Washington State's Carbon Tax Initiative

Yesterday, Harvard economist, Gregory Mankiw wrote an article for the New York Times, The Key Role of Conservatives in Taxing Carbon, commenting on a proposal for a carbon tax. A coalition, comprised of a number of representatives from a variety of environmental organizations and local communities, known as the Alliance for Jobs and Clean Energy, has opposed a carbon tax initiative in Washington State because they think that the revenues from the carbon tax should be used differently. Mankiw takes a political angle in his article, urging conservatives to support carbon taxes by suggesting that the opposition comes from Democrats (though there is no Democratic leadership identified in the coalition's steering committee). Mankiw does not, however, discuss why the carbon tax proposed by Carbon Washington is good policy or why the opposition's proposals are potentially problematic. I'd like to do that here.

First, I'd like to explain how the Washington State carbon tax would work and examine that proposal. Then I'll consider the main concerns of the opposition. The full text of the proposal is available here.

• How the tax works: The proposed carbon tax for Washington state will tax fossil fuels at an initial rate of $15 per metric ton of carbon dioxide, increasing to $25 per ton in the second year and then increasing at a rate of 3.5% plus inflation (up to a maximum of $100 in 2016 dollars). The carbon tax on fuels will be collected from businesses licensed to sell fuels (such as motor vehicle fuels and aircraft fuels) and crude oil used to manufacture other petroleum products. The carbon tax on electricity will be collected from utilities in a manner similar to sales and use taxes. When the prices increase for electricity, gasoline and goods that are manufactured and transported using fossil fuels, people will tend to use less of them. They may decide to use less electricity by lowering the thermostat, take public transportation, or find substitute goods (that are cheaper because they are manufactured, transported and delivered without the use of fossil fuels).
• Exemptions: Public transportation systems and agriculture are initially exempt from the full impact of the tax; instead the tax will phase-in over a 40-year period for these sectors.  These phase-ins will limit the price increases for public transportation and food grown in Washington. In addition, those who use carbon sequestration can have their taxes rebated. 
• Who pays (ultimately): Even though the tax is collected from businesses, the tax will be passed forward to consumers. Taxes on energy are ultimately included in the purchase price of all goods and services that use fossil fuels in manufacturing and transporting goods. As I explained in my 2010 article on carbon taxes and cap and trade systems, Mitigating the Distributional Impacts of Climate Change Policy, all incidence studies show that regardless of who collects the tax, consumers are the ones who ultimately pay it. People can avoid the tax by reducing their use of gas, electricity, and goods manufactured using fossil fuels. The goal of the tax is to encourage people to make changes (such as lowering the thermostat in the winter and raising it in the summer, weatherizing their homes, and using public transportation) that use less fossil fuel-based energy. The carbon tax will also likely create demand for non-fossil fuel energy resources.
• Use of Revenues: The carbon tax is expected to generate $1.7 billion in revenues. I-732 proposes to use those revenues to reduce the sales tax, provide a rebate to low-income working families and eliminate the business and occupational tax for manufacturers.  Each of these proposals have pros and cons.
• Reduction in the State Sales Tax. The I-732 carbon tax proposal is revenue neutral. The money collected from the carbon tax will be delivered back to the people who are impacted by the carbon tax (rather than used by the government on other projects). In my article about a national level carbon tax or cap-and-trade policy, I argued that the revenues should be rebated to households as a lump sum and should be delivered to households through the income tax. Reducing the sales tax is less efficient and less effective because the price decreases through the sales tax undercut the price increases from the carbon tax (resulting in higher use of fossil fuels than the carbon tax was designed to deliver). A lump sum rebate would be more effective because it allows the carbon tax to work, but then returns the funds to households at a later time and in a manner that they are more likely to spend the money on something other than energy or fuels. In my article, I proposed to deliver the lump sum rebate through the income tax because it would be easy to administer (income tax administrators calculate income annually, household energy use and other consumption roughly corresponds to income, and rebates could be calculated based on income). However, Washington State does not have an income tax. Therefore, the sales tax reduction is not a bad substitute. A reduction in the sales tax would also track more closely household carbon consumption than estimates based on income by quintile (my proposal).
• Rebate for Working Households. In addition to the sales tax reduction, I-732 proposes a rebate of up to $1500 a year for low-income households in Washington state that receive the federal Earned Income Tax Credit (EITC). This proposal reaches many of the households that would experience the most harsh effects of the carbon tax, but it would not generally reach elderly households or unemployed individuals. 
• Elimination (more or less) of the Business and Occupational Tax for Manufacturers.  Manufacturers in Washington State would likely be harmed by the tax. If they pass the carbon tax forward to retailers, and ultimately to consumers, their goods will have higher prices than those manufactured in other parts of the United States and the world. This puts the manufacturers at a competitive disadvantage and may encourage them to close factories in Washington state and move to locations that are not impacted by the carbon tax. This is known as "leakage." By reducing the Business and Occupational Tax, I-782 may be effectively offsetting the impacts of the carbon taxes on these businesses and the goods they manufacture. This is not an optimal result. Ideally you want the price of goods to reflect their carbon content (the amount of carbon dioxide emitted as a result of their manufacture, transportation and use). However, this may be the best means available to keep businesses from moving out of Washington State. Washington cannot impose border taxes on goods imported from other states or countries under the Commerce Clause (Article I, Section 8, Clause 3),  and the Import-Export Clause (Article I, Section 10, Clause 2) of the Constitution. 

The Alliance for Clean Jobs and Energy appears to oppose I-732 (though they have not made a statement on their website).   

• Carbon Tax versus Cap-and-Trade? The Alliance has previously supported cap-and-trade legislation proposed by the governor. In general, cap and trade programs are less efficient, and in some circumstances, less effective than carbon taxes. As my friend, Shi-Ling Hsu, one of the authors of the I-732 carbon tax proposal, has explained in his book, The Case for a Carbon Tax, a carbon tax is better than cap-and-trade because it is precise, flexible, easily implemented and administered, less susceptible to arbitrage and gaming, and less likely to create entrenched interests that will oppose future innovations.  

• Better Use of Revenues. The main concern of the Alliance appears to be that they believe the carbon tax revenues should be spent differently. According to a Seattle Times news article, the coalition's leaders argue that the carbon-tax revenues should be spent on clean-energy investments, schools and other community programs. The cap-and-trade proposal that the Alliance supported in the past would have directed revenues to the state education budget, transportation projects, and affordable housing programs. While these projects are laudatory, beneficial and needed, they will not benefit the coalition of community groups in the short term, and may not benefit them to the degree that the decrease in the sales tax and the rebates would.  This use of revenues would also not likely be as popular on a state-wide basis.
  

• Future Benefits Versus Current Relief. First, any benefits from using carbon tax revenues to construct affordable housing, schools and renewable energy facilities are likely to occur in the future. The design, permitting, and construction for these kinds of projects all take time. In the meantime, low-income households will suffer preferentially from the carbon tax because they spend a larger percentage of their income on energy than higher income households and they have less ability to reduce those costs because they rent their homes and lack the authority to make weatherization improvements.  
• Distribution of Benefits. Affordable housing and improved transportation are often hotly disputed land use issues that cause delays and increase costs. Their benefits will not be distributed uniformly or even according to the amount of carbon tax paid. The structure of the programs often determine who benefits from these projects. A recent Supreme Court case demonstrates that states can further a pattern of discrimination by steering affordable housing to certain neighborhoods. Even if affordable housing units are developed in optimal locations, low-income households may not receive much of the intended benefit. Some studies have shown that affordable housing subsidies (such as tax credits) are enjoyed primarily by tax credit investors and developers rather than the households they are intended to benefit. Each dollar of subsidy is estimated to only provide 35 cents in rent savings for low income households. Similarly, the benefits of tax subsidies to renewable energy projects appear to accrue primarily to investors rather than consumers because of the transaction costs and other costs associated with tax credit transactions.
  
• Popularity of Tax Cuts Versus Investments. The coalition also suggests that alternative energy investments, affordable housing, and improved schools would be more popular than tax cuts. I think that the opposite is true. The tax is imposed throughout Washington State. While many of the political interests in the urban centers would support use of carbon tax revenues for energy development, affordable housing and school improvements, the less urban areas are quite conservative. They would likely find reductions in the state sales tax and rebates more appealing because they entail less redistribution. When revenues are to be steered toward certain types of government programs, it's not always clear who the winners and losers will be. This uncertainty may undermine efforts to pass the initiative. For a broader discussion, please see Section III of my carbon tax article, which discusses the equity and efficiency of alternate proposals for uses of revenues from carbon taxes and cap-and-trade programs. The paper evaluates the fairness the different proposals from a variety of political perspectives. 

While providing a lump sum rebate to consumers from the carbon tax revenues would be ideal in terms of achieving efficiency and managing the equity problems that arise from the carbon tax, the I-732 proposal has been constructed well and thoughtfully. Based on the political economy of Washington State, it has a higher likelihood of being passed than either a cap-and-trade program or a carbon tax in which the revenues are used for particular projects. It will also offset the impacts to low-income households in a more straightforward way. While additional provisions to aid unemployed workers and elderly households would improve the program, the proposal appears to be politically feasible, effective, and just.