Bush-era tax cuts are scheduled to expire at the end of 2012, leading to interest in raising revenue through a carbon tax. This revenue could be used to either cut other taxes or to avoid cuts in Federal programs. There is a body of economic research suggesting that such an arrangement could be a win-win-win situation. The first win—Congress could reduce personal or corporate income tax rates, extend the payroll tax cut, maintain spending on social programs, or some combination of these options. The second win—these cuts in income taxes would spur the economy, encouraging more private spending and hence more employment and investment. The third win—carbon dioxide (CO2) pollution and oil imports would be reduced. This analysis uses the MIT U.S. Regional Energy Policy (USREP) model to evaluate the effect of a carbon tax as part of a Federal budget deal. A baseline scenario where temporary payroll cuts and the Bush tax cuts are allowed to expire is compared to several scenarios that include a carbon tax starting at $20 per ton in 2013 and rising at 4%. We find that, whether revenue is used to cut taxes or to maintain spending for social programs, the economy is better off with the carbon tax than if taxes remain high to maintain Federal revenue. We also find that, in addition to economic benefits, a carbon tax reduces carbon dioxide emissions to 14% below 2006 levels by 2020, and 20% below by 2050. Oil imports remain at about today’s level, and compared to the case with no carbon tax, are 10 million barrels per day less in 2050. The carbon tax would shift the market toward renewables and other low carbon options, and make the purchase of more fuel-efficient vehicles more economically desirable.

Three Questions With John Reilly:

Q: What led you to consider a carbon tax as part of a Federal budget deal?

A: There is clear need to reduce the Federal deficit but at the same time there is interest in maintaining at least some of the Bush tax cuts that will expire at the end of the year. This has led to interest among some in Congress in raising revenue through a carbon tax and using the revenue to either cut other taxes or to avoid draconian cuts in Federal programs. There is a body of research in economics suggesting the possibility that such arrangement could be a win-win, or even a win-win-win situation. The first win – Congress could reduce personal or corporate income tax rates, extend the payroll tax cut, maintain spending on social programs, or some combination. The second win – these cuts in income taxes would spur the economy, encouraging more private spending and hence more employment and investment. The third win – carbon dioxide pollution and oil imports would be reduced. While in principle it is possible to get such a positive result, in practice it can depend on the specific proposal. Recent interest in such a deal has focused on a $20 per ton tax on carbon dioxide emissions, starting soon, and rising at 4% per year in real terms – a carbon pricing approach the Congressional Budget Office had considered a couple of years back, but not as part of a deal that would use revenue to cut other taxes. There is also concern with how different tax cut and spending changes would affect lower and middle income households. So we thought it useful to complete a careful analysis of such a plan.

Q: How did you construct your study and what did you find?

A: We were able to make use of a model we have developed of the U.S. economy that has significant detail on the energy economy, taxes and taxation, and households of different income levels. We factored in the expiration of the Bush personal and corporate income tax cuts and the temporary payroll tax cut. If these are allowed to expire, that will go a long way toward reducing the deficit. Starting from that point, we used the CBO carbon pricing path. We calculated the net new revenue such a carbon tax would raise, and we used that revenue to cut tax rates or maintain spending on social programs. We also considered options where we used half of the revenue for an investment tax credit. In general, we found the win-win-win result we thought might be there. Whether we cut taxes or maintained spending for social programs, the economy was better off with the carbon tax than if we had to keep other taxes high to maintain Federal revenue. By allocating only net new revenue from the carbon tax, we assured that all of the options we considered were "revenue neutral." Congress will face many difficult tradeoffs in stimulating the economy and job growth while reducing the deficit. However, with the options we considered there were really no serious tradeoffs at the highest level – the macro economy improved, income taxes were lower, and pollution emissions reduced.

Among the detailed options we considered there are some smaller trade-offs. Those options where we used all of the net carbon revenue for cutting income taxes gave more benefits over the next 10 to 20 years compared to the options where half of the revenue was used for an investment tax credit. The investment tax credit diverts income away from consumption spending today and toward investment. This works for the economy just as in your personal life: when you save for the future, that leaves less spending for the present. But when those savings earn a return, you then have more to spend in the future. So the tradeoff with the investment tax credit is whether we would like to spur consumption immediately or build investment for the future. Given the current recession and unemployment, the balance might tip more toward options that increased spending today.

The other tradeoff was how the different plans affected households at different income levels. Not surprisingly, maintaining social programs was best for lower income households. Maintaining these programs also improved the economy because it shifted income to households with a higher propensity to consume. This created more consumption, but obviously less savings, so in the longer run this option was not as beneficial for the whole economy as other options. On the other end of the spectrum cutting personal and corporate income taxes, especially when combined with an investment tax credit, benefitted wealthy households the most. Wealthy households on average pay more taxes, and thus tax cuts benefit them more. They also are more likely to receive income from investments, and so expanding investment benefits them. The most neutral option was extension of the payroll tax cut. Because there is an income limit on this tax, cutting the rate has a limited benefit for households above the income limit, and the net effect is a more equal affect on all households.

But again, these are minor tradeoffs, as in most cases we are looking at benefits to all households.

Q: How would a carbon tax improve our environment and energy future?

A; Given the critical nature of economic growth, jobs and the budget deficit, the third win – environment and energy – almost doesn't matter. That said, we find the carbon tax reduces emissions to 14% below 2006 levels by 2020, and 20% below by 2050. We see no increase in oil imports, which by 2050 is 10 million barrels a day less than in our projection without the carbon tax. The carbon tax would shift the market toward renewables and other low carbon options, and make the purchase of more fuel-efficient vehicles more economically desirable. These are goals Congress has pursued using various tax credits. Those tax credits reduce tax revenue and contribute to the Federal deficit. By shifting to a carbon tax instead of such credits, we create similar incentives for cleaner energy technologies, but we raise revenue rather than spending it. Even if we ignore these environmental and energy benefits, this type of tax reform would still be a good thing for the economy.