Full Title: The Potential Rold of a Carbon Tax in U.S. Fiscal Reform
Author(s): Warwick McKibbin, Adele Morris, Peter Wilcoxen, Yiyong Cai
Publisher(s): Brookings
Publication Date: 7/2012

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Description:

This paper examines fiscal reform options in the United States with an intertemporal  computable general equilibrium model of the world economy called G-Cubed.  Six policy  scenarios explore two overarching issues: (1) the effects of a carbon tax under alternative  assumptions about the use of the resulting revenue, and (2) the effects of alternative measures  that could be used to reduce the budget deficit.  We examine a simple excise tax on the carbon  content of fossil fuels in the U.S. energy sector starting immediately at $15 per metric ton of  carbon dioxide (CO2) and rising at 4 percent above inflation each year through 2050.   We  investigate policies that allow the revenue from the illustrative carbon tax to reduce the long  run federal budget deficit or the marginal tax rates on labor and capital income.  We also  compare the carbon tax to other means of reducing the deficit by the same amount.

We find that the carbon tax will raise considerable revenue: $80 billion at the outset, rising to  $170 billion in 2030 and $310 billion by 2050.  It also significantly reduces U.S. CO2 emissions  by an amount that is largely independent of the use of the revenue.  By 2050, annual CO2  emissions fall by 2.5 billion metric tons (BMT), or 34 percent, relative to baseline, and  cumulative emissions fall by 40 BMT through 2050.

The use of the revenue affects both broad economic impacts and the composition of GDP  across consumption, investment and net exports.  In most scenarios, the carbon tax lowers  GDP slightly, reduces investment and exports, and increases imports.  The effect on  consumption varies across policies and can be positive if households receive the revenue as a  lump sum transfer.  Using the revenue for a capital tax cut, however, is significantly different  than the other policies.  In that case, investment booms, employment rises, consumption  declines slightly, imports increase, and overall GDP rises significantly relative to baseline  through about 2040.  Thus, a tax reform that uses a carbon tax to reduce capital taxes would  achieve two goals: reducing CO2 emissions significantly and expanding short-run employment  and the economy.

We examine three ways to reduce the deficit by an equal amount.  We find that raising  marginal tax rates on labor income has advantages over raising tax rates on capital income or  establishing a carbon tax.  A labor tax increase leaves GDP close to its baseline, reduces  consumption very slightly and expands net exports slightly.  Investment remains essentially  unchanged.  In contrast, a capital tax increase causes a significant and persistent drop in  investment and much larger reductions in GDP.  A carbon tax falls between the two: it lowers  GDP more than a labor tax increase because it reduces investment.  However, its effects on  investment and GDP are more moderate than the capital tax increase, and it also significantly  reduces CO2 emissions.   A carbon tax thus offers a way to help reduce the deficit and improve  the environment, and do so with minimal disturbance to overall economic activity.