Carbon Tax: Weighing the Options for Financing Reconciliation

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Last week, The New York Times reported that in opposing corporate or individual income tax increases, Senator Kyrsten Sinema (D-AZ) has pushed other Senate Democrats, such as Senator Ron Wyden (D-OR), to consider a carbon tax to finance some of the infrastructure package. A carbon tax would be a less economically harmful pay-for than either personal or corporate income tax hikes and a more efficient way to reduce carbon emissions than green energy tax credits, but would come with other trade-offs.

Lawmakers will have to consider three main issues as they weigh whether to include a carbon tax in the reconciliation package: economic impact, revenue collection, and tax burden distribution. Economic theory suggests that the best way to deal with externalities (the negative side effects of certain activities) is to put a tax on such activity equal to the negative side effects. Given that carbon emissions contribute to climate change, it makes sense to place such a tax on carbon emissions.

One difficulty is determining the exact social cost of CO₂ emissions, for which there is a wide range of estimates. The Obama administration estimated the social cost of carbon to be around $50 per ton, and the Biden administration’s current evaluation is $51 per ton. Some economists believe the “true” number is closer to $100 per ton, while the Trump administration used estimates between $1 and $7. The carbon tax Democratic officials are discussing would begin as a tax of between $10 and $20 per ton of CO₂ on the low end of estimates for the social cost of carbon.

Carbon taxes are economically efficient in the long run, as they deal with unpriced social costs. And evidence from existing examples of carbon taxes confirms their efficacy in reducing carbon emissions. Evidence from Sweden, Japan, and Canada, among other countries, shows that carbon taxes work. However, certain design flaws, such as providing exemptions for specific industries, can undermine the effectiveness of carbon taxes. That is because exempted sectors do not face the disincentivizing effect of the carbon tax, leading to lower emissions reductions. Lawmakers should keep that trade-off in mind as they consider how to design a U.S. carbon tax.

Carbon taxes would also be less harmful than alternative revenue raisers like higher corporate income taxes, as they are primarily taxes on consumption, rather than investment. As my colleague Erica York noted this April, a carbon tax of $25 per ton would generate more tax revenue than raising the corporate tax rate to 28 percent, while reducing economic output by less. When factoring in the economic effects of each tax, we find the bottom quintile would be worse off under a more progressive code with a higher corporate tax than under a more regressive code with a carbon tax. Further, evidence from the European Union and British Columbia suggest that carbon taxes have a minimal to modestly positive impact on overall output, partially due to carbon taxes reducing government reliance on more harmful taxes.

Carbon taxes are often criticized as regressive because lower-income individuals would pay a slightly higher share of their income under a carbon tax than higher-income households would. An important consideration for lawmakers is that although carbon taxes are slightly regressive, they can actually be less regressive than regulatory approaches to reducing emissions. For example, Georgetown economist Arik Levinson found in a 2019 study that the burden of fuel efficiency standards fell more heavily on low-income households than a carbon tax would have. Similarly, the existing set of tax credits for clean energy are complex and often skew towards wealthy households.

In light of the Biden administration’s promise not to raise taxes on people earning more than $400,000 a year, policymakers are likely to consider a carbon tax-and-dividend approach, which would use some (or all) of the revenue generated by the carbon tax for a cash payment that would effectively wipe out the burden of a tax increase. That approach would ameliorate the distributional concerns but would reduce the revenue the tax would raise to pay for new spending programs in the reconciliation package.

A carbon tax would be a more efficient solution to address carbon emissions than the mix of green energy tax credits lawmakers are considering, and it would be a less economically damaging source of revenue than higher corporate or personal income taxes. Lawmakers may be concerned about the distributional impact, though choosing to offset the burden with a rebate would significantly pare back the net revenue a carbon tax could raise.