Last week, at an event at the American Enterprise Institute, Senators Sheldon Whitehouse (D-RI) and Brian Schatz (D-HI) unveiled the American Opportunity Carbon Fee Act—a carbon tax that places a $49 per ton fee on carbon emissions. According to Whitehouse and Schatz, the tax would be implemented at the point of extraction or importation of fossil fuels and would steadily increase over time. Taxing carbon emissions at the point of extraction would mean that the tax would be placed at the earliest point in the supply chain—during the mining or drilling process used to recover fossils fuels.
The plan’s advocates claim the bill will be revenue neutral, as revenues will be used to offset a reduction in the corporate tax rate and to offer workers an annual inflation-adjusted $550 refundable tax credit to offset payroll taxes. The bill also plans to use the carbon tax revenue to deliver $10 billion annually in grants to states to help low-income and rural households and to help workers transition to new industries. In addition to carbon tax credits, the plan also proposes a border adjustment tax to adjust prices of imports and exports so that they also reflect the cost of carbon emissions.
Advocates of the carbon tax argue that it is the preferable way to internalize the costs of carbon emissions because it allows market actors to achieve a given amount of emissions reductions at the lowest cost to them. The carbon tax rate is calculated based on a figure known as the social cost of carbon (SCC), which attempts to approximate the cost of carbon emissions. As IER noted in a formal comment on the issue, the social cost of carbon is a misleading figure and should not serve as a basis for public policy.
In addition to the problems surrounding the social cost of carbon, there are also concerns about the effect a carbon tax would have on the American economy and the effectiveness a carbon tax would have on actually reducing global temperatures in a meaningful way. Given the degree of focus others have devoted to these areas of debate, I want to focus instead on how the political process is likely to shape a carbon tax bill.
A Brief Introduction to Public Choice
Conventional wisdom holds that actors in the political sphere are motivated to make decisions based on what they think will promote the “public good.” Although this may be one factor in an individual’s political decision-making process, assuming that the “public good” is the primary motivation behind political decision-making does very little to describe the actual behavior of voters, politicians, and bureaucrats. This assumption allows people who routinely push for government intervention in the economy to pay little attention to the effect the political process will have on their policy proposals.
It is a mistake to view actors in the public sector as magnanimous public servants guided primarily by their desire to promote the public good. When a person moves from the private sector to the public sector, there is no magical stripping of their self-interest; they continue to seek what is best for them, except now under a different set of incentives and institutions guiding their behavior. This insight—often referred to as behavioral symmetry—means that it is reasonable to apply the rational actor model of economic theory to the political process. In other words, just as we believe that self-interest is the primary thing that influences decision-making by individuals in a market setting, the same holds true for people in political life. This realistic view of political behavior is called public choice theory, which can be best summarized as the application of economic theory and modeling to the analysis of political behavior.
It’s clear that most advocates of a carbon tax would prefer not to apply public choice analysis to their proposals because doing so exposes the carbon tax to further scrutiny. By using this realistic approach to examining political behavior, it is clear that the political process is likely to distort a carbon tax plan in ways that should concern anyone interested in building a freer and fairer economy.
Government Will Seek to Maximize Revenue
Because a tax represents a source of revenue for government, Congress is likely to set a carbon tax rate that collects more revenue than one that simply reflects the uninternalized costs of carbon emissions.
In March, Benjamin Zycher of the American Enterprise Institute explained why this is the case in a report where he outlined the problems of a similarly structured carbon tax plan released by the Climate Leadership Council:
In short, the efficient tax rate is something approximating the marginal social cost of GHG (“carbon”), with perhaps some downward adjustment for the deadweight economic costs (“excess burden”) imposed by the tax system on the economy. That is not the same as the revenue-maximizing tax rate, and democratic political institutions can be predicted to opt for the latter under a broad range of assumptions.
“Revenue maximization” means the present value of the revenue stream over some time horizon, that is, at some discount rate. Accordingly, the tax rate that maximizes revenues over a short period is very likely to be higher than that maximizing revenues over the long run, due to the greater ability of market participants to find ways to avoid the tax given more time to do so, in particular when the tax rate is higher rather than lower. Because marginal members of the congressional majority are likely to be the incumbents in greatest danger of defeat in the next election, it is not difficult to predict that the political equilibrium for a carbon tax will be a rate maximizing revenues over a time period shorter rather than longer, precisely because for those marginal members of the majority the time horizon is the next election.
In other words, the incentive for government to collect more revenue through a carbon tax in the short-term will lead Congress to select a carbon tax rate that is above the uninternalized cost of carbon emissions. The result: an already costly policy that limits economic growth becomes even more expensive and destructive to our economy.
Tax Credits Will Go to the Politically Connected
The American Opportunity Carbon Fee Act proposes to return the tax’s revenues to American workers through annual tax credits on payroll taxes. Here again, advocates of this carbon tax plan are overlooking the impact the political process will have on their legislation.
It’s clear that a carbon tax will have disproportionate effects on the fossil fuel industry and areas like Texas, Alaska, and West Virginia where that industry is a major component of the economy. Therefore, it’s naive to think that the revenue from a carbon tax will not be used in a way that favors these groups over the rest of the American people. A realistic examination of our political system demonstrates that special interests stand to gain more in exemptions and special privileges than the average taxpayer stands to lose through any given tax. When you combine that with the fact that businesses and special interest groups have the time and the resources to dedicate to lobbying for special treatment, it becomes clear that the revenues from a carbon tax won’t be distributed to the American public as evenly as the plan describes. The more likely scenario is that the revenue from a carbon tax will be directed toward groups who stand to lose the most if a carbon tax is adopted.
The Affordable Care Act is a perfect example of the process described above. The ACA required insurance companies to offer coverage to every applicant but also restricted insurers from charging premiums that accurately reflect the risk of the people they were insuring. The fact that premiums were forcibly set too low created an enormous financial strain on health insurance companies. However, because it was clear that the ACA would have a negative impact on health insurers, a complicated system of subsidies was offered to these companies to alleviate their financial struggles. As health insurance premiums skyrocketed for average Americans, big businesses were gifted billions of dollars to ease their pain.
It’s easy to see how a similar scenario will play out with a carbon tax. Businesses that are hurt most by a carbon tax will lobby for subsidies from government to offset the financial burden, and the revenue from the carbon tax will be directed disproportionately to them.
Border Carbon Adjustments
This plan also calls for a border adjustment tax on the carbon content of both imports and exports in order to protect American businesses and punish nations that have not imposed a carbon tax. What is actually being described here is a complicated system of price adjustments to imports and exports—one that no serious advocate of a liberal market economy should be willing to advocate.
Given the complexity of international trade and the fact that imports and exports often contain components from several different countries, a border adjustment is likely to significantly grow the size of government and its involvement in international trade. A border adjustment tax on carbon would require things like: tracking and calculating the carbon price of each component of a good based on its country of origin; adjusting prices for exchange rates; and adjusting these values based on the proportion of each component’s overall value of the good. It’s clear that this complicated system would require an aggressive expansion of government’s already over-involved role in trade, making it more difficult for goods to flow across borders.
Finally, like many other parts of the bill, carbon-based border adjustment taxes are also susceptible to influence by interest groups. The complexity of border-adjusted carbon pricing gives lobbyists and special interests more opportunities to exploit the system through loopholes, special rates, and exemptions—something we can reasonably expect the groups most affected by border adjustment taxes to lobby for.
The American Opportunity Carbon Fee Act Is Not a Market Solution
The most astonishing part of this proposal is that it is being touted as a market-based solution to carbon pricing. Yes—this proposal and its advocates are using language that might sound familiar to advocates of the free market, as prices are certainly an important element of the market process. However, it should be clear that this proposal calls on the political process to set the price of carbon—a process that is unlikely to end in the way carbon tax advocates describe. As such, the aspects of this bill that sound like a market-based solution are merely a veneer disguising what the American Opportunity Carbon Fee Act really is: A complex system of wealth transfers and border taxes that are likely to serve special interests at the expense of the American people.
 [T]he use of the SCC as an input into federal regulatory actions is totally inappropriate. The Administration is treating the SCC as if it is a scientifically valid, objective fact of the external world, akin to the charge on an electron or the boiling point of water at sea level. However, the SCC is no such thing, at least in our present state of understanding. Rather, the SCC is an arbitrary output from very speculative computer models. It can be adjusted up or down as the analyst wishes, simply by changing a few key parameter choices. Simply by adjusting the parameter and modeling choices in plausible ways, a knowledgeable economist can generate SCC estimates that are very high, very low, or even negative—meaning that carbon dioxide emissions actually shower “positive externalities” on humans beyond the direct benefits to the emitters, and therefore should (according to the Administration’s logic) receive federal subsidies.