Tuesday, December 4, 2012

Fixing the Carbon Tax

This blog has previously questioned the foresight of those who support a carbon tax regarding its regressive nature. The regressive nature of a carbon tax is defined in that it creates a greater burden on the poor. Some have argued against this characterization claiming that there is an association between income and carbon emissions thus the wealthier the individual the greater amount of money he/she will have to pay in taxes. While this assertion is correct it only focuses on the absolute nature of the tax, not the relative nature of the tax. The regressive issue correlates to the percentage of income that poor individuals spend on energy and fuel related activities. The addition of the tax increases this burden further complicating the decision making process between food, energy and medical supplies. The percentage of expenditure is what matters in this situation not the total amount spent because the rich have a higher probability of affording the increase versus the poor because the rich have more disposable income. It does not matter that one has to spend $1,000 more if one has $30,000+ more to spend.

Proponents believe this regressive characteristic of a carbon tax can be countered by establishing a dividend system making the carbon tax revenue neutral for the government. Basically all of the money collected from a carbon tax will be offset to the public in some way. Some plans propose relief of payroll or sales taxes, but neither one of these options would be effective. Payroll tax relief is not appropriate because it does not account for individuals without jobs and it could also negatively influence Social Security funding. Sales tax relief is not appropriate because the chief goal of the carbon tax is to eliminate carbon emissions and one side element to reducing emissions is not just to convert to trace emission sources, but to also create more efficiency and less consumption. The provision of sales tax relief could create a psychological conflict similar to Jevon’s Paradox regarding consumption and carbon emissions if a person attempts to ‘maximize’ their tax relief.

Others want to distribute an annual dividend similar to those issued by certain companies and the State of Alaska equally divided among all adult citizens with half shares (typically) going to children. For example the Carbon Tax Center (CTC) provides an example of such a system focusing only on gasoline. In the example a $10 per ton of CO2 tax raises an estimated $55 billion dollars of revenue annually and then is divided evenly among 300 million U.S. citizens for an annual rebate of $183. Ignore the fact that in this example both adults and children receive the same amount of money, which is probably not suitable. The CTC then calculates that the average lowest quintile income individual will spend an extra $80 annually on gas due to the carbon tax, thus these individuals will net $103 per year from the carbon tax. Despite the limited nature of the example the CTC and other carbon tax proponents use this mindset as a means to counteract the regressive nature of a carbon tax.

Unfortunately those who hold the belief that monetary dividends will effectively mitigate the regressive nature of the tax are not accounting for the changes in behavior that the tax is supposed to motivate. First, note that analysis like the CTC example above is somewhat complicated because the assumptions are rarely listed in an organized and clear manner. For example the CTC expects a carbon tax to focus on applying the tax as far upstream as possible most likely at source points. Basically the tax should apply when a producer (coal mine, natural gas wellhead, port facility, importer, etc.) transfers ownership of a given quantity of the material to another party (energy utility, oil refiner, owner of a gas pipeline, etc.).

This strategy is appropriate and should be effective for eliminating waste, maximizing efficiency and reducing costs. However, when analyzing how the tax affects individuals it must be stated how the companies who are absorbing the tax pass that burden off to these individuals. For most analysis it appears that authors are assuming that an equal burden is passed on to consumers. This assumption may not be accurate for it stands to reason that an equal burden is the minimum that a company would try to recoup from the tax. Therefore, costs for downstream consumers may increase more than for upstream providers where the tax is actually applied. Some may celebrate this change because higher costs could eliminate carbon emissions even faster, but this change would also make a carbon tax more regressive.

The second important element that most, if not all, carbon tax proponents are forgetting is how the nature of the tax changes with time. The carbon tax will increase over time, which will create a dual expansion of the regressive characterization of the carbon tax. First, a higher tax will lead upstream providers to increase their prices for downstream consumers placing a greater burden on all consumers, but more so on those that have less overall money to spend (the poor). Second, a higher tax will further motivate those who have the capacity and funds to reduce their consumption of carbon emitting elements, thus reducing the total amount of transferred tax they have to absorb and the total number of carbon products taxed leading to a reduction in the size of the dividend check received from the government. It stands to reason that rich individuals will be in better position to reduce their carbon emissions versus the poor through the purchase of high capital cost trace emission products like solar panels and electrical/hybrid vehicles.

A side note to this second point is that it is more likely that rich people have more control over their living arrangements (houses and condos versus apartments) as well. This control affords them a better opportunity to install things like solar panels or solar water heaters versus apartment landlords that do not have to pay utilities and could balk at the costs ($250,000+ per complex) of installing these high capital cost trace carbon emission items for their tenets. Therefore, individuals living in apartment or low-income housing may have no ability to significantly change their carbon consumption habits as time passes. With this handicap poor individuals will struggle even further under the increasing burden of the carbon tax as time passes and the tax increases.

Clearly because numerous carbon tax proponents do not acknowledge this reality as a problem they have not produced a solution. At this moment there appears to be two possible solutions. First, the dividend derived from the tax can be progressive versus matching. Basically poorer individuals will be given a larger percentage of the total dividend and richer individuals will be given a smaller percentage. While this system would give poorer individuals more money and thus greater opportunity to invest in trace emission energy and transportation sources, numerous individuals would view such a system as unfair. Interestingly the fairness of such a system is much more complicated than most would care to consider.

Second, because the goal of the carbon tax is to reduce emissions and the conversion from heavy emitting sources and strategies to lower emitting sources and strategies is basically one-directional a clause in the carbon tax could lower the tax rate when certain emission reduction targets are reached. This method is possible because of the one-directionality of conversion in that once someone starts powering their business through say geothermal energy over coal they almost never switch back to coal largely because of all of the financial investment required for the initial switch. Therefore, lowering the tax rate on carbon after certain emission reduction targets are obtained is acceptable and will help those individuals who did not have the resources and/or capacity to move away from heavier carbon emissions.

Such a carbon tax could operate in the following manner:

- The carbon tax would increase with the passage of time until reaching a particular ceiling [for example the tax would be $15 per ton of CO2 in the first year increasing $5 per ton for the first 10 years then increasing $15 per ton for the next 10 years with no increases afterwards (a final tax value from a time perspective of $215 per ton of CO2 20 years after the institution of the tax)].

- The reason for the small increase transitioning to the large increase is to provide a form of grace period to allow individuals and business to adjust to the tax in a controlled and efficient manner and then balloon the tax to ‘punish’ those who have yet to move from high carbon emission sources to low carbon emission sources.

- However, because not all parties have emission decisions under their control, especially the poor, there must be a means to offset the cost of the time-maximized tax. The goal of the carbon tax is to reduce carbon emissions, thus reducing the carbon tax with respect to emissions can offer this offset. To ensure the validity of the carbon tax no emission related reductions would take place until after the first 10-year period. After 10 years, a 50% emission reduction based on 2005 emission levels will reduce the tax rate by 20%. Afterwards each 12.5% emission reduction would correspond to a 10% tax rate reduction resulting in a total tax reduction of 60%. Note that these tax reductions correspond to emission reduction ranges not direct values.

- If the carbon tax succeeds then under the above system the slope of the tax relative to time will not progressively increase like the currently championed system, but will instead increase until reaching a maximum and then decrease at a lesser magnitude to the increasing slope relative to the emission decrease. Note the graph below.

- As stated above this system works because once individuals and business switch to trace emission materials and systems these groups will not switch back when the carbon tax drops for it will simply cost more money to switch again and if emissions go back up then the tax will increase because the emission goal will no long be achieved.

- One concern some might raise is that a decreasing tax relative to decreasing carbon emissions may create an artificial emission reduction floor before zero emissions. This position would argue that certain individuals/groups would not give up high carbon emissions because the tax could decrease (versus a conventional system where the tax continues to increase), thus total emission reduction would not reach 100%, but instead 80-90ish%. However, for this to occur these carbon consuming groups need to absorb the burden of the tax throughout its lifecycle including the maximum. This strategy makes little sense for paying the tax will almost definitely result in higher costs versus switching to a trace generator (of course assuming that these individuals have the capacity and funds to make the switch)].

Finally states need to create organizations that will manage how prices change from principle suppliers to secondary suppliers to consumers to ensure that principle or secondary suppliers are not price gouging their respective consumers and scapegoating that gouging on the tax. The low competitive nature of larger source carbon emitters could even suggest that state governments create a price ceiling relative to the tax to eliminate the possibility of price gouging in the first place. Also government may need to intervene if apartment landlords refuse to properly adjust to the carbon tax instead of forcing their tenets to absorb it due to low economic mobility.

Overall it is important to establish a form of carbon emission limitation either directly (cap and trade) or indirectly (carbon tax) to motivate a reduction in carbon emissions. There have been numerous debates on whether a cap and trade or a carbon tax system would be superior at reducing emissions with a carbon tax having pulled ahead recently because of its transparency and simplicity. However, carbon tax proponents are behaving a lot like solar/wind proponents in that they are only studying how their solution affects the present, not the future. A critical element to creating an appropriate solution is to not only address the chief problem, but also understand any potential problems that will arise from the original solution. Carbon tax proponents must address how poor individuals will be negatively affected by the carbon tax not only in the present, but also in the future. The emission reduction adjustment discussed above is only one means of addressing this future problem.

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