In recent years, a handful of vocal conservatives have been arguing that a carbon “tax swap deal”—where new revenues from a carbon tax are used dollar-for-dollar to reduce existing taxes—could provide a win-win, both mitigating climate change and even boosting conventional economic growth. I wrote an entire study for IER debunking this case, but in the present post I want to quote from a recent survey journal article to show just how dubious the alleged “double dividend” from a carbon tax truly is. As we will see, it’s only theoretically possible to get this outcome if the government uses the new carbon tax in order to reduce the total tax burden on owners of capital while increasing the burden on workers and consumers. Does any conservative think progressives—who are smitten with the runaway bestselling book by Thomas Piketty, lamenting the gains of the capitalist fat cats—are possibly going to let this happen?
The Dagger in the Double Dividend: The “Tax Interaction Effect”
The logic of a carbon tax swap deal at first sounds reasonable enough: If the government is going to tax an ostensible “bad” like carbon dioxide emissions because of the threat of climate change, then surely the way to limit the economic damage is to use the new revenues to cut pre-existing taxes.
That logic is correct insofar as it goes. Given that the government levies a huge carbon tax, it’s better for the economy if the new revenue is returned to taxpayers, rather than used to fund higher levels of government spending.
However, proponents of a carbon tax often take this correct logic and extend it erroneously, when they claim that the economy will be better off compared to the original status quo with no carbon tax in the first place. That conclusion does not follow.
The reason is the “tax interaction effect.” I’ve written a comprehensive post here, spelling out how this subtle mechanism works. For our purposes, let me summarize it quickly: If there are already distortionary taxes on labor and capital, then adding a new carbon tax amplifies their destructiveness, over and above the normal economic drag you would expect from the carbon tax itself. Intuitively, the carbon tax drives up the prices of goods and services, reducing the effective income of workers and capitalists (because now their paychecks and dividend earnings don’t “go as far” at the store). Thus, the new carbon tax acts as an implicit hike in the pre-existing taxes on labor and capital, making them more destructive than they were originally.
This “tax interaction effect” obviously cuts against the economic benefit of a revenue-neutral carbon tax swap deal. The empirical question is, “Does the increase in destructiveness from the new carbon tax exceed the relief given to workers and capitalists from the tax rebate?”
In general, the answer is NO, meaning that the tax code—focusing purely on conventional economic measures, not climate change—ends up being more distortionary or inefficient even with a dollar-for-dollar carbon tax swap deal. The intuitive explanation for this empirical outcome is that carbon taxes are levied on a narrower tax base. For example, to wring $100 billion out of the economy in carbon taxes will require a much higher rate of tax, compared to the reduction in tax rates on labor and capital if the government then returns that $100 billion as a tax break. Because the destructiveness of taxes increase more than proportionately with the rate of tax, even a totally revenue-neutral carbon tax swap will typically harm conventional economic growth, job creation, and real income.
Let the Expert Explain It
To see just how difficult it is even in theory to get a “double dividend”—where a carbon tax swap deal boosts the economy while cutting emissions—let us quote from a pioneer in this literature, Lawrence H. Goulder, and his 2013 review article in the journal Energy Economics. Although his language is more technical than the way I’ve been explaining it, the following excerpt both confirms my general description and then shows the one way that the conservative boosters of a carbon tax could get the result that they’ve been pitching to their readers.
Although the initial theoretical analyses tended to reject the double dividend, a second wave of models offered more scope for the double dividend by acknowledging additional potential channels for beneficial efficiency impacts from green taxes. One such channel is an improvement in the relative taxation of capital and labor. If, prior to introducing the environmental tax, capital is highly overtaxed (in efficiency terms) relative to labor, and if the revenue-neutral green tax reform shifts the burden of the overall tax system from capital to labor (a phenomenon that can be enhanced by using the green tax revenues exclusively to reduce capital income taxes), then the reform can improve (in efficiency terms) the relative taxation of these factors. If this beneficial impact is strong enough, it can overcome the inherent efficiency handicap that (narrow) environmental taxes have relative to income taxes as a source of revenue. Similarly, if the initial tax system is highly distorted in terms of consumer goods, and the green tax reform improves the system in that dimension, then the double dividend can occur after all.
The presence or absence of the double dividend thus depends on the nature of the prior tax system and on how environmental tax revenues are recycled. Empirical conditions are important. This does not mean that the double dividend is as likely to occur as not, however. The narrow base of green taxes constitutes an inherent efficiency handicap…Although results vary, the bulk of existing research tends to indicate that even when revenues are recycled in ways conducive to a double dividend, the beneficial efficiency impact is not large enough to overcome the inherent handicap, and the double dividend does not arise. [Bold added.]
Those conservatives who have been led to believe that a carbon tax swap deal will “help the economy” so long as it’s tied with other tax cuts need to study the above excerpt carefully. Because a carbon tax starts out with such a handicap in terms of conventional economic efficiency, the only way even in theory it can make the tax code in total more efficient is if the bulk of the revenue is used to cut taxes on capitalists, so that the workers (through higher energy prices and conventional taxes) end up shouldering the burden of the new carbon tax.
Does any conservative reader actually think this is a politically feasible policy? Try to imagine President Obama saying the following in a national address: “We’d like to provide some tax relief to workers and the elderly dependent on Social Security, who are seeing gasoline, electricity, and natural gas prices zoom upward from this new carbon tax, but I’m sorry, we just can’t do it. No tax relief for you. The thing is, those folks getting dividend and interest income need a tax break more than you do, because my Administration is committed to minimizing what my friend Larry Summers calls the ‘deadweight loss’ of the tax code.”
As I’ve documented on these pages, the progressive Left is licking its chops in anticipation of spending new carbon tax revenues on their pet “green” projects. So we’re already in Fantasy Land when conservatives assure us that a U.S. federal carbon tax will be used exclusively to cut pre-existing taxes.
Yet the case against a carbon tax swap deal is even stronger. Even if new carbon tax revenues were used dollar-for-dollar to provide tax relief, the only way to possibly help the economy would be to target the tax breaks at capitalists, allowing consumers and workers to suffer the brunt of higher prices with an inadequate tax break compensation. Do conservatives think there is any chance of such a policy being passed, let alone remain in force once average Americans realize they’re getting screwed?
 Lawrence H. Goulder. 2013. “Climate Change Policy’s Interactions with the Tax System.” Energy Economics 40: S3-S11. Available at: http://www.stanford.edu/~goulder/Papers/Published%20Papers/Climate%20Change%20Policy’s%20Interactions%20with%20the%20Tax%20System.pdf