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The Cap-and-Trade Giveaway

Friday, June 26, 2009

A cap-and-trade system with freely allocated permits is equivalent to a carbon tax in which the tax revenue is given to stockholders.

The American Clean Energy and Security Act of 2009, a bill co-authored by Congressmen Henry A. Waxman and Edward J. Markey, may soon come to the House floor for a vote. The bill details an expansive greenhouse gas reduction agenda, including the establishment of a cap-and-trade system.

Under cap and trade, American firms must have a permit for each ton of greenhouse gases that they emit. The permits are tradable, meaning that firms may buy and sell them. By limiting the quantity of emissions permits, the federal government controls the total quantity of greenhouse gases emitted. The Waxman-Markey bill requires that America's economy-wide emissions be reduced to 17 percent of 2005 levels by 2050.

In simple economic models, a cap-and-trade system can be identical to a carbon tax. If the government sells all of the permits to firms at auction, it raises the same revenue as if it had imposed a tax on carbon. Like a carbon tax, a cap-and-trade system is a market-based regulatory mechanism to reduce carbon emissions. These mechanisms impose a cost on carbon emissions by requiring emitters to either pay a tax or obtain a permit. Ideally, this cost should be equal to the environmental damage caused by emissions. Market-based solutions tend to be the most efficient regulatory approach for correcting environmental externalities because producers and consumers are left free to choose the most cost-effective way to reduce emissions. This efficiency can be lost under regulatory systems that dictate particular ways to reduce emissions.

The best policy option would be to use the revenues from cap and trade or from a carbon tax to decrease the marginal tax rates of other distortionary taxes.

A central question in the current cap-and-trade debate is whether permits should be given to carbon emitters at no cost rather than being auctioned. Although President Obama called for all permits to be auctioned, the Waxman-Markey bill would give away most of the permits, at least over the next few decades. Advocates of free allocation claim that such a policy would save consumers from energy price increases; in reality, however, such a policy would provide windfall gains to stockholders without restraining energy prices.

It is a mistake to believe a firm that is given free permits would not increase prices. The value of a permit is determined by its usefulness, not how the firm obtained it. Firms that are allocated free permits face the same production incentives as a firm that pays for them. If emission permits are traded at a price of $20 per ton, the cost of emitting an additional ton of greenhouse gases is $20 for all firms. A firm that has no permit must spend $20 to buy one from another firm; a firm that has a freely allocated permit must give up the opportunity to sell it to another firm for $20. Because emissions are costly, production of carbon-intensive goods still falls and prices of these goods still rise. Although firms that receive free permits have no out-of-pocket permit costs, they still pass along to consumers their opportunity costs, the value of the income they could have earned by selling the permits.

Therefore, under a system of free permit allocation, the stockholders of companies that receive free permits would receive windfall gains. A cap-and-trade system with freely allocated permits is equivalent to a carbon tax in which the tax revenue is given to stockholders. This gift does not provide the economic benefits of a reduction in taxes on business investment, because the gift is not linked to firms’ current investments.

Under a system of free permit allocation, the stockholders of companies that receive free permits would receive windfall gains.

So, what should we do with the revenue from auctioning cap-and-trade permits or from a carbon tax? In earlier years, some analysts thought that it should be used to expand existing government programs, because the environmental externality-correcting features of a cap-and-trade system or a carbon tax alleviated any potential tax distortions. However, economists have shown that this is not the case. Because households work to purchase goods and services, a cap-and-trade system or a carbon tax that forces households to work more to make the same purchases (because the goods are more expensive) penalize households’ decision to work. In this way, cap and trade or a carbon tax exacerbates the economic inefficiencies inherent in our current tax system.

Although President Obama called for all permits to be auctioned, the Waxman-Markey bill would give away most of the permits, at least over the next few decades.

Therefore, the best policy option would be to use the revenues from cap and trade or from a carbon tax to decrease the marginal tax rates of other distortionary taxes, such as the payroll tax and individual and corporate income taxes (or to reduce the deficit, which would encourage capital accumulation and help prevent future marginal rate increases). Using the revenue in that fashion would alleviate much of the economic inefficiency that would otherwise arise from cap-and-trade or a carbon tax.

The allocation of emissions permits and decisions on how to spend the revenue raised from permit auctions are sure to be legislative arguments that will not be easily resolved. However, one thing is for certain: Just as implementing a carbon tax and then giving away all of the profits from the tax to rich shareholders would be a policy that no one would support, "free permit allocation" under a cap-and-trade system should be quickly dismissed as a bizarre policy option. Don't give away the cap-and-trade permits!

Alan Viard is resident scholar at the American Enterprise Institute. This article was adapted by Amy Roden, AEI’s program manager for economic policy studies, and Scott Ganz, formerly AEI’s program manager for economic policy studies, from a longer paper. Viard was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University. He has also worked for the Treasury Department’s Office of Tax Analysis, the White House’s Council of Economic Advisers, and the Joint Committee on Taxation of the U.S. Congress.

FURTHER READING: Viard recently released Tax Policy Lessons from the 2000s (AEI Press, 2009), a collection of essays which explore the role taxes play in setting policy and their effect on businesses' financial and investment decisions. Findings were discussed at this AEI event. He also wrote “Keynes at the Border?” on the common fallacy that imposing taxes on imports and rebating taxes on exports would stimulate the economy.

Image by Darren Wamboldt/Bergman Group.

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