Carbon Tax: Deficit Reduction and Other Considerations
Released: 2013-04-02T00:00:00

Introduction

The FY2013 budget deficit is projected to be $845 billion, or 5.3% of gross domestic product (GDP). From 2009 through 2012, the federal budget has exceeded $1 trillion annually. While budget deficits have begun to decline, current fiscal policies remain unsustainable, and budget deficits are projected to continue. Under CBO's alternative fiscal scenario, which assumes continuation of many current policies, the deficit as a percentage of GDP is projected to decline to 3.7% by 2016, before again increasing to exceed 5% by 2022. Over time, unsustainable deficits can have negative macroeconomic consequences, including reduced savings for investment, higher interest rates, and higher levels of inflation. Restoring fiscal balance will require spending reductions, revenue increases, or some combination of the two.

Policymakers have considered a number of options for raising additional federal revenues (see the text box below). One potential option is a carbon tax. Several economists and policy analysts from across the political spectrum have expressed interest in a carbon tax mechanism in recent years. Other stakeholders have expressed strong opposition to carbon tax proposals.

In the 113 th Congress, Senators Sanders and Boxer have introduced legislation ( S. 332 ) that would apply carbon tax (a "carbon pollution fee") on fossil fuels and other materials, starting at $20 per ton of CO 2 emissions, rising 5.6% per year over a 10-year period. In addition, Representative Waxman and Senator Whitehouse, among others, released a carbon tax discussion draft. Their proposal would also impose a carbon pollution fee, requiring certain carbon emitters to purchase "carbon pollution permits" from the Department of the Treasury. The discussion draft requests comment on the level of the tax and on how the revenues should be used.

In addition, Members proposed several carbon price systems in previous Congresses—as identified in Appendix C —most frequently as an efficient means to stimulate greenhouse gas (GHG) emission reductions. In addition, some countries have levied carbon taxes (or something similar) for over 20 years.

Several Members of the 113 th Congress have expressed opposition to a carbon tax. Two concurrent resolutions introduced in the House ( H.Con.Res. 8 and H.Con.Res. 24 ) propose to express the opposition of Congress to a federal carbon tax, citing concerns about the potential negative economic impact. A similar concurrent resolution has been introduced in the Senate ( S.Con.Res. 4 ).

Other policy considerations, including environmental concerns, may also lead to consideration of a carbon tax. GHG in the atmosphere trap radiation as heat, warming the Earth's surface and oceans. The key human-related GHG is carbon dioxide (CO 2 ), primarily generated through the combustion of fossil fuels: coal, oil, and natural gas. Although fossil fuels have facilitated economic growth in the United States and around the world, fossil fuel combustion has inadvertently raised the atmospheric concentration of CO 2 by about 40% over the past 150 years. Almost all climate scientists agree that these CO 2 increases have contributed to a warmer climate today, and that, if they continue, will contribute to future climate change.

Many economists have argued that current fossil fuel prices reflect a market failure , because GHG emissions from fossil fuels contribute to current and future climate change, yet fossil fuel prices do not reflect climate change-related costs. Market failures distort economic efficiency by affecting consumer behavior. For example, energy consumers may make choices that are not in society's best interest, consuming more than the optimal amount of GHG emitting fuels, if prices do not reflect climate change-related costs.

Carbon taxes, or GHG fees, have been proposed as one means to correct such a market failure. Another option is a cap-and-trade program, which would attach a price to GHG emissions by limiting their generation. To some extent, a carbon tax and cap-and-trade program would produce similar effects: Both would place a price on carbon, and both are estimated to increase the price of fossil fuels. Preference between the two approaches ultimately depends on which variable one prefers to control—GHG emissions or costs.

A tax based on carbon content of fuels is different from a tax based on energy content, such as a Btu tax (see the text box below). Placing an emissions fee on CO 2 (and possibly other GHG emissions) could stimulate lower emissions and spur innovation in new lower-emitting technologies. A tax or fee based approach would allow markets to determine the level of investment in lower-emissions technologies. In addition, carbon tax revenues could be used to support multiple objectives, such as deficit reduction, or to replace existing taxes (e.g., payroll, income).

The first section of this report examines carbon tax design and implementation issues, including the point of taxation, the rate of taxation, and the distribution of tax revenue. The second section discusses several carbon tax policy considerations: revenue potential, economic efficiency, equity, and operability. The final section highlights key issues related to the use of carbon tax revenues. Specifically, how might addressing the regressivity of a carbon tax diminish its revenue-raising potential, and what is the potential for a carbon tax to contribute to deficit reduction goals?

Design and Implementation

When establishing a carbon tax, there are several implementation decisions to be considered. Key considerations include (1) the point of taxation—where to impose the tax and what to tax; and (2) the rate of taxation. Information on how a carbon tax might affect fossil fuel prices is also provided.

Point of Taxation

The point of taxation would influence which entities would be required to (1) make tax payments based on emissions or emission inputs (e.g., fossil fuels), (2) monitor emissions or emission inputs, and (3) maintain records of relevant activities and transactions. The point of taxation does not necessarily reveal who bears the cost of the tax, as the cost may be passed on to intermediate producers or consumers. (This will be discussed in a later section.)

GHG emissions are generated throughout the economy by millions of discrete sources: smokestacks, vehicle exhaust pipes, households, commercial buildings, livestock, etc. Although CO 2 is the primary GHG at many sources, some sources predominantly emit non-CO 2 GHGs, such as methane. When determining which sources and which GHG gases to control through a tax, policymakers would need to balance the benefits of comprehensiveness with administrative complexity and costs. Applying a carbon tax at the points of emissions from all GHG sources would present enormous logistical challenges.

CO 2 emissions are fairly easy to verify from large stationary sources, such as power plants. For almost 20 years, measurement devices have been installed in smokestacks of large facilities, reporting electronic information to the U.S. Environmental Protection Agency. For smaller sources, CO 2 emissions are a straightforward and accurate calculation based on the carbon content of fossil fuels consumed. Other GHG emissions, such as methane, nitrous oxides, sulfur hexafluoride, and others, could be more difficult or less reliable to verify. Thus, administrative costs and non-compliance risks would likely increase with a broader scope of an emissions tax. However, limiting the tax scope could result in perverse effects, with sources potentially shifting processes, facility size, or location to avoid taxes.

Policymakers may consider limiting the tax to sectors or sources that emit large percentages of the total U.S. GHG emissions or those that are relatively easy to measure. Or, the tax could be applied to reliable proxies for emissions in the production-to-emission chain. For example, as illustrated in Figure 1 , potential emissions could be taxed at "upstream" (e.g., wells) or "midstream" (e.g., refineries) stages in that process, taking advantage of specific chokepoints in the fossil fuel market.

Alternatively, policymakers could employ a "downstream" approach, applying a carbon tax at the point where the gas is released to the atmosphere. For example, a carbon tax could be applied at sources required to report GHG emissions to EPA. In 2011, EPA collected emissions data from approximately 8,000 facilities, covering between 85% and 90% of all U.S. GHG emissions.

Table A-1 (in Appendix A ) lists the top emission sources of six principal GHGs in the United States. These sources combine to account for approximately 95% of these gases (based on 2011 data). Table A-1 also provides potential points of taxation that could cover some percentage of emissions from these sources. For example, fossil fuel combustion accounts for almost 80% of total U.S. GHG emissions. To attach a price to these emissions, policymakers could apply a carbon tax to a relatively small number of entities, including

petroleum refineries (115) and petroleum importers (235); coal mines (1,296) and coal-fired generators using imported coal (19); and some combination of natural gas sector entities (discussed below).

Table A-1 (in Appendix A ) provides several options of points in the natural gas production-consumption chain at which a carbon tax could be applied. See Figure B-1 (in Appendix B ) for an illustration of the natural gas production-consumption chain. For example, policymakers could apply a carbon tax at natural gas wellheads and points of import. This should cover 100% of the CO 2 combustion emissions from end-users as well as emissions downstream of the extraction process (e.g., fugitive emissions, pipeline operations). Although this option would involve a large universe of entities (over 500,000), a relatively small number of operators control a large percentage of domestic production. In addition, most of the natural gas producing states levy some type of tax or fee on natural gas, many of which apply at the point of production. Some of these taxes are based on volume (i.e., cubic feet); others are based on value of the resource. One potential challenge of applying the tax at the wellhead would be that the CO 2 content of the extracted gas may vary to some degree. In contrast, pipeline quality natural gas is more uniform.

Employing another option, policymakers could apply the tax at (1) entities who report natural gas deliveries to the Energy Information Administration (EIA) on Form EIA-176 and (2) natural gas processors, in sum, about 2,200 entities. This would likely cover nearly 100% of the CO 2 emissions from combustion as well as some of the CH 4 emissions from natural gas systems ( Table A-1 ).

Rate of Taxation

Although setting the carbon tax rate would likely involve political considerations, several economic approaches could be used to inform the debate. As a public finance instrument, the tax rate could be based on the estimated revenues needed to reduce or eliminate projected budget deficits. This approach would be challenging, because estimates of future budget deficits (and thus the revenues needed to address them) are "inherently uncertain." Moreover, a carbon tax would have some impact on the overall economy (and thus the overall tax base) that would make such a calculation more difficult.

Alternatively, the tax rate could be tied to climate change objectives. For example, Congress could set a tax rate based on the estimated benefits associated with avoiding climate change impacts. Some economists would say that the optimal level of a carbon tax would be at the "marginal cost of climate change," which is the incremental cost of damages of one more ton of emissions. This is sometimes called the Social Cost of Carbon (SCC). The rate could include, as well, the cost of incremental damages of ocean acidification and other possible effects associated with carbon emissions (e.g., related air pollution).

Estimates of the risks of GHG emissions are uncertain and cover a wide range. Analysts must place monetary values on goods and services that may be difficult or controversial to estimate, such as human health/life, water supplies, agricultural production, or recreational activities. In addition, the element of time particularly complicates the valuation. The factor of time would demand a consideration of what global society should be willing to pay now to avoid future damages due to additional emissions generated today . In short, basing the tax rate on a precise estimate of GHG emission-related risks would present extraordinary challenges.

An alternative climate change approach would involve basing the tax rate on an estimate of the carbon price needed to meet a specific GHG emissions target. Such estimates, though relatively more certain than the SCC, are similarly based on multiple assumptions. Accordingly, estimates of carbon prices in hypothetical carbon reduction schemes have varied dramatically. For example, multiple parties prepared such estimates during the development of H.R. 2454 (in the 111 th Congress), which intended to reduce GHG emissions to 17% below their 2005 levels by 2020. The emission allowance price estimates ranged from $16/metric tons of CO 2 equivalent (mtCO 2 e) to $49/tCO 2 e in 2015, with the estimated range increasing over time. Moreover, it could be challenging to reach political agreement on the GHG emissions target sought as well as the tax rate that would achieve it.

Given the uncertainty in the above estimates and a desire to avoid "shocking" the economy with a sudden change in tax policy, some have proposed starting a carbon tax with a rate that is initially set at a low rate, with that rate rising annually as announced for a fixed period or indefinitely. This approach would have several potential advantages: it is simple to explain and understand; it provides predictability to investors and consumers; and it allows policymakers to hedge against the risks of carbon emissions.

Carbon Tax Effects on Fossil Fuel Prices

Different fossil fuels generate different amounts of CO 2 emissions per unit of energy. Therefore, a carbon tax, which is based on CO 2 emissions, would levy a higher charge (per unit of energy) on some fuels than others. As indicated in Table 1 , coal generates approximately 80% more CO 2 emissions per unit of energy than natural gas, and approximately 28% more emissions per energy than crude oil. These differences in emissions intensity would lead to different tax rates per unit of energy across different fuels in a carbon tax regime.

Table 2 includes estimates of the tax levied on fossil fuels and motor gasoline at different carbon tax rates. The change in price that consumers would see would likely not be the same as the carbon tax. Carbon taxes could affect fuel prices in complex ways. For example, energy consumers, to the extent possible, would likely shift their preferences to less expensive fuels, and the underlying prices of the fuels would change. Actual price increases that result from the illustrative carbon taxes in Table 2 would depend on whether

a carbon tax is applied at the beginning of the production process ("upstream") to fossil fuels ( Figure 1 ); the price impacts are passed through to end-users and not absorbed by upstream energy producers or midstream entities (such as retailers); and consumers modify their behavior in the marketplace—energy conservation, fuel substitution, etc.

Framework for Evaluation

Policymakers may consider a carbon tax based on a number of policy motivations and potential benefits, including

increased federal revenues, reduced federal budget deficits, reduced GHG emissions, climate change, and ocean acidification, enhanced energy security, improved economic efficiency, and/or reduced tax rates from other revenue sources.

In recent years in the United States, most carbon tax proposals have aimed primarily to discourage GHG emissions. In these proposals, a tax or fee would be levied on GHG emissions or the inputs (i.e., fossil fuels) that lead to emissions. The tax or fee raises the price of the emission-generating products, and therefore can, on the one hand, motivate suppliers to reduce the emissions involved in making the product and, on the other hand, encourage consumers to buy less of the product. This policy instrument sets the tax (cost) per unit of emissions and relies on private decision-makers to find the most efficient means to reduce the emissions. A carbon tax is one of several "market mechanisms" that relies on the efficiencies of markets to maximize cost-effectiveness.

Though this policy instrument is commonly called a "carbon tax," its application could be broader than this term suggests. First, the policy may apply not just to CO 2 emissions, but also to multiple GHGs (e.g., methane or sulfur hexafluoride), including some that may have no molecular carbon. Second, if the levy's primary purpose were to charge those who use the atmosphere to absorb the full cost of their GHG emissions, the levy might instead be considered a "user fee." Regardless, this report uses the term "carbon tax," because this report focuses on the policy instrument's potential to raise revenues and reduce the federal budget deficit.

There are a number of issues to be considered when evaluating tax policy proposals. The following sections analyze a generic carbon tax option using the criteria listed below:

adequacy— the ability to generate a desired amount of revenues; economic efficiency— the potential to enhance or diminish the productivity of the U.S. economy; equity— the subjective determination of a proposal's fairness; o perability— the combination of multiple factors, including administrative ease, transparency, avoidance of perverse outcomes, and consistency with federal and international norms and standards; and political feasibility— the likelihood of enactment given a tax's visibility to the public and public opinion, differential regional implications, contribution to deficit reduction or other objectives, pledges made by some lawmakers not to raise taxes, etc.

Adequacy—the Potential to Generate Revenues

The revenues that would be generated under a carbon tax vary greatly depending on the design features of the tax, namely the tax scope (i.e., base) and rate, as well as such independent factors as prices in global energy markets. Several recent proposals to price or tax carbon, where revenue estimates are available, are presented below.

In 2011, the Congressional Budget Office (CBO) evaluated a hypothetical cap-and-trade program in which CO 2 emission allowances (i.e., permits to emit one metric ton of CO 2 emissions) would be sold at auction and traded in a carbon market. The auction revenues generated in this program would be analogous to tax revenues under a carbon tax system. CBO estimated the allowance price, which, under an actual program, would be determined by market forces, would begin at $20 per metric ton of CO 2 (mtCO 2 ) in 2012 and increase 5.6% annually. This allowance price estimate, and its projected annual increase, is akin to a prescribed carbon tax rate. CBO estimated that such a regime would raise $1.2 trillion over the 2012 to 2021 budget window ( Table 3 ).

As a point of reference for the above carbon tax revenue estimates, Figure 2 identifies the major sources of federal receipts in FY2011. As the figure illustrates, the range of potential carbon tax revenues is comparable (at least in the early years of the carbon tax system) to the revenues collected from current federal excise taxes. Nearly half of all federal excise tax receipts come from taxes on gasoline and diesel fuels.

Legislation introduced in the 112 th Congress, the Save Our Climate Act of 2011 ( H.R. 3242 ), would have established a carbon tax on domestic and imported fossil fuels, as well as the carbon content of biomass, municipal solid waste, and any organic material used as fuel. The tax rate would have begun at $10 per short ton of CO 2 emissions (tCO 2 ), increasing by $10 annually until total U.S. CO 2 emissions are 20% or less of CO 2 emissions in 1990. The bill states that it would reduce the federal budget deficit by $480 billion over 10 years.

Other revenue estimates have been made in recent years of carbon taxes considered or included in a number of deficit and debt reduction proposals. As one example, in 2010, the bipartisan Debt Reduction Task Force (Domenici-Rivlin) considered, but did not ultimately recommend, a tax on CO 2 emissions. The report estimated that a tax of $23 per ton of CO 2 emissions starting in 2018, increasing 5.8% annually, would raise approximately $1.1 trillion in cumulative revenues through 2025.

In addition to a carbon tax design, a 2012 Resources for the Future (RFF) study identified several factors—electricity demand and natural gas prices—that could influence carbon tax revenue. The study found that the magnitude of these factors' influence increases as the tax rate increases. Figure 3 illustrates the RFF study findings.

In Figure 3 , RFF compares tax revenue estimates using assumptions from EIA's 2009 and 2011 Annual Energy Outlook (AEO) publications. According to the study, the AEO assumptions regarding future electricity demand and fuel prices, namely natural gas, varied dramatically between the 2009 and 2011 versions. These variances lead to different estimates of potential carbon tax revenue. For example, as illustrated in Figure 3 , estimated revenues in 2020 from a tax rate of $25/mtCO 2 would vary across scenarios by about $10 billion. A $40/mtCO 2 tax rate would generate an estimated revenue range across scenarios of almost $20 billion in 2020.

Further, Figure 3 highlights a key result of a carbon tax that may affect its ability to provide a reliable source of revenue. Note that the tax revenues in the electricity sector begin to decline around 2030 with the $40/mtCO 2 tax rate. The study concluded this decline is due to a diminishing reliance on fossil fuels and relatively greater reliance on low-carbon energy sources, such as renewables and nuclear.

The projected scenario in Figure 3 highlights a fundamental revenue adequacy concern associated with a carbon tax approach: if a primary goal of a carbon tax is to reduce its own tax base (i.e., carbon emissions), would this tax provide a reliable stream of revenues over time? With revenue reliability as a primary goal, governments impose taxes on activities to which producers and consumers are not very price-sensitive. In other words, the imposed taxes lead to minimal changes in market behavior. Researchers debate how much producers and consumers would respond to a tax on GHG emissions by reducing emissions or switching to goods and services that generate fewer emissions (because they embody lower taxes). With a higher degree of responsiveness, either revenues would decline or the tax rate per ton of emissions would need to increase over time to maintain the revenue stream (assuming that maintaining certain revenue stream is determined to be a policy objective).

Economic Efficiency

Economic theory suggests that a carbon tax could improve the efficiency of the economy by at least three means:

first, markets could produce a more optimal mix of goods and services if the costs of emitting GHG while manufacturing products, providing services, or using goods were "internalized" into market prices; producers and consumers would more fully respond to the full costs of their decisions, resulting in a more economically efficient outcome; second, a tax on an activity that yields pollutants, such as GHG emissions, would discourage the polluting activity and therefore could be more efficient than an alternative tax that yields the same revenues but discourages a beneficial activity (e.g., investment); and third, adding a smaller tax on a new activity, such as potential carbon emissions, could be less distortionary to production and consumption than increasing the tax rate on currently taxed activities.

The difficulty associated with setting an optimal carbon tax rate makes achieving potential efficiency gains challenging. Further, a stand-alone carbon tax (e.g., one where revenues were not used to offset other taxes) could have efficiency costs, as a carbon tax would increase existing distortions on inputs in the production process. The difficulty of implementing an efficiency-enhancing carbon tax is compounded in a tax system that already contains a number of distortionary taxes.

Many Taxes Have Distortionary Effects50

Many people are concerned about several potentially "distortionary" effects of taxes on society. Many economists consider that taxes take money away from people and change the relative prices of goods and services compared to what they would be without taxes; thus, taxes are considered "distortionary" by altering free market decisions. To minimize distortions (and generate a reliable stream of revenues), governments often prefer to tax products or activities for which consumer demands are relatively insensitive to price increases. Some of these taxed items are recognized as essential or socially desirable, such as income, employment, and investment. Taxes may also be "distortionary" because they discourage a taxed but beneficial activity. For example, many economists argue that payroll and income taxes are distortionary because they discourage employment and investment. If these taxes were reduced, the incentives to hire/work and invest, they argue, would be greater.

Also, as tax rates (i.e., the tax per unit of a product or service) increase, they become more distortionary. That is, higher tax rates have greater potential to shift choices away from optimal "free market" outcomes. As an example, consumers may respond proportionately more strongly to a $1.00 tax per gallon on gasoline than a $0.20 tax per gallon (in other words, the efficiency losses associated with a tax increase exponentially with the tax rate). Thus, applying lower tax rates to broader tax bases can help minimize inefficiencies.

Taxes May Correct Market Failures

Not all results from economic activity are considered desirable—pollution being one example. When producers or consumers discharge pollution—including GHG emissions—to another person's private property or a publicly shared resource—such as the atmosphere—without paying to do so, they are not paying for the full cost of a product or activity. Economists would describe this outcome as a "market failure," because the costs associated with GHG emissions are not captured in the economic decision process. Economists contend that levying a charge on GHG emission would be an economically efficient way to correct the failure. For example, in terms of environmental policy, fossil fuel prices do not reflect the costs—related to climate change and ocean acidification damages—associated with the GHG emissions. A pollution discharge fee could internalize these external costs into market prices.

A primary argument in favor of a carbon tax is that it would, in theory, increase the efficiency of markets by discouraging "bad" activities. A carbon tax would discourage pollution that imposes costs on others who do not necessarily benefit from the polluting activity. These may include future generations that bear the dislocations of climate change, or fishery sectors in developing countries that experience lower yields in acidified oceans.

A carbon tax would encourage energy consumers—for example, power plants, industry, households, etc.—to (1) switch to less carbon-intensive fuels; (2) use less energy or use energy more efficiently; and (3) prefer products or services that are lower-priced by virtue of incorporating less emission tax. Each of these activities would reduce GHG emissions compared to a business-as-usual track and could improve economic efficiency.

An Economically Efficient Carbon Tax Rate55

To improve efficiency, a carbon tax would need to be set at the "right" level. According to basic economic theory, the "right" level would be one that equilibrates the tax rate to the incremental harm, now and in the future, that a ton of GHG emissions imposes. To find this tax rate precisely, one would need to know the marginal costs of climate change and ocean acidification.

However, estimating the effects and placing a monetary value on them is both controversial and reliable only over a wide range. Hence, no consensus is likely to emerge regarding a precisely "right" carbon tax rate. An analytical or political estimate is feasible but may not be the most economically efficient outcome. Further, setting carbon tax rates based on revenue needs for deficit reduction, or some other purpose, would not necessarily result in setting a rate that is proportional to the incremental harm of GHG emissions.

Equity

The "equity" or "fairness" of taxes can be evaluated by looking at how different parties are affected. How the burden of a tax is ultimately divided between different parties is described as the economic incidence of the tax. To evaluate the subjective concepts of "equity" and "fairness" in tax policy, economists often examine two different types of equity: vertical and horizontal. In addition, some economists consider individual and generational equity. A complete policy analysis might consider the potential trade-off between economic efficiency and equity. These four elements of tax equity are discussed below.

Vertical Equity

The notion of vertical equity suggests that those with a greater ability to pay should contribute more. Without some of tax revenue redistribution, carbon taxes are generally considered to be "regressive," because lower-income households generally spend a higher percentage of their income on energy-related goods and services than do higher-income households. The actual or perceived regressivity of carbon or fuel taxes can have a strong influence on the political feasibility of the instrument. For example, the coalition of advocates for low-income people and opponents of energy taxes arguably contributed to the failure of President Clinton's 1993 "Btu Tax" proposal (see the text box above), which was introduced as part of a deficit reduction package.

Particular carbon tax design elements could reduce its regressivity. For example, carbon tax revenues could be used to reduce other taxes (e.g., income) or be redistributed to lower-income households through a variety of funding mechanisms (see the section " Alternative Uses for Carbon Tax Revenues " below).

Horizontal Equity

Horizontal equity examines whether potential tax-payers with similar characteristics would receive equivalent tax treatment. Questions of horizontal equity may arise if particular industries or economic sectors that predominately emit non-CO 2 GHG emissions (e.g., methane) were exempted from the carbon tax regime, while industries or sectors of comparable size were included based on their CO 2 emissions.

Individual Equity

Some people consider taxes unfair when they involve government interference in private transactions, including freedom to use one's resources as one chooses. This is sometimes considered a violation of "individual equity." To minimize infringement of individual equity, some would argue that taxes should be levied on, and commensurate with, the benefit an individual receives from the taxed activity, or "benefit taxation." (Proponents contend that not to violate individual equity would require that the tax be voluntary.) Some might counter that a carbon tax is a kind of "benefit taxation," levied on the benefit the carbon source receives by being allowed to discharge the pollution to the atmosphere.

Generational Equity

Are the burdens of taxation and benefits from governmental spending fairly distributed across generations? This is a particular concern in the context of the federal deficit and GHG-induced climate change, both of which would likely shift costs from the current generation to subsequent generations. At first glance, a carbon tax could potentially support generational equity by helping to slow or reduce GHG-induced climate change and by potentially reducing the deficit (depending on the fate of tax revenues).

However, an assessment of generational equity is complex. Some may argue that a carbon pricing mechanism would reduce the wealth of the current generation, consequently reducing the productive capacities of future generations. Moreover, some may argue that, instead of a carbon price approach, increased investment in technology would yield greater benefits for future generations. Others may counter that increased investments today may result in increased consumption, providing minimal benefits for future generations and foregoing the opportunity to address climate change impacts. Such an outcome would disproportionately burden future generations.

Operability

Some tax options may be elegant in terms of economic theory but, in practice, present considerable logistical challenges. This section identifies some of the key administrative issues that might arise when implementing a carbon tax.

Administrative Ease

In previous debates over carbon taxes, which largely focused on discouraging GHG emissions, many proponents asserted that carbon taxes would be administratively simple compared to the principal emissions control alternatives—notably, a cap-and-trade program or emissions performance standards. As with other comparisons, the relative advantage of a carbon tax would depend on the designs of the instrument alternatives under scrutiny.

Any new kind of tax would require new administrative systems, but a carbon tax system could potentially take advantage of existing frameworks. A well-developed administrative structure for collecting taxes already exists in the United States. In addition, approximately 13,000 facilities report annual GHG emissions to EPA. Therefore, EPA already collects carbon tax emissions data covering about 90% of all U.S. GHG emissions. However, a tax program would presumably be administered by the Department of the Treasury. Transferring data should not be technically difficult, but broader cooperation across agencies would likely be necessary to share respective expertise and to promote compliance.

Consistency with Federal and International Norms and Standards

Policymakers might consider the degree to which a carbon tax is consistent with other policies that support other objectives: pollution control, energy affordability, and national security. Superficially, carbon taxes would seem to be consistent with other GHG emission control standards, but would conflict with incentives to make fossil fuels more affordable.

In terms of linking a U.S. GHG emission reduction scheme with international efforts, a carbon tax may be at a disadvantage, because the most prominent international activity, namely the European Union's Emission Trading Scheme, currently involves a cap-and-trade approach.

Potential Perverse Effects

Some carbon pricing policies may yield unexpected and unwelcome results. For carbon taxes, one such "perverse effect" would be the potential to increase the cost of business activity in the United States. Over time, this could result in reduced revenue from both the carbon tax and other taxes. This consideration has led some other countries to exempt energy-intensive manufacturers in specific or strategic sectors from energy or carbon taxes.

In addition, a carbon tax could lead to emissions "leakage," if businesses moved operations overseas to avoid the tax. This outcome would depend on a number of factors, however, including relative fuel mixes, efficiencies of power production and transportation, border taxes, etc.

Transparency

Tax policies that are transparent may be more likely viewed as fair, as taxes being paid are understood by those responsible for paying the tax. In recent years, many have grown more skeptical of complex financial structures. Potential complexity and opaqueness of a cap-and-trade program was one factor that led some advocates of GHG control policies to prefer carbon taxes as a policy instrument.

While a carbon tax could be designed to be simple and transparent, Congress could also choose to establish a carbon tax framework that rivals the complexity of a cap-and-trade program. For instance, policymakers could provide subsidies or exemptions to the fossil fuel industry or certain consumers (e.g., agricultural users) or enact incentives for producing, processing, and exporting fossil fuels. In addition, policymakers could allow for tax credits for carbon sequestration projects, similar to carbon offsets in a cap-and-trade regime. As with carbon offsets in a cap-and-trade program, this would require a further level of administrative responsibilities, and potentially weaken the program.

Ironically, transparency, particularly in regards to costs, could be a political liability for a carbon tax. Although both a carbon tax and a cap-and-trade program would impose higher energy costs, the costs from a cap-and-trade program would be more difficult to estimate, because the market would determine the price of emission allowances (and thus the overall costs of the program).

Political Feasibility

Certain stakeholders are likely to exercise strong opposition to a carbon tax. These include energy-intensive manufacturers, farmers, and regional energy interests—especially those whose asset values may fall with expected impacts on profitability of owned or leased coal and oil resources. One may look to numerous reviews of the histories of both the Clinton Btu tax proposal and more recent cap-and-trade bills for lengthier views regarding political feasibility.

Contribution to Deficit Reduction

The possible contribution of a carbon tax to deficit reduction would depend on the magnitude and scope of the carbon tax, various market factors (discussed above), and assumptions about the size of the deficit. In February 2013, CBO released budget projections for fiscal years 2013 to 2023. Under current law, CBO estimated the 10-year budget deficit at $6.8 trillion, or 3.4% of GDP. However, using an alternative fiscal scenario, CBO projected a larger deficit—$9.1 trillion, or 4.5% of GDP.

Enacting the carbon tax options discussed in the previous section could reduce future budget deficits. As illustrated in Figure 4 , a $20/mtCO 2 price on carbon (increasing by 5.6% annually) would have a considerable impact on budget deficits using CBO's February 2013 baseline projection.

The 10-year budget deficit could be reduced from $6.8 trillion to $5.6 trillion, or from 3.4% to 2.8% of GDP. Overall, a $20/mtCO 2 price on carbon would reduce the 10-year budget deficit by more than 17%.

Under CBO's alternative fiscal scenario, the same carbon tax would have a smaller impact on budget deficits.

The deficit would be reduced from $9.1 trillion to $7.9 trillion, or from 4.5% to 3.9% of GDP. Overall, a $20/mtCO 2 price on carbon would reduce the 10-year budget deficit by about 13%.

The analysis above assumes that 100% of carbon tax revenue would be applied toward deficit reduction. The following section explores possible alternative uses for carbon tax revenues.

Alternative Uses for Carbon Tax Revenues

Carbon tax revenues may be used to achieve a variety of policy goals. However, one revenue use necessarily forgoes the opportunity to apply that level of revenue to support other objectives, like deficit reduction. Therefore, in deciding how to allocate carbon tax revenues, policymakers would encounter trade-offs among objectives. Such trade-offs include

1. minimizing economy-wide costs resulting from a carbon tax; 2. alleviating the costs borne by subgroups in the U.S. population, regions, economic sectors, and generations; and 3. supporting specific policy objectives, such as deficit reduction, climate change mitigation, energy efficiency, technological advances, domestic employment, or energy diversity.

A comprehensive discussion of alternative uses of carbon tax revenues and the involved trade-offs is beyond the scope of this report. Three possible options, which have received some attention in recent years, are discussed below.

Distribute Carbon Tax Revenues to Households

If Congress were to consider a carbon tax system, a key debate would likely involve the degree to which carbon tax revenues would be returned to households to alleviate the expected financial burden imposed by the carbon tax. A 2007 study estimated that households and businesses that are end users would experience the vast majority (87%) of the private costs under a carbon pricing regime (the remaining 13% was attributed to coal, oil, and gas producers and fossil electricity generators). Moreover, businesses—to the extent they were able—would likely pass through to household consumers some of their increased energy/electricity costs in the form of higher prices for their goods and services. Costs that are not passed through to consumers in the form of higher prices are borne by either labor, through reduced wages, or owners of capital, through reduced returns on investment.

Depending on how and to whom carbon tax revenues are distributed, lower-income households could face a disproportionate increase in tax burden. As illustrated in Table 4 , a carbon tax "in isolation" (i.e., without revenue redistribution of some kind) could have a disproportionately greater impact on lower-income households than higher-income households—a regressive outcome. As Table 4 illustrates, a carbon tax in isolation would reduce after-tax income for taxpayers in the lowest income deciles by 3.4%, while taxpayers in the highest income deciles would see their income fall by 0.8%.

The remaining rows in Table 4 show how the household impacts would change if carbon tax revenues were rebated to households using different rebate mechanisms.

An equal lump-sum rebate of carbon tax revenues would be progressive, increasing incomes for those in the lowest income deciles relative to higher-income brackets. A payroll tax rebate for workers, in this case, would reduce but not eliminate the regressivity of the carbon tax. Lower-income households without individuals in the workplace would not receive a rebate under this approach. Adding a rebate for Social Security recipients to the payroll tax rebate would address the lower-income households with individuals not in the workplace, and further enhance the progressivity of this policy option.

In this scenario, both a lump-sum carbon tax rebate and a carbon tax rebate that includes Social Security recipients increase the after-tax income of lower-income households while decreasing the after-tax income of higher-income households. Using carbon tax revenues to reduce payroll taxes would increase the after-tax income of middle-income households, while lower-income households would see their after-tax income fall.

Among the policies surveyed in Table 4 , using carbon tax revenues to finance lump-sum rebates to households provides the most benefit to the lowest-income. While enhancing the progressivity of the overall tax system may be attractive from an equity perspective, lump-sum rebates to households offer limited potential for gains in overall economic efficiency. If carbon tax revenues are instead used to offset other distortionary taxes in the economy (i.e., payroll, income), the costs associated with a carbon tax may be reduced or eliminated.

Studies that examine the distribution of a carbon tax rely on a number of modeling assumptions. Metcalf (2007), for example, assumes that the costs of the carbon tax are related to energy expenditure patterns across income groups. An alternative approach is to look at the distribution of the carbon tax, assuming that the carbon tax reduces returns to factors of production: labor, capital, and fossil fuel resources. Under this approach, the regressivity of a carbon tax is reduced. If the burden of the carbon tax falls more heavily on owners of capital, as opposed to labor, the carbon tax affects higher income households that tend to derive more of their income from capital. Further, lower income households that receive a larger share of their income from transfer payments (e.g., social security), would be less affected by a carbon tax. While the "baseline" distribution of a carbon tax (i.e., the distribution of a carbon tax absent revenue recycling) differs under various modeling assumptions, the general conclusions regarding different policy choices for uses of carbon tax revenues often remain the same. Lump-sum redistribution of carbon tax revenues tends to be more progressive, while policies that reduce payroll taxes tend to be less regressive than those that reduce taxes on income or capital.

Address Economy-Wide Costs

Some are concerned about potential economy-wide costs that a carbon tax would impose. Economy-wide costs, or macroeconomic costs, are often measured in terms of changes in projected gross domestic product (GDP) or another societal-scale metric, such as efficiency cost or welfare changes.

A tax on carbon would likely lead to increased energy costs, which could reduce GDP growth. However, most measures of economic costs imposed by a carbon tax do not consider the climate change benefits or ancillary benefits that a carbon price would provide. The ultimate economic effects would depend on a number of factors, including the magnitude, design, and use of revenues of the carbon tax.

Economic studies indicate that using carbon tax revenues to offset reductions in distortionary taxes—labor, income, and investment—would be the most economically efficient use of the revenues and yield the greatest benefit to the economy overall. Studies also conclude that using tax revenues to lower the federal deficit would yield an economy-wide benefit, because of the reduced need to impose distortionary taxes in the future. But this benefit would be delayed and its realization assumes policymakers would, sometime in the future, address the deficit by raising taxes.

Using carbon tax revenues to offset other distortionary taxes is sometimes described as revenue recycling, a fiscal strategy that may yield a "double-dividend":

1. reduced GHG emissions, achieved through the new carbon price, and 2. reduced market distortions, achieved through lower taxes on desirable behavior.

According to a 2011 study, economic literature generally finds that revenue recycling may reduce the economy-wide costs imposed by a carbon tax intended to reduce GHG emissions, but may not eliminate them entirely. However, the same 2011 study and a 2012 study both provide scenarios in which a carbon tax and revenue recycling would produce a net increase in Gross Domestic Product. In other words, these studies found that, in certain situations, that the economic improvements gained by reducing existing distortionary taxes would outweigh the costs imposed by the new carbon tax. In both studies, the potential benefits of reduced GHG emissions were not part of the calculation, largely because these estimates carry considerable uncertainty.

For example, the 2012 study projected a net reduction in GDP and employment—a measure of economy-wide costs—when carbon tax revenues were used to (1) reduce the deficit, (2) provide lump-sum transfers to households, or (3) reduce payroll taxes. However, when carbon tax revenues were used to reduce marginal tax rates on capital income (e.g., the corporate tax), employment and GDP increased relative to the baseline. While using carbon tax revenues to reduce tax rates on capital may enhance economic efficiency, such policies would not offset the increased burden imposed by a carbon tax on low-income households.

Assist Carbon-Intensive, Trade-Exposed Industries

Carbon-intensive, trade-exposed industries would likely face disproportionate impacts within a U.S. carbon tax system. This issue received considerable attention during the debate over H.R. 2454 in 2009 (the 111 th Congress) and would likely receive similar attention if Congress were to consider establishing a carbon tax system.

An industry's carbon intensity is a function of both direct CO 2 emissions from its manufacturing process (e.g., CO 2 from cement or steel production) and indirect CO 2 emissions from the inputs to the manufacturing process (e.g., electricity, natural gas). In general, trade-exposed industries are those that face considerable international competition. A carbon tax would present a particular challenge for these industries. Compared to other domestic industries, they would be less able to pass along the tax in the form of higher prices, because they may lose global market share (and jobs) to competitors in countries lacking comparable carbon policies.

To address these impacts, policymakers could distribute a portion of the carbon tax revenues to these industries. As one point of reference, under H.R. 2454 (111 th Congress) such industries would have received approximately 15% of the emission allowance value—analogous to 15% of carbon tax revenue—through 2025, steadily decreasing to zero thereafter. At the time, some questioned whether this allotment was sufficient. Regardless, the data and administrative resources necessary to implement such a program would be substantial.

Alternatively, policymakers could supplement a carbon tax scheme with a border adjustment mechanism that would essentially apply a tariff to carbon-intensive, imported goods. Such a mechanism was included in H.R. 2454 (111 th Congress). Under that proposal, EPA would have required importers of energy-intensive products from countries with insufficient carbon policies to submit a prescribed amount of "international reserve allowances," for their products to gain entry into the United States. Implementation of this approach would present substantial administrative challenges, particularly in terms of data from other nations.

In addition, either the revenue distribution or border adjustment approach would likely raise concerns of trade complications. These issues are beyond the scope of this report. For further information, see CRS Report R40914, Climate Change: EU and Proposed U.S. Approaches to Carbon Leakage and WTO Implications .

Concluding Observations

Carbon taxes, or fees on emissions of some or all GHG emissions, have been proposed for many years by economists and some Members of Congress. A new carbon price would help reduce GHG emissions contributing to climate change and ocean acidification, and tax revenues could support a range of policy objectives, including deficit reduction.

Carbon tax revenues would depend strongly on the scope and rate of the tax and multiple market factors, which instill uncertainty in revenue projections. A $20/mtCO 2 carbon tax on U.S. CO 2 emissions would generate approximately $90 billion in its first year. If applied toward deficit reduction, carbon tax revenue (of this magnitude) could have some impact on projected budget deficits, but impacts vary considerably depending on which budgetary baseline is assumed.

Regardless, if policymakers established a carbon tax, they would likely face pressure from multiple stakeholders seeking a portion of the carbon tax revenues. Households would be expected to bear a large portion of the burden imposed by a carbon tax. Lower-income households, in particular, would face a disproportionate impact if revenues were not recycled back to them in some fashion. In addition, specific industries may experience disproportionate impacts. Carbon tax revenues that are used to offset the burden imposed on various sectors or specific population groups would not be available to support other objectives, like deficit reduction.

Appendix A. Potential Applications of a Carbon Tax

Table A-1 below identifies sources of GHG emissions that account for 0.5% or more of total U.S. GHG emissions. The sources are listed in descending order by their percentage contribution. Carbon dioxide emissions from fossil fuel combustion, which accounts for almost 79% of total U.S. GHG emissions, are broken down by fossil fuel type: petroleum, coal, and natural gas.

The right side of the table identifies potential points in the economy at which a carbon tax could be applied. The table lists the number of entities that would be involved with different tax applications. For some emission sources the number of "entities" may be relatively large. However, in some of these cases, the number of companies that operate these entities is considerably smaller. For example, natural gas wells involve a large universe of entities (over 500,000), but the 500 largest natural gas producers accounted for approximately 94% of total U.S. production in 2007.

The right-hand column of the table provides an estimate of the percentage of total U.S. GHG emissions that would be subject to a carbon price with a given tax application. For example, a carbon tax applied at natural gas wells (based on a well's gross production) could attach a price to all CO 2 emissions that would result from domestic natural gas combustion. In addition, this application could attach a price to non-combustion related emissions, such as CH 4 emissions that occur during production and transportation. The potential for additional coverage explains why the percentage in the right-hand column may be larger than the percentage in the left-side column ("Percentage of Total U.S. GHG Emissions").

Appendix B. Illustration of Natural Gas Sector

Appendix C. Carbon Pricing Proposals in the 111 th and 112 th Congresses

Members introduced two carbon tax bills in the 112 th Congress:

H.R. 3242 (Stark), introduced October 24, 2011: Would have established a carbon tax on domestic and imported fossil fuels, as well as the carbon content of biomass, municipal solid waste, and any organic material used as fuel. The bill states that it would reduce the federal budget deficit by $480 billion over 10 years, with remaining revenues paid as dividends to individuals. H.R. 6338 (McDermott), introduced August 2, 2012: Would have required carbon emitters to purchase non-transferrable emissions permits from the U.S. Treasury. The Treasury would have used emissions targets to determine the price of these permits. Revenues would have been used both for deficit reduction and to provide dividends to individuals.

In the 111 th Congress, policymakers introduced at least nine stand-alone, market-based proposals that sought to reduce GHG emissions. These bills included carbon tax, cap-and-trade, and hybrid approaches. Of the bills that specified a distribution formula for carbon tax revenue or emission allowance value, only three (and one draft bill) would have allotted allowance value or tax revenue that would explicitly support deficit reduction (listed in order of proposed date):

H.R. 2454 (Waxman-Markey), introduced May 15, 2009: 0.2% of emission allowance value in 2016-2026, zero in subsequent years. S. 1733 (Kerry-Boxer), introduced September 30, 2009: 10.3% of emission allowance value in 2016, increasing to 30% in 2030. S. 2877 (Cantwell), introduced December 11, 2009: 25% of emission allowance value (subject to the appropriations process) to a fund, which could be used to support a myriad of policy objectives, including deficit reduction. Kerry-Lieberman draft legislation, released May 12, 2010: 6.8% of emission allowance value in 2016 and 2030.