The Carbon Emissions Tax Effect

by: Ryan Avent

Conor Clarke has a look today at Marty Feldstein’s recent Journal piece on how tax increases might derail the economic recovery. Conor notes that the increases aren’t due to start until 2011, but Feldstein is ready for that line of argument:

Even if the proposed tax increases are not scheduled to take effect until 2011, households will recognize the permanent reduction in their future incomes and will reduce current spending accordingly.

Ok, but what if the tax increases don’t necessarily signal a permanent reduction in future incomes? For example, Feldstein isn’t happy about the cap-and-trade plan:

Mr. Obama’s biggest proposed tax increase is the cap-and-trade system of requiring businesses to buy carbon dioxide emission permits. The nonpartisan Congressional Budget Office (CBO) estimates that the proposed permit auctions would raise about $80 billion a year and that these extra taxes would be passed along in higher prices to consumers. Anyone who drives a car, uses public transportation, consumes electricity or buys any product that involves creating CO2 in its production would face higher prices.

CBO Director Douglas Elmendorf testified before the Senate Finance Committee on May 7 that the cap-and-trade price increases resulting from a 15% cut in CO2 emissions would cost the average household roughly $1,600 a year, ranging from $700 in the lowest-income quintile to $2,200 in the highest-income quintile. Since the amount of cap-and-trade tax rises with income, the cap-and-trade tax has the same kind of adverse work incentives as the income tax. And since the purpose of the cap-and-trade plan is to discourage the consumption of CO2-intensive products, energy or means of transportation by raising their cost to consumers, the consumer-price increases would be the same for a 15% reduction in C02 even if the government decides to give away some of the CO2 emissions permits.

Emphasis mine. Here’s the thing — the cap-and-trade “tax” doesn’t rise with income. If you get a raise at work or earn overtime pay, you don’t automatically pay more tax. The “tax” increases with the level of emissions embedded in your behavior. It is a consumption tax, but it’s not neutral — the tax shifts relative prices, which means that by changing behavior the burden of the tax can be reduced.

So the cap-and-trade “tax” plan only reduces future income to the extent that households can’t shift away from carbon-intensive goods and services, and of course, the entire idea of the tax is that eventually households will be able to entirely avoid the emission of carbon, and therefore the tax. There is not, then, a permanent reduction in future income.

But the other point that I like to make is that a perfectly rational household, faced with a cap-and-trade plan to take effect in 2011, has two options. It may reduce spending now to prepare for increased costs down the road. It may also invest in goods now that will reduce the impact of the tax in 2011 and beyond — more efficient automobiles or homes near transit, better insulation and double-paned windows, more efficient appliances, a bicycle. I see no reason why the net effect of the tax should be reduced current spending.