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The multibillion dollar question: How to spend carbon revenues?

Debates over carbon pricing policies tend to focus on the costs imposed on firms and households. When a carbon tax or cap and trade program is introduced, firms see energy-related operating costs rise, drivers pay (cents) more at the pump, households see the prices of energy – and energy-intensive goods – tick up.


On the flip side, in addition to reducing harmful emissions, these policies generate revenues.  Estimates of the total value of revenues from the auctioning of emissions allowances in the European Union’s Emission Trading Scheme are estimated to be around €10 billion annually. In California, lawmakers expect sales of greenhouse gas pollution permits to bring in $5 billion annually.

By now you may be wondering – where is all this money going?   The answer varies across the jurisdictions that are implementing carbon pricing policies. This week’s blog takes a look at how two very different revenue recycling policies are panning out.

How should we be spending carbon $$ (in theory)

Over the past decade, economists have been busy analyzing the implications of different uses of carbon revenues, paying particular attention to how carbon pricing policies interact with pre-existing taxes. The policy recommendations that emerge from these studies depend critically on what policy makers are trying to achieve.

Model 1: If minimizing the economic costs imposed by the carbon pricing policy is the primary concern, substituting carbon for distortionary taxes on capital produces the largest economic cost savings. Recent work by Dale Jorgensen and co-authors suggests that if carbon revenues are used to offset taxation of capital spending, the performance of the overall economy (in terms of GDP) could actually improve under a carbon tax.

Model 2: If policy makers are concerned about the equitable distribution of policy impacts across different income/demographic groups, there is a case to be made for reductions in payroll taxes, or even targeted transfers, to correct for the regressivity of a carbon tax (i.e. taking a larger percentage of a lower-income and a smaller percentage of a higher income) and/or meet re-distributional objectives.

Model 3: If policy makers are losing sleep over budget deficits, carbon revenues can be used to offset increases in capital, labor, or consumption taxes that would otherwise be needed to balance the budget.  Here again, offsets to capital tax increases provide the largest economic benefits, followed by labor taxes, consumption taxes, and lump-sum transfers.

Model 4: If concerns about global climate change are paramount, tax revenues can be used to support the research and development of clean energy research, development, and deployment that many see as essential inputs to meaningful climate change mitigation in the long run.

 How should we be spending carbon $$ (in public opinion)

Whereas economists see the costs and benefits of many options, public opinion on how revenues should be spent appears less equivocal.

A group of political scientists – including my former Michigan colleague Barry Rabe  – recently conducted a national survey to gauge public support for a carbon tax. The survey asked several questions about “support for a tax on carbon-based fuels such as coal, oil, and natural gas”.  They find that the level of support for the tax varies significantly with the choice of how to allocate revenues:


What is particularly striking about these results is the extent to which tying revenues to a particular use – renewable energy investment in particular – increases support for the carbon tax.

How are carbon $$ actually being spent  (in practice)

Carbon pricing is underway! Here on the west coast, between California and British Columbia, we are seeing some real live experimentation with hybrid-versions of the four models summarized above.

I was fortunate enough to spend some time recently in British Columbia, home to old growth forests, humpback whales, and a revenue neutral carbon tax.  I seized the opportunity to play carbon tax tourist and ask lots of questions.

The BC carbon tax is pegged at CDN $30/tonne  CO2e (approximately $27 US). To put this in some perspective, the tax adds about 25 cents per gallon. For a fascinating account of the mechanics and politics of the BC carbon tax, read this paper.

When the carbon tax was first introduced, the provincial government made a commitment to return carbon tax income to BC residents via tax reductions and lump-sum payments. The enacting legislation actually threatens to reduce the Finance Minister’s salary by 15% should he fail to deliver on this revenue neutrality promise.  To date, the finance minister is still getting paid; all tax revenues have been “recycled” through a number of tax channels. Initially two thirds of the tax cuts went to individuals (including a low income tax credit and reductions in personal income taxes) and one third to firms via corporate tax reductions. Over time, the share of tax cuts flowing to the business community has increased to more than half.

Of course, it is difficult to know for certain whether these tax cuts would have happened even without the carbon tax. What we do know is that distortionary taxes have been reduced as the carbon tax increased. A recent paper suggests these changes in the tax structure have been progressive. Moreover, my very unscientific polling of whoever would talk to me about carbon taxation suggests that the Canadian-on-the-street understands how carbon tax revenues are being spent and believes that this approach is working. Oh Canada!

Next stop, California

The politics of the California cap-and-trade-program, constraints imposed by the state’s constitution, and a host of other complicating factors have given rise to a very different allocation of carbon revenues in California as compared to BC. Currently, a majority of permits are allocated for free as a form of industrial assistance, allocated to utilities on behalf of ratepayers (Californians, look out for your lump sum climate credit this month) or set aside as a cost-containment reserve. The remainder are sold at auction to generate revenues.

By law, permit auction revenues are deposited into a Greenhouse Gas (GHG) Reduction Fund to be used to support projects and programs that reduce GHG emissions; 25 percent of all revenues must benefit disadvantaged communities.  Although this may sound straightforward in principle, implementing this in practice has been messy.  Facing major budgetary challenges , the 2013-14 Budget Act loaned $500 million in auction revenues to the General Fund.  In June, California passed a state budget that allocates a quarter of cap-and-trade revenues to help pay for a highly controversial high-speed rail project.

Critics of the carbon pricing policies look at this and see a gravy train… “a massive new scheme of general taxation to be used for the whims and wish lists of the politicians.”  The Legislative Analysts Office, in addition to several environmental groups,  have argued that it is very hard to justify devoting scarce climate funds toward a new high-speed rail system on the grounds that it’s the most effective way to reduce carbon emissions.

Regional experimentation with carbon pricing policies has the potential to successfully demonstrate proof of critical policy concepts, increasing the likelihood that other jurisdictions will follow suit.  Economists have demonstrated how the allocation of carbon revenues generated by carbon pricing can significantly affect the success of  the policy in theory. Political scientists are highlighting how the choice of how to allocate revenues significantly affects the political feasibility and durability of the policy. In sum, these spending choices are an important part of the larger policy picture.

British Columbia is successfully demonstrating a disciplined approach to ensuring that carbon tax revenues offset other tax distortions. In contrast, California is aiming to spend revenues on climate change mitigation programs and technologies. This approach resonates in principle with a majority of voters.  But in terms of demonstrating this model in practice, so far not so good.  California needs a more measured and less political system of allocating carbon revenues to meet important policy goals.



5 thoughts on “The multibillion dollar question: How to spend carbon revenues? Leave a comment

  1. Revenue from Australia’s now defunct carbon tax was all recycled via the tax system, that did not stop the (conservative) Coalition Government being elected on the back of its repeal. The new government have however been having trouble filling the “budget black holes” that the tax will leave without resorting to tax increases. This may have been part of the political strategy of the former government: make it very (politically and financially) expensive to remove it. Unfortunately they are devoted to repeal at all costs. Australia now has no carbon tax.

  2. Thanks for your attention to this important issue, Meredith. The multibillion dollar question was also part of the title of a Next 10 project that i helped to name. I’m tempted to say, “great minds think alike,” but I’m not going to put myself in your league.

    If you are interested about the Next 10 project, I’ll include at the bottom. Two separate macroeconomic papers are most directly relevant. Interestingly, they find that an equal per capita dividend (or rebate) performs just as well as tax reductions.

    Here are a few excerpts from the Executive Summary:

    *When GHG emission allowances are auctioned
    and revenues are returned to California residents
    as proportional personal income tax relief or equal
    per capita dividends, employment will increase by
    about one-half of one percent (0.5%).
    Π*There is little difference in the aggregate (overall)
    impacts of the two approaches for returning auction
    revenue to households, i.e. the two strategies of
    personal income tax reductions and dividends.
    *ΠReturning revenue to households through the
    dividend approach has a slightly more positive
    impact in terms of net employment growth.

  3. Carbon tax policies such as AB32 are destined to fail because they substitute political decisions for market decisions. The public objection to the policies is likely to grow as politicians are seen as using or abusing carbon tax revenue for programs and purposes not directly related to their intended environmental objective. And no, bullet trains, free pre-school, and more state budget spending beyond what intended tax revenue supports are not excuses sufficient to divert the funds all of which should be used to reduce taxes.

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