Harnessing the Power of Markets to Solve the Climate Problem

December 10 2020 • Gilbert E. Metcalf

In this chapter, Gilbert E. Metcalf, the John DiBiaggio Professor of Citizenship and Public Service and Professor of Economics at Tufts University, argues that a carbon tax should be the centerpiece of any portfolio of policies that aim to achieve zero net emissions. However, a carbon tax alone is insufficient to achieve zero net emissions, and argues that regulation, federal support for innovation, and reforming current energy tax incentives and regulatory rulemaking should be part of a comprehensive climate policy agenda. 

Metcalf describes key decisions that policymakers face when designing a federal carbon tax:  

  • Tax base and point of taxation: Because the carbon content of fossil fuels is consistent at each stage of the process, they can be taxed at any point along the chain from extraction to consumption, allowing for flexibility when administering the tax. 
  • Tax rate: Economic efficiency dictates that the tax rate would be set equal to the social marginal damages from emissions—so-called the Social Cost of Carbon (SCC). Pinning down the SCC is difficult given its reliance on key parameters that are subject to considerable uncertainty: climate sensitivity, the discount rate, and the magnitude of economic damages. Given these three areas of uncertainty, other approaches, such as revenue targeting and emissions reduction targeting, will also be relevant for setting the tax rate.
  • Trade and competitiveness: A carbon tax can be designed on a production or consumption basis. Although levying a consumption-based tax is more challenging than a production-based tax, consumption-based taxes mitigate the competitiveness concerns raised by production-based taxes. To simplify the consumption-based tax, Metcalf suggests imposing a tax on select carbon-intensive goods based on the carbon content of like-domestically produced goods.
  • Achieving desired emissions reductions: Metcalf proposes a tax mechanism called an Emissions Assurance Mechanism (EAM) designed to achieve any desired emission-reduction goal. Once a carbon tax legislation is enacted with an initial tax rate and default growth rate, the EAM tracks cumulative emissions and automatically adjusts the tax rate as needed. The EAM avoids the need for Congress to continually revisit the tax rate over time.
  • Use of revenue: A carbon tax could collect significant amounts of revenue which could be used in numerous ways. Metcalf argues that the tax should be implemented in a revenue-neutral way, including, potentially, progressive household rebates. It could also be used to finance Green New Deal initiatives though he argues that the currently low interest rates make borrowing for green infrastructure investments highly attractive.
  • State-level policies: Most state-level carbon pricing programs are cap-and-trade programs. Implementing a carbon tax will drive down allowance prices in state or regional programs and so affect revenues. Congress should consider how best to address potential revenue losses to these programs so as not to punish states that are early movers on climate policy. 

Other policies will be necessary in addition to carbon taxes to achieve a significant reduction in the country’s GHG emissions. Metcalf highlights the need for policies that regulate emissions not amenable to taxation, such as agricultural emissions of methane. He also recommends updating current environmental regulations of GHG emissions, supporting research and development, and addressing the regulatory and institutional barriers, such as state resistance to interstate transmission lines. Metcalf stresses the importance of providing consistency in regulatory analysis — most notably the calculation of damages from GHG emissions and the treatment of co-benefits — as well as eliminating many energy-related tax breaks.

Finally, Metcalf discusses the economic evidence on the macroeconomic impact of a carbon tax. Economic analysis shows that while job creation or economic growth would not be adversely affected, carbon taxes would substantially change the composition of jobs in the economy. However, a carbon tax could raise $2.2 trillion net revenue over a 10 year window and modest amounts of this collected revenue could be used to ease the burden of this change and help the U.S. efficiently transition to a new economy.