Impose a Tax on Emissions of Greenhouse Gases

Background

Greenhouse gases—particularly carbon dioxide (CO₂)—accumulate in the atmosphere as a result of the burning of fossil fuels (such as coal, oil, and natural gas). Other actions such as deforestation and releases of methane from livestock, oil and gas systems, and other sources add to the accumulation of greenhouse gases. That contributes to climate change, which imposes costs on people and countries around the globe, including the United States.

In 2021 the Congressional Budget Office projected that under current law, climate change would result in a 1 percent reduction in the level of real gross domestic product by 2050. That estimate accounts for both negative and positive effects of climate change on economic activity, although it does not capture all the effects that climate change could have. Some aspects of climate change are entirely negative. For instance, wildfires, floods, hurricanes, and tropical storms harm people and reduce the nation's output of goods and services by damaging and destroying buildings, equipment, and inventory. Other aspects of climate change have both positive and negative effects, depending on location or time of year. For example, although the productivity of agricultural land, labor supply, and labor productivity are expected to decline overall, some parts of the country are expected to experience increases in those outcomes.

Although the effects of climate change are expected to increase over time, they are much more uncertain in the more distant future. There is some risk that large changes in global temperatures will trigger catastrophic damage, causing substantial harm to human health and well-being. Moreover, greenhouse gases are long-lived, meaning that they remain in the atmosphere and affect the climate for many decades after they are emitted. Because they have such long-lasting effects, delaying actions to limit emissions of those gases affects the country's ability to avoid potentially harmful effects in the future.

Greenhouse gas emissions of all kinds are typically measured in CO₂ equivalents (CO₂e), or the estimated amount of carbon dioxide that would cause an equivalent amount of warming. Under current law, annual emissions are projected to average 5.9 billion metric tons of CO₂e from 2023 to 2032.

Reducing global emissions of greenhouse gases would decrease the magnitude of climate change and the expected costs and risks associated with it. The federal government regulates some greenhouse gas emissions and provides financial incentives to reduce them, but except for a charge on some methane emissions from the oil and gas industry, it does not directly tax emissions. A well-designed tax that covered most energy-related emissions would result in reduced emissions and their associated harms. A tax on such emissions would have similar effects to a tax on consumption wherein goods and services would be taxed on the basis of their energy use.

Option

This option consists of three alternatives that would tax emissions of greenhouse gases. (The option would not impose a tax on methane emissions that are already subject to the charge applied to emissions from the oil and gas industry.) Each alternative would go into effect in January 2023.

The first alternative would impose a tax of $25 per metric ton on energy-related emissions of CO₂ in the United States (such as those from electricity generation, manufacturing, and transportation) and on some other greenhouse gas emissions from large U.S. manufacturing facilities. The tax would increase at an annual rate of 5 percent plus the rate of inflation since the previous year.

The second alternative is identical to the first, except that the annual rate of increase would be 2 percent, adjusted for inflation.

Under the third alternative, the tax would also rise by 2 percent each year, adjusted for inflation, but it would exclude gasoline from that tax.

Effects on the Budget

According to estimates made by the staff of the Joint Committee on Taxation and CBO, implementing the first alternative would reduce the deficit by $865 billion from 2023 to 2032. If the tax increased more slowly, as in the second alternative, the deficit would decrease by $769 billion over that period. Excluding gasoline from the tax as well, as in the third alternative, would further limit the decrease in the deficit, to $571 billion. All three alternatives would reduce taxable business and individual income. The resulting reduction in income and payroll tax receipts would partially offset the increase in excise taxes, and the estimates for the option reflect that offset. The estimates also reflect a reduction in emissions that would occur as businesses and consumers responded to the tax.

On average, about 3.9 billion metric tons of greenhouse gas emissions—mostly energy-related CO₂ emissions—would be taxed each year over the 2023–2032 period under the first alternative. About 1 percent more greenhouse gas emissions would be taxed under the second alternative. (Because the tax would increase more slowly than under the first alternative, it would not discourage emissions as strongly. As a result, there would be more emissions subject to the tax.) About 3.0 billion metric tons would be taxed under the third alternative. At the end of 2023, greenhouse gas emissions covered by the tax would be roughly 7 percent lower under the first two alternatives, and around 6.5 percent lower under the third alternative, than is projected under current law. In 2032, energy-related emissions would be 11 percent lower under the first alternative than is projected for that year under current law, 9 percent lower under the second alternative, and 8 percent lower under the third alternative. The first alternative would have a greater effect on emissions because of its greater annual increases in the tax rate. In 2032, the tax rate under the first alternative would be nearly one-third higher than it would be under the other two alternatives.

The third alternative, which exempts gasoline, would reduce greenhouse gas emissions from 2023 to 2032 by 5 percent less than the second alternative would, even though gasoline currently contributes around 20 percent of energy-related CO₂ emissions in the United States. That disparity would arise because gasoline consumption is not very sensitive to changes in price. (A tax of $25 per metric ton of CO₂ would increase the price of gasoline by about $0.22 per gallon.) Exempting gasoline from the tax would reduce the deficit by about $200 billion less from 2023 to 2032 than would the second alternative, which does not exempt gasoline.

The tax would provide incentives for businesses to produce goods and services in ways that yield fewer emissions (for example, by generating electricity from wind rather than from coal) and for individuals to consume goods and services that yield fewer emissions (for example, by choosing vehicles and appliances that are more energy-efficient) or to use them less intensively (for example, by driving less or choosing temperature settings that use less energy). In its initial year, the tax would motivate emissions reductions that cost less than $25 per ton to achieve but not those that would cost more than $25 per ton. In subsequent years, the cost of emissions reductions that businesses and consumers would choose to make would increase along with the annual increase in the tax rate. Because it excludes gasoline, the third alternative in this option would not provide an incentive for businesses and individuals to reduce their vehicle emissions by choosing more fuel-efficient vehicles or driving less.

The effects of choosing a moderately higher or lower tax rate would be roughly linear: Under each alternative, every dollar of increase or decrease in the initial $25 tax rate would cause the deficit effect of the tax over the 10-year period to rise or fall by about 3.5 percent. Similarly, the 10-year decrease in the deficit under each alternative would rise or fall by about 4 percent for every percentage-point increase or decrease in the annual rate of increase in the tax.

Uncertainty About the Budgetary Effects

The estimates for this option are uncertain for two key reasons. First, estimated baseline emissions—that is, the projected amounts of greenhouse gases that would be emitted in the absence of the tax—depend on estimates of future economic activity and of the relative future prices of various fuels and energy technologies. Both kinds of estimates are uncertain. Second, even if those projections were accurate, estimated reductions in emissions stemming from the tax would still be uncertain, in part because they depend on responses to the tax that have uncertain outcomes, such as the development of new technologies.

Long-Term Effects

In the long term, the effect of the tax on emissions of greenhouse gases would be subject to several offsetting factors. Because of technological change, the cost of reducing emissions from any given source will probably decline. But because businesses and consumers would first reduce emissions where it was least costly to do so, over time, the remaining opportunities to reduce emissions would be increasingly costly to achieve using any given technology. At the same time, the increasing tax rate would broaden the set of emissions reductions that businesses and individuals would find worthwhile over time. So even as low-cost ways to reduce emissions were identified and implemented, the rising tax would give businesses and individuals an incentive to implement other, higher-cost ways of reducing emissions. The net effect on the cost of emissions reductions is uncertain. The relationship between that cost and the rising incentive provided by the emissions tax—and thus on future revenues from the tax—is also uncertain.

Distributional Effects

A tax on greenhouse gas emissions would not affect all households uniformly. The total burden of the tax would include its effects on average real (inflation-adjusted) incomes, households' income- and payroll-tax liabilities, relative prices, and relative returns on factors of production. For some of those effects, the burden would be larger, relative to their income, on households with lower income than on those with higher income, and for others it would be relatively larger on higher-income households.Overall, the tax would place a slightly larger relative burden on lower-income households.

The tax would reduce the real value of wages and returns on investment. A larger share of income for higher-income households comes from those sources, so that reduction in real income would place a relatively larger burden on those households. Partially offsetting that effect, however, is the fact that because higher-income households face higher tax rates, they would benefit more from the accompanying reduction in the real burden of income and payroll tax liabilities.

The tax would also introduce a wedge between the prices that consumers pay for goods and services and the returns that investors and workers receive for producing them. The more carbon-intensive the good or service was, the larger the wedge would be. Thus, the tax would increase the cost of producing and consuming goods such as gasoline and electricity relative to other, less carbon-intensive goods such as clothing and food. Lower-income households spend a greater share of income on those energy-related goods than higher-income households do, so that effect would place a relatively larger burden on lower-income households.

Finally, a tax would probably reduce average returns on capital relative to wages, largely because carbon-intensive industries tend to be capital intensive. That would slightly narrow the difference in tax burden between lower- and higher-income households because wages make up a larger share of income for households with lower income than for those with higher income because higher-income households have relatively more investment income.

Economic Effects

In addition to having the behavioral effects reflected in conventional budget estimates, such as the ones shown above, a tax on emissions would affect households' and businesses' incentives in several ways that would have effects on the economy. Because an emissions tax would lead to a slight overall decline in after-tax returns on capital relative to the after-tax returns on labor, incentives to invest would also decline somewhat, and some investment capital would flow toward less capital-intensive industries. However, that effect is uncertain and would probably decrease over time as factors of production moved among different sectors of the economy to better equalize the effect of the tax on the returns on capital and labor. The tax would increase costs of production for energy-intensive industries to the extent that firms in those industries could not switch to lower-carbon fuels in their production processes. Among fuel suppliers, coal producers in particular could experience a substantial reduction in demand.

The tax would discourage saving to the extent that it reduced consumers' future purchasing power. Because the emissions tax would increase annually in real terms, the expected future cost of consuming goods and services would be higher than the current cost of that consumption. In that sense, it is equivalent to a tax on saving, because it would reduce the purchasing power of income saved for future consumption.

The tax would reduce the real value of wages, which generally would lead people to work less because other uses of their time would become relatively more attractive. (A reduction in real wages could cause some people to work more hours because they would need to work more hours to maintain the same standard of living. On balance, that effect would be smaller, CBO estimates.) The magnitude of the effect on the real value of wages is uncertain because it would depend on both how much the tax affected real income and how the decrease in emissions affected labor productivity. For example, if emissions fell more rapidly than projected, then revenues raised by the tax would be lower, reducing the negative impact the tax would have on real incomes. Additionally, there could be an offsetting positive effect of the tax on labor productivity—and thus wages and real, after-tax incomes—if the reduction in emissions, due to the tax, helped mitigate productivity-lowering harms such as infrastructure damage caused by rising sea levels, airborne particulates from wildfires, exposure to extreme temperatures, and storm damage to property. However, since greenhouse gases are global pollutants, those harms also depend on actions taken by other nations.

Other Considerations

The effects of greenhouse gas emissions on the earth's climate are the same regardless of which country emits them. Reducing emissions in the United States would diminish the probability of catastrophic damage from climate change but would have only a small effect if other countries with high levels of emissions did not also cut them substantially.

The efficacy of the tax in reducing greenhouse gas emissions would depend on the extent to which domestic producers responded to the tax by importing some carbon-intensive goods that they would otherwise have produced domestically—in effect, exporting some of their carbon-intensive production to other countries with less stringent policies toward those emissions. Such "carbon leakage" would occur particularly with goods that are carbon-intensive and easily traded. Ultimately, averting the risk of future damage caused by emissions would depend on collective global efforts to cut emissions.

The administration of the tax would be simpler if it was collected "upstream" (as is done with many excise taxes) where carbon-intensive fuels first enter the economy rather than "downstream" where those fuels are used by individual consumers. For example, the tax could be collected from producers, importers, and refiners of fossil fuels on the basis of the emissions released when those fuels were eventually used, such as to generate electricity. The administrative costs to the federal government of a tax on greenhouse gases would depend on the design of the tax and are not included in the estimates for this option.

A tax on greenhouse gas emissions would interact with existing tax preferences and spending programs that support users and producers of certain fuels and energy technologies. Some of those preferences and programs—subsidies for purchasing electric vehicles, tax preferences for producing electricity from renewable sources, and demonstration projects for carbon capture and storage, for instance—reduce greenhouse gas emissions. The rationale for those forms of government support would be reduced if most energy-related emissions were taxed. Reducing those existing forms of government support would result in additional deficit reductions.

In addition, reducing or eliminating existing support could result in more uniform treatment of all sources of energy production for both investors and users. A more uniform treatment would better allocate capital across its uses, resulting in increased economic efficiency and growth. A tax would induce emissions reductions where they could be achieved at the lowest cost, which—compared with achieving the same overall reductions in other, more costly ways—would free up resources for other purposes.