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I Love It When You Talk Carbon Taxes!

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In the Odyssey, Odysseus had to be tied to the mast to resist the call of the Sirens, who tried to lure his ship onto the rocks. These days the siren song of a carbon tax fills the ear of many commentators who urge us to recognize its beauty and steer our ship in its direction. A Washington Post editorial is a recent example.

The premise of the Post editorial is that cap and trade regimes are complex, vulnerable to special pleading, and do not guarantee success in reducing emissions, while a tax is simple and sure in its effects. But this is grass-is-greener thinking. The Post compares a flawed version of one approach (cap and trade) to an idealized version of the other (tax) and not surprisingly, the idealized approach wins.

The fallacy in this argument is that the same political body (our Congress) that, we are assured, will insist on putting special interest features into a cap and trade bill, when presented with a tax approach, will vote only for the purest proposal, firmly rejecting all lobbyists' pleas.

Those who argue that a tax approach is less likely to be designed for special interests than a cap approach simply are ignoring the tax code. We have decades of empirical evidence in the U.S. that when Congress designs tax policies it rarely resists the entreaties of special interests.

It is worth reading the history of recent (Nixon onward) energy tax proposals done by the group Tax Analysts. It is hard to see anything in that history that suggests a carbon tax would be successful (or if something called a carbon tax were enacted that it would actually accomplish anything).

The fate of the 1993 BTU tax proposal by Bill Clinton is instructive. It had its origins with then Vice President Gore's support for a carbon tax. That idea never got out of the Administration because of the impact it would have had on coal. Instead the Administration proposed a tax based on BTUs so that the tax on coal was the same as on natural gas per unit of delivered energy even though coal's carbon emissions were twice as high. Before the Administration bill was introduced, further concessions to coal were made. The BTU tax just squeaked through the House, thanks to the addition of lots of exemptions required to get the votes.

The Washington Post summarized the exemption feeding frenzy in David Hilzenrath's May 28, 1993 piece (purchase required):

"Some opponents of the energy tax have already been accommodated with exemptions proposed by the administration itself or the House Ways and Means Committee.

"For example, Clinton proposed exempting grain alcohol used as fuel, a concession to grain growers, and the House tax-writing committee proposed exempting much of the electricity consumed in the production of aluminum. But such concessions seem to have fueled the demand for even more changes in the tax.

"Both Boren and Breaux come from states with considerable oil and natural gas production. For Breaux, however, the greater concern may be Louisiana's energy-intense industrial base, including chemical, glass and plastics makers that export products."

But the BTU tax was stripped completely in the Senate, being replaced by a small gasoline tax that had only modest revenue raising benefits and almost no carbon or energy security benefits. More on this cautionary tale can be found in this New York Times news analysis and this paper from the Center for a New American Security.

A major public policy problem with the tax approach is that the debate quickly becomes all about money. A proposal that is initially designed to achieve another purpose like energy efficiency or greenhouse gas reduction is analyzed over and over again by every interest group and member of Congress based almost entirely on its economic impact on constituents. Economic impacts will be an important topic in a cap approach to be sure but the supporters of a cap proposal have something that tax advocates do not have: the ability to keep the focus on the direct and intended effect of the legislation - how much does it cut pollution? In a tax bill, the effects on pollution are indirect and run a much larger risk of being submerged in the more easily calculated impacts of the tax provisions on various fuels, consumer energy expenses, and different regions of the country.

The Post editorial also cites results from the European Union emission trading system (EU ETS) to argue that cap approaches do not work. What about that? Well, phase one of the EU ETS was intentionally a pilot program: it was short-term, lasting only a few years, and it was put in place quickly, before either the government or industry had a good idea of what actual emissions were. Since it was a pilot, governments decided to err on the side of being generous with allocations and spent no time seriously considering longer-term allocation policies. Allowances were not allowed to be carried forward from the pilot phase to the later phases, making them almost worthless as the end of the pilot phase approached. None of these flaws is inherent to a cap system and none of them is being ignored as real cap programs are being designed.

Politicians certainly can design a flawed version of a cap, though the one example of a national cap enacted by Congress (the 1990 acid rain program) fully achieved its emission reduction objectives. It was flawed in giving away all allowances for free but because reduction requirements were substantial, continuous emission monitors were required on all sources, and most power companies were still operating in regulated markets, the windfalls and market distortions that occurred in the pilot phase of the EU emission trading system did not happen here.

There are some issues that are unavoidable with either a cap or a tax approach that is designed by real-world politicians. One of them is an awareness of regional and interest-based impacts.

There is nothing magic about a tax frame that makes these issues of distributional politics disappear. A cap program will be not be immune to these considerations, to be sure. But there is no evidence that a tax approach has a greater potential to avoid special interest deals.

Meanwhile, the now solid awareness of the importance of allowance allocation design is causing special interests to retrench in major ways from their earlier positions seeking free allocations of allowances. For example, while just a year ago, many firms in the coal power sector were arguing for free allowances for all coal generators based on the "model" of the acid rain law, they have abandoned that and are now proposing allocations to electric distribution companies with a stipulation that all of the value of those allowances be passed through to customers. This is the approach proposed in the USCAP Blueprint. An exception for unregulated coal plants is proposed only for the portion of compliance expenses that cannot be passed through to customers. Even the Edison Electric Institute has proposed that nearly all allowances for the power sector be provided to distribution companies with the same requirement of pass-through of benefits to customers. Similarly, the USCAP Blueprint (joined in by three major oil companies) does not call for any free allowances to oil and gas fuel providers to cover the emissions from the fuel they sell, a departure from what the oil industry has proposed in the past.

Cap proposals are criticized for allowing offsets and there are real problems with many offsets proposals. But offsets are in cap proposals to deal with claims that the cost of a reduction program will otherwise be "too high" for certain interests. Those same interests are not going to say "never mind" just because the cost is imposed in the form of a tax rather than an allowance price. No serious observer thinks a tax bill that moves through Congress would forbid offsets. The carbon tax bill introduced by Rep. John Larson (D-CT), H.R. 3416, includes a wide open offset provision, creating a tax rebate for firms that implement offset projects. The bill also provides for tax proceeds to be dedicated for purposes similar or identical to those found in cap and trade bills ("clean" energy investments; negatively affected industries). These provisions reflect the political realities that are recognized by the drafters of such bills but are typically ignored by commentators who laud the apparent simplicity and certainty of hypothetical tax approaches.

What about the claim that a tax will enjoy broader political support? It's a statement of historical fact, not a partisan comment, that Republicans in Congress, particularly when a Democratic President has been in the White House, have overwhelmingly opposed taxes put forward for energy or environmental policy purposes. In 1993 not a single Republican voted for the Clinton BTU tax bill in the House, nor in the morphed gas tax version in the Senate. These materials on the RNC website from the 2006 and 2008 campaigns make for interesting reading by those forecasting a post-partisan embrace of a carbon tax. The unfortunate fact is that such tax policies are red meat for demagogues. It is very likely that a decision to actually attempt a tax approach to climate protection would be walking into a political trap. That is too big a risk to take when so much rides on enacting climate legislation without further delay.

It is perfectly possible for Congress to craft a good climate bill that relies on a cap and includes complementary policies to drive carbon intensity improvements in the key sectors of electric power, vehicles, fuels, and buildings. The fact that it is possible does not guarantee it will happen. But rather than dismiss a cap as an inherently flawed approach, is it too much to hope that commentators would resist the calls of the tax sirens and recognize that both approaches can be implemented well or poorly? Then we could focus on the real issues that we need to address to achieve a good policy result in time to protect the climate.

This post originally appeared on NRDC's Switchboard blog.

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