for Income Quintile

Average for All

Households

Lowest Second Middle Fourth Highest

Excess Potential for

Allowance Substitution Efficiency

Costs3 Costs Gains

Free Distribution/Decrease

in Corporate Taxes

In dollars

As a percentage of

income"

Auction/Decrease in

Corporate Taxes

In dollars

As a percentage of

income"

Free Distribution/

Lump-Sum Rebate

In dollars

As a percentage of

income"

Auction/Lump-Sum Rebate

In dollars

As a percentage of

income"

-530 -600 -740 -900 1,810

-3.1 -2.4 -2.2 -1.9 1.8

-510 -530 -630 -790 1,510

-3.0 -2.1 -1.9 -1.7 1.5

-340 -450 -620 -800 1,250

-2.0 -1.8 -1.8 -1.7 1.2

310 140 -90 -370 -940

1.8 0.5 -0.3 -0.8 -0.9

0 -100

0 -0.2

0 -100

0 -0.2

0 -100

0 -0.2

0 -100

0 -0.2

Some

Greatest

None

None

SOURCE: Congressional Budget Office.

NOTE: The numbers in this table derive from data on each quintile's cash consumption and estimates of cash income. More complete measures of

income and consumption would include in-kind items, such as employer-paid health benefits orfood stamps, and thus could yield somewhat

different findings. Data limitations preclude such measures, however. Consequently, these numbers should be viewed as illustrative and

broadly supportive of the conclusions in this analysis rather than as exact figures.

a. Allowance cost borne by the average U.S. household minus allowance value received by the average U.S. household.

b. Measured as a percentage of after-tax income before the policy change.
CHAPTER THREE DISTRIBUTING THE OVERALL ECONOMIC EFFECTS AMONG U.S. HOUSEHOLDS 23

The final scenario, free distribution of allowances coupled with a lump-sum rebate of government

revenue, would be less regressive than the scenario

above (an auction and a decrease in corporate taxes).

In this case, average household income in the highest

quintile would rise by 1.2 percent. The share of allowance value captured by shareholders under a free

distribution ofallowances would be more concentrated

in higher-income householdsthan the benefits ofa corporate tax cut would be. But the government could

use its share of the allowance value from a free distribution to offset policy costs for low-income households, thus reducing the regressivity ofthat method of

allocation (assuming that the government recognized

that tax collections would rise as a result ofthe recipient firms' windfall profits and recycled that additional

revenue). The government would, however, have more

funds available for helping low-income households ifit

auctioned off allowances than if it gave them away

(see Box 3). The amount of revenue available for

lump-sum rebates would more than offset policy costs

for low-income households if the government auctioned off allowances, but not ifit distributed them for

free.

How do those distributional results compare with

the effects of other allowance-allocation and revenuerecycling strategies? The distributional effect ofrecycling revenue is determined by the progressivity ofthe

taxes that are cut. The personal income tax is less

progressive in its incidence than the corporate income

tax, so ifrevenue was used to reduce personal income

taxes, the results would be less regressive than ifrevenue was used to lower corporate income taxes. (In

other words, since lower-income households bear a

larger share of the personal income tax burden, they

would receive a larger share of the benefits if it was

reduced.) Likewise, payroll taxes are less progressive

than either corporate or personal income taxes. Thus,

if the government used its additional revenue to cut

payroll taxes, the policy would still be regressive but

less so than if either personal or corporate income

taxes were reduced.9

That discussion assumes that tax rates would be reduced proportionately. For example, if personal income tax collections were cut by 5

percent, CBO assumes that the rate for each tax bracket would be cut

by 5 percent. However, progressive taxes could be reduced in a way

that would give the reduction a progressive distributional effect. For

example, rates for lower tax brackets could be cut more than rates for

higher tax brackets.

Box 3.

Offsetting the Additional Costs

to Low-Income Households

When the government sells emission allowances

through an auction, it captures more of their value

than when it gives the allowances away. That means

the government has more funds available to offset

the additional costs that the allowance policy imposes on low-income households, if it wants to.

One way to assess different methods for allocating allowances is to consider how many low-income

households the government could compensate for

policy-induced increases in their costs. Under the

assumptions made in this analysis, ifthe government

gave away carbon allowances and directed all ofthe

value that it captured to low-income households, it

could offset cost increases for all of the households

in the lowest quintile and approximately 70 percent

of the households in the second quintile. (That estimate assumes that households are compensated for

their actual loss in real income as a result of the policy; that loss equals their share of allowance and

substitution costs minus the income thatthey receive

from the free distribution of allowances.)

Households above that cutoff, however, would

not receive any of the government's share of the allowance value. Households in the second quintile

that were not compensated would see their real income fall by 2.6 percent, and households in the middle and fourth quintiles would experience 2.4 percent

and 2.2 percent declines, respectively. Households

in the highest income quintile would be better off

than before because they would capture the majority

of the allowance value through owning stock in the

companies that received the allowances. Their average household income would rise by $1,000, or 1

percent. Thus, although this approach would offset

cost increases for some low-income households, it

would be regressive for households above the cutoff.

The government could offset cost increases for

more households if it auctioned off allowances, because it would capture all of their value. In that

case, the government could compensate all of the

households in the first four quintiles and approximately 45 percent of the households in the highest

quintile for their policy-induced costs. Households

in the highest quintile that did not receive compensation would see their income decline by an average of

$1,800, or 1.7 percent.
24 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

Table 6.

Change in Average After-Tax Household Income Under Various Allowance-Allocation and

Revenue-Recycling Scenarios, with International Trading

Average for Income Quintile

Average for

All Households

Allowance-Allocation/

Excess

Allowance

Costs3

Substitution

Revenue-Recycling Scenario Lowest Second Middle Fourth Highest Costs

Free Distribution/

Decrease in Corporate Taxes

In dollars

As a percentage of income6

-330

-1.9

-370

-1.5

-460

-1.4

-550

-1.2

1,070

1.0

-40

-0.1

-40

-0.1

Auction/Decrease in

Corporate Taxes

In dollars

As a percentage of income"

-320

-1.9

-330

-1.3

-390

-1.1

-490

-1.1

890

0.9

-40

-0.1

-40

-0.1

Free Distribution/

Lump-Sum Rebate

In dollars

As a percentage of income"

-210

-1.2

-280

-1.1

-380

-1.1

-500

-1.1

730

0.7

-40

-0.1

-40

-0.1

Auction/Lump-Sum Rebate

In dollars

As a percentage of income"

180

1.1

70

0.3

-70

-0.2

-240

-0.5

-590

-0.6

-40

-0.1

-40

-0.1

SOURCE: Congressional Budget Office.

NOTE: The numbers in this table derive from data on each quintile's cash consumption and estimates of cash income. More complete measures of

income and consumption would include in-kind items, such as employer-paid health benefits orfood stamps, and thus could yield somewhat

different findings. Data limitations preclude such measures, however. Consequently, these numbers should be viewed as illustrative and

broadly supportive of the conclusions in this analysis rather than as exact figures.

a. Allowance cost borne by the average U.S. household minus allowance value received by the average U.S. household.

b. Measured as a percentage of after-tax income before the policy change.

ImplicationsforEconomicEfficiency. Although this

study focuses on the distributional effects of several

possible allowance-allocation and revenue-recycling

strategies, different strategies would also have different implications for economic efficiency. Quantifying

those efficiency trade-offs is beyond the scope of this

analysis, but some general conclusions are possible.

The government could use its increased revenue

to stimulate economic activity and thus reduce the economic cost of achieving a 15 percent reduction in carbon emissions. That could occur ifit used the revenue

to offset existing taxes—such as those on capital, labor, and personal income—that discourage economic

activity by discouraging labor and investment. If

those taxes were reduced, incentives to save, invest, or

work could increase, and efficiency gains could result.10

If, instead, the government opted to recycle

revenue in the form of a lump-sum rebate, it would not

increase the incentives for work and investment, and

no efficiency gains would be realized (see Table 5). In

addition, the fraction of allowance value that shareholders would receive if the government gave allowances away would not provide those households with

increased incentives for work and investment.

10. Those efficiency gains are measured relative to a policy that restricts

carbon emissions but does not reduce existing taxes.
CHAPTER THREE DISTRIBUTING THE OVERALL ECONOMIC EFFECTS AMONG U.S. HOUSEHOLDS 25

Table 7.

Change in Average After-Tax Household Income When Domestic Trading Is Replaced

by International Trading

Average for

All Households

Excess

Allowance-Allocation/ Average for Income Quintile Allowance

Costs3

Substitution

Revenue-Recycling Scenario Lowest Second Middle Fourth Highest Costs

Free Distribution/

Decrease in Corporate Taxes

In dollars 200 230 280 350 -740 -40 60

As a percentage of income" 1.2 0.9 0.8 0.7 -0.7 -0.1 0.1

Auction/Decrease in

Corporate Taxes

In dollars 190 200 240 300 -620 -40 60

As a percentage of income15 1.1 0.8 0.7 0.6 -0.6 -0.1 0.1

Free Distribution/

Lump-Sum Rebate

In dollars 130 170 240 300 -520 -40 60

As a percentage of income" 0.8 0.7 0.7 0.6 -0.5 -0.1 0.1

Auction/Lump-Sum Rebate

In dollars -130 -70 20 130 350 -40 60

As a percentage of income" -0.7 -0.2 0.1 0.3 0.3 -0.1 0.1

SOURCE: Congressional Budget Office.

NOTE: The numbers in this table derive from data on each quintile's cash consumption and estimates of cash income. More complete measures of

income and consumption would include in-kind items, such as employer-paid health benefits orfood stamps, and thus could yield somewhat

different findings. Data limitations preclude such measures, however. Consequently, these numbers should be viewed as illustrative and

broadly supportive of the conclusions in this analysis rather than as exact figures.

a. Allowance cost borne by the average U.S. household minus allowance value received by the average U.S. household.

b. Measured as a percentage of after-tax income before the policy change.

The potential for efficiency gains is greater if a

cut in corporate income taxes follows an allowance

auction rather than a giveaway of allowances. The

reason is that the amount of revenue for recycling is

greater when allowances are auctioned off; hence, the

decrease in corporate income taxes can be larger.

That means that the auction and corporate tax cut

strategy surpasses the free distribution and corporate

tax cut strategy from the perspectives of both equity

and economic efficiency (see Table 5).

Results Under International Trading

How would international trading alter the domestic

trading results outlined above? Under domestic trading, the net effect (on average for all households) of

companies passing their allowance costs on to households (through price increases) and ofthe government

distributing allowance value to households would be

zero. (That result is indicated by the zeros in the column labeled "excess allowance costs" in Table 5.) But

under international trading, U.S. spending on allowances would exceed the value of U.S.-issued allowances by some $40 per household (see Table 6). That
26 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

Box 4.

How a General-Equilibrium Analysis Might Change the Distributional Effects

The distributional effects reported in this study result

from a "partial-equilibrium" analysis, which focuses

on how increases in the cost of carbon would affect

households through changes in the prices of consumer

goods. But a carbon-allowance policy could also

place unequal burdens on households through

changes in the prices and quantities of other markets,

such as those for capital and labor. In other words,

"general-equilibrium" effects might occur. Those effects could alter the distributional results reported

here through two main channels: interactions with

existing taxes and output effects on the relative returns to capital and labor.

Effects Through Existing Taxes

The economics literature on the efficiency effects of

pollution taxes says that the presence of other taxes,

and the distortions they cause, will affect the ultimate

costs that new pollution-reducing requirements impose on society. Most economists have concluded

that pollution-reducing requirements exacerbate the

discouraging effect that existing taxes on labor and

capital have on economic activity—a connection

known as the tax-interaction effect.1

1. For a good survey of this literature, see A. Lans Bovenberg and

Lawrence H. Goulder, "Environmental Taxation," in Alan Auerbach and Martin Feldstein, eds., Handbook ofPublic Economics, 3rd ed. (Amsterdam: Elsevier, forthcoming).

This study's estimate of the inefficiency, or substitution, cost of a carbon trading policy does not take

into account existing taxes. Thus, it probably understates the cost of the policy to the economy as a

whole. Measuring and distributing the additional

losses from existing taxes, however, is not possible

without using a computable-general-equilibrium

(CGE) model. Such a model would specify behavioral choices for different types of households and

allow a more complete estimate of how an increase in

the cost of carbon would affect other markets. For

example, higher consumer prices (caused by the allowance requirement) would lead to lower real wages

and thus decrease the labor supply. That decrease

would exacerbate the distortions in the labor market

caused by taxes on labor. In addition, accounting for

taxes in other markets would mean that the cost of a

carbon-allowance program would be different with

lump-sum rebates than with a cut in corporate taxes.

That difference would occur because cutting corporate

taxes would lower the inefficiencies that such taxes

cause, but issuing lump-sum rebates would not.

Existing taxes also matter because they generate a

prepolicy revenue base. According to information

from CGE modelers who participated in Stanford University's Energy Modeling Forum, the 15 percent cut

in carbon emissions assumed in this study could reduce gross domestic product (GDP) by about $22 billion. Such a drop would imply a decrease in government tax receipts equal to 40 percent of the decline in

GDP, or roughly $8.8 billion, the Congressional Budget Office (CBO) estimates. Lower tax receipts would

excess allowance spending would be paid to foreign

firms.

Taken in isolation, excess allowance costs would

make the average U.S. household worse off under international trading than under domestic trading.11

That is only part of the story, however. International

trading would also lowersubstitution costs (from $ 100

per average household to $40). As a result, total costs

—excess allowance costs plus substitution costs—

11. The United States would need to export more of its goods to pay for

the import of foreign allowances, which would crowd out domestic

consumption.

would be $80 per household under international trading as opposed to $ 100 under domestic trading. Overall, therefore, international trading would make U.S.

households better off because it would lower the total

policy costs for the nation as a whole. That result

holds true regardless of what assumptions are made

about the price of foreign allowances or the speed at

which carbon emissions decrease as allowance prices

rise (the price-responsiveness estimate). The size of

the gain, however, would vary depending on those assumptions.

Households that would bear a disproportionate

share of the costs of a carbon trading program (rela-
CHAPTER THREE DISTRIBUTING THE OVERALL ECONOMIC EFFECTS AMONG U.S. HOUSEHOLDS 27

Box 4.

Continued

reduce the revenue available for recycling and thus

the government's ability to use revenue recycling to

achieve goals of equity or efficiency.

CBO interprets the estimates of GDP loss from

the Energy Modeling Forum participants as corresponding to a carbon trading program with lump-sum

revenue recycling. The $8.8 billion decline in tax

receipts would reduce each household's rebate by $80

(from a level of $860 if allowances were auctioned

and $200 if they were distributed for free).

Recycling revenue by cutting corporate taxes

would produce a smaller decline in GDP, and hence a

smaller revenue loss, because it would reduce the

overall inefficiency cost of the carbon-allowance policy. However, the basic finding that a carbon trading

policy would be less regressive if the government recycled its additional revenue by issuing lump-sum

rebates than if it decreased corporate taxes would remain the same. That result would hold true even under the extreme assumption that cutting corporate

taxes would produce no decline in overall revenue.

Output Effects on Relative Returns

The second way that the general-equilibrium effects

of a carbon-allowance policy could affect households

differently is through changes in the relative returns

to capital and labor. The pioneering work of economist Arnold Harberger showed that taxes on specific

types of factors or output can affect the relative returns to factors of production, depending on "factor

substitution" and "output effects."2In the context of

this study, it is the output effects that are relevant: a

charge on carbon can alter the relative returns to laborers versus capitalists, depending on how the ratio

of capital to labor in carbon-intensive industries compares with the ratios in other industries. As production in carbon-intensive industries declines, production in other industries that use less carbon will increase, and that change in the mix of outputs implies

changes in relative demands for capital and labor.

For example, if the carbon-intensive energy sector of the economy is more capital-intensive (has a

higher capital-to-labor ratio) than other industries, the

general-equilibrium output effects would cause the net

rate of return on capital to fall relative to the net wage

rate. Such effects on relative factor returns would

affect the distribution of the cost or tax burden among

income quintiles, because capital income is concentrated among higher-income households. Thus, if

carbon production was capital-intensive, the generalequilibrium output effects on relative factor returns

would tend to alleviate some of the regressivity associated with higher prices for consumer goods. But if

carbon production was labor-intensive, any regressivity would be exacerbated.

2. See Arnold C. Harberger, "The Incidence of the Corporation

Income Tax," in Harberger, ed., Taxation and Welfare (Boston: Little, Brown, 1974), pp. 135-162.

tive to their share of the allowance value) would see

their situation improve under international trading

compared with domestic trading. (That result is illustrated in Table 7 on page 25, which shows the relative

gain or loss that households would incur if a foreign

supply of allowances were available. In other words,

it shows the difference between the changes in Table 6

and the changes in Table 5.) Households that would

experience losses under domestic trading—low-income

households in all ofCBO's scenarios except an auction

and lump-sum rebate—would be made better off by

international trading. For example, in the free distribution and corporate tax cut scenario, the after-tax

income ofthe average household in the lowest quintile

would be $200 higher with international trading than

with domestic trading alone.

Likewise, households that would receive a disproportionate share of the allowance value under domestic trading—high-income households in all of

CBO's scenarios except the auction and lump-sum

rebate—would be worse off under international trading. For example, in the free distribution and corporate tax cut scenario, international trading would reduce average household income in the highest quintile

by $740.
28 WHO GAINS AND WHO PAYS UNDER CARBON-ALLOWANCE TRADING? June 2000

Limitations of the Analysis

One drawback of CBO's study is that it takes a

"partial-equilibrium" approach to analyzing the distributional effects of a carbon trading policy. In other

words, it examines how the policy would affect households through changes in the prices of consumer

goods, but it does not account for other possible effects of the policy, such as impacts on the markets for

capital and labor. Accounting for those effects would

require using a "general-equilibrium" approach (see

Box 4 on pages 26 and 27).

By relying on detailed household-level data, this

study can account for the overall reduction in carbon

emissions that would occur and distribute total costs

and allowance value among households on the basis of

their existing patterns of consumption, income, and

taxes. But using those data means focusing on annual

measures of income and spending. Such an annual

perspective may not accurately reflect a lifetime perspective, because ratios of consumption to income

vary throughout people's lives. Other analyses, however, suggest that any policy that raises the price of

consumer goods would continue to be regressive (although to a lesser degree) if it was based on lifetime

spending relative to lifetime income. The reason is

that lifetime consumption as a share of lifetime income—like the annually based ratio—tends to fall as

the level of lifetime income rises (because bequests

rise with income).12Further, information about lifetime incidence of a policy can be inferred from annual

data by examining the subset of the population that is

middle aged. CEX data indicate that consumption-toincome ratios would decline with increases in

income for middle-aged households, but to a lesser

extent than for the population as a whole.13That indi12. See Diane Lim Rogers and Don Fullerton, Who Bears the Lifetime

Tax Burden? (Washington, D.C.: Brookings Institution, 1993); Paul

L. Menchik and Martin David, "The Incidence of a Lifetime Consumption Tax," National Tax Journal, vol. 35, no. 2 (June 1982), pp.

189-203; and Gilbert E. Metcalf, "A Distributional Analysis of Green

Tax Reforms," National Tax Journal, vol. 52, no. 4 (December

1999), pp. 655-681.

13. That pattern occurs because income is more equal across quintiles for

middle-aged people than it is for the population as a whole.

cates that the price effects of a carbon trading policy

would continue to be regressive, but slightly less so, if

measured on a lifetime basis.

Another limitation of this analysis is that it is

based on average national effects. For example, the

estimate of how much the cost of electricity would

increase reflects the average carbon intensity of electricity production throughout the United States. The

actual cost of the policy would vary significantly between regions depending on the fuels used to generate

electricity in each place. In addition, the effects experienced by any particular household could differ significantly fromthe effects on the average household in

its quintile because of differences in individual households' patterns of consumption.

Conclusions

CBO's analysis shows that the ultimate incidence of a

carbon trading policy is largely a function of the policy's design. Although the distribution of allowance

and substitution costs is determined by households'

purchasing patterns, that is just part of the story. The

government determines the ultimate incidence of the

policy by choosing how to allocate emission allowances and how to use the increased revenue it collects

as a result. Understanding the distributional implications ofthose choices is important because the amount

of wealth that a carbon trading policy would redistribute could be very large, dwarfing the magnitude ofthe

substitution costs.

The government could use its share ofthe allowances' value to achieve at least two possible goals:

making the policy more equitable by recycling the revenue in a way that offset the regressivity ofthe policyinduced price increases, or seeking gains in economic

efficiency by using the revenue to decrease existing

distortionary taxes. The government's ability to

achieve either ofthose goals would be greater ifit auctioned off allowances than if it gave them away.

Furthermore, the goals of equity and efficiency

could conflict. A strategy that sought efficiency gains

by cutting corporate income taxes would make the

policy even more regressive than its initial price ef-
CHAPTER THREE DISTRIBUTING THE OVERALL ECONOMIC EFFECTS AMONG U.S. HOUSEHOLDS 29

fects.14 Such a cut would be both more equitable and

more efficient if it followed an auction of allowances

rather than a giveaway. Nevertheless, both of those

scenarios would be regressive overall; the free distribution and corporate tax cut would simply be more

regressive. The share of allowance value that is captured by households when the government gives allowances away (as it has done with past pollution-rights

trading programs) increases the regressivity ofthe policy and does not generate any increased saving or investment. The only one ofthe four policy scenarios in

CBO's analysis that was not regressive was an allowance auction followed by a lump-sum rebate of the

resulting revenue.

This study did not look at using more than one

allowance-allocation or revenue-recycling strategy at

once. But in reality, the government could use its revenue to meet several objectives simultaneously. For

example, it could use some ofthe revenue to offset the

effects of price increases on low-income households

and some to improve economic efficiency by paying

down the national debt or reducing existing taxes.

Likewise, some ofthe allowances could be distributed

for free while the remainder were sold at auction.

Some researchers have examined what fraction of the

revenue from a carbon-allowance auction would be

necessary to compensate firms in the fossil-fuel sector

for their transitional (or adjustment) costs. Those analysts assume that the rest ofthe revenue would be used

to offset existing taxes.15Likewise, proposals by Resources for the Future and the Corporation for Enterprise Development would use auction revenues in a

combination of ways.

Finally, this analysis concludes that international

trading of carbon allowances would lower the total

cost imposed on U.S. households, but that gain would

not be shared equally. Households that would receive

a disproportionate share of the allowances' value in a

given allowance-allocation and revenue-recycling scenario under domestic trading would be relatively

worse offunder international trading, because the total

value associated with U.S.-issued allowances would

fall as the supply of foreign allowances lowered the

price per allowance. But households that would experience a loss in real income under domestic trading

would be relatively better offunder international trading. In all but one of the allowance-allocation and

revenue-recycling scenarios that CBO examined,

lower-income households would fare better under international trading than domestic trading and households in the highest income quintile would fare worse.

14. That would be true for proportional decreases in any progressive tax,

including personal income taxes and payroll taxes.

15. See A. Lans Bovenberg and Lawrence H. Goulder, "Neutralizing the

Adverse Industry Impacts of C02 Abatement Policies: What Does It

Cost?" (paper prepared for the Fondazione Eni Enrico Mattei and National Bureau of Economic Research Conference on Behavioral and

Distributional Effects of Environmental Policy, Milan, Italy, June

1999).