The Fiscal Cliff and a

U.S. Carbon Tax?

Adele C. Morris, Ph.D.

Fellow

The Brookings Institution

December 6, 2012

1

What is the fiscal cliff?• Abrupt changes in fiscal policy next year under

current law (CBO baseline)

» Federal government spending cuts

» Tax increases

• Without new law, CBO projects a recession in 2013.

» GDP in 2013: 0.5% lower than in 2012

» Unemployment in Q4 of 2013: 9.1 %

» Negative stimulus in weak recovery = bad idea

• Fiscal cliff is a short run problem.

2

Fiscal Cliff

3

Going over the cliff

Fixingthe cliff but creating huge long run deficits

4

A large carbon tax now would make the fiscal cliff worse, not better.

• But, the fiscal cliff forces a discussion of tax

and spending policy – short run and long

run.

5

What are the long run problems?

• Unsustainable deficits and debt

• Inefficient tax system

» Creates distortions in consumption choices

» Drives investment away from US

• Deficit reduction must be on the agenda.

• Tax reform has bipartisan interest.

6

7

8

Why do we need to prevent high debt/GDP?

• Borrowing costs for everyone go up and makes

the problem worse

• U.S. beholden to foreign buyers of U.S. debt

• People buy Treasury bonds instead of making

other productive investments

• Reduces the option to spend more later

• Financial markets could react badly to poor

governance.

Source: Hassett and Mathur, February 2011, via D. Marron.

U.S. Corporate Tax Rate is Now a High Outlier

10

Potential Reasons to Embed Carbon Tax Within Broader Fiscal Reform

• Lower/reform other taxes

• Reduce deficit

• Reduce need for Clean Air Act Regulation, state

policies, and other regulation and subsidies

• Limit cuts in social safety net spending

• Allow progressive tax reforms

• Build larger platform for deal-making

• Limit rent-seeking and delay on climate policy

Lower costs of tax and regulatory system

Lower burden on poor

Raise probability of success?

11

Change the relative prices of fuels

• Carbon tax changes relative prices of inputs and outputs based on carbon content of energy.

• Economic activity incorporates cost of emissions

• More efficiency, less fossil fuel, more renewables, new technology

• Revenue is not a carbon tax’s primary economic purpose, but it could be handy.

0

5

10

15

20

25

30

Natural

Gas

Gasoline Coal

Emissions in Kg C/mBTU

12

Revenue Recycling Can Lower Costs of Climate Policy

•Carbon tax revenue can offset the macroeconomic

drag of higher real price levels.

•Using revenue to reduce the federal budget deficit or

other taxes can reduce costs of the program by 15%

to 70%.

•But, carbon tax is regressive and reducing tax rates

benefits higher income households most.

» Clear tradeoff between efficiency and equity

Carbon tax is regressiveBurden of $15/ton tax on CO2 equivalent (no recycling)

Source: Mathur and Morris, forthcoming

14

Our analysis

• Carbon tax with different recycling

scenarios

» Initially $15 per ton of CO2

» Rising at 4% per year

» Applied to primary fossil fuels and imports

– Coal mining

– Crude oil extraction

– Natural gas extraction

» US only

McKibbin, Morris, and Wilcoxen, “The Potential Role of a Carbon Tax in US Fiscal Reform,” Brookings, July 2012

15

Revenue is substantial, even for low tax rate

01

00

20

03

00

Bill

ion

s o

f D

olla

rs

2010 2020 2030 2040 2050Year

Simulation S1_CT/LS

Tax Revenue

$80B

$310B

$170B

16

Emissions decline significantly

-2.5

-2-1

.5-1

-.5

0B

MT

2010 2020 2030 2040 2050Year

Simulation S1_CT/LS

Change in Carbon Dioxide Emissions

34% below

baseline in

2050

Cumulative

reduction:

40 billion

metric tons

17

Capital tax swap results are sharply different than other scenarios

-.8

-.6

-.4

-.2

0.2

Pe

rce

nt

of

Ba

se G

DP

2010 2020 2030 2040 2050Year

S1_CT/LS S2_CT/DR

S5_CT/LTR S6_CT/KTR

GDPCapital tax

swap

Labor tax swapRebates

18

Don’t let the fiscal crisis go to waste.

• Climate change is a market failure.

• Most efficient to establish increasing economy-wide

price signal.

» Default is more costly regulation.

• Use revenue to lower other tax burdens and deficit,

protect the poor, in context of broader fiscal

package.