By Hattie Weatherley (BSc Economics with a Placement Year)
[This essay was written for the Government, Welfare and Policy third-year undergraduate module. Students were tasked with writing a blog-style essay on a topic linked to a group poster project. Topics were chosen by students and reflect their own interests. The essay gave them experience of writing content in an engaging style for a non-expert audience. What you see below is one of this year’s top-marked blog-style essays. Christa Brunnschweiler]
Climate experts predict increasing negative impact on our welfare, livelihoods, and the way we live because of CO2 driven climate change, and the search for the most effective mitigation policies is on. Governments have been setting vigorous CO2 reduction targets for decades to achieve “net zero”, such as commitment to “The Paris Agreement”. Yet, deadly impacts of the climate crisis are increasingly felt all over the world and reaching unprecedented hights each year, inducing unparalleled costs on society. The World Health Organisation states climate change impacts our wellbeing in several ways by causing heatwaves, storms, floods, and disruption of food systems which can directly cause injury, illness and even death.
The United States have been brandished as a tangible example of said costs, with heat trapping gasses onsetting a multitude of severe weather conditions including extreme rainfall and wildfires in California. It is clear this is not a problem to be dealt with in the future. The world cheered as the US re-entered the global environmental stage upon the Biden Administration re-joining The Paris Agreement in 2021, committing to reduce greenhouse gas pollution by 50% from 2005 levels by 2030. Despite this ambitious commitment, a nation-wide CO2 reduction policy has not been established. Several states, local governments, and corporations have pursued their own climate goals, but this is insufficient to make up for long term resistance and four years of environmental rollbacks under Trump. The US is lagging behind the rest of the world in climate action, so strong advances are needed to catch up and improve international competitiveness in this field. As the second biggest polluter of CO2 worldwide, what can the US do to achieve their targets and fulfil responsibility to citizens and the rest of the world?
Here enters the carbon tax. The carbon tax is a primary method of putting a price on CO2 in the atmosphere by enforcing a fee per ton of emissions. The general idea is to make polluters pay, which incentivises companies and individuals to reduce carbon activity by cutting their costs. It is possible for a well-designed tax to reduce the risk of climate change, minimise costs of reducing emissions, encourage innovation of ‘greener’ technologies, and increase public revenue. But the truth is that implementing a carbon tax poses significant challenges.
Climate change is not just an environmental issue but also a social one. It requires us to address inequality and welfare between wealthy and poor countries and rich and poor within countries. US Consumers’ political resistance to carbon taxes is one of the reasons for the US’ environmental policy falling short. With fears stemming from carbon prices rising, the distributional impact of the policy must be at the centre of discussion.
Households with the largest carbon footprints tend to be those with the highest incomes. However, one of the biggest concerns with carbon pricing is that it disproportionately impacts low-income households, as a higher proportion of their income would have to be spent on carbon. The graph below shows a study exploring the impact of a $200/tCO2 across an array of household income levels, quintile 1 being the lowest and quintile 5 being the highest.
Distributional impact of $200/t CO2 Tax across Households in the US.
Source: Carbon Pricing: Effectiveness and Equity – ScienceDirect
In quintile 1, the tax would claim more than 12% of the lowest earning households’ income. At the other end of the spectrum, the equivalent tax claims less than 9% of household income for the highest earners in the US, showing this policy is clearly regressive. Families in quintile 1 would be particularly stretched, since energy is often a relatively large share of household expenditure.
What can we do to remedy this situation?
Policymakers should use carbon tax revenues in a way that reduces the burden and encourages economic growth. It is possible to divide revenues from the tax between dividends for poorer households to reduce the distortionary impacts. This can be done by returning revenues directly to citizens through lump-sum rebates, or by reducing pre-existing tax rates in other areas known as a “double dividend”. The intention here being the poorest household’s incomes do not suffer because of the tax, diminishing living standards are prevented, and welfare is maintained or improved.
Economists are divided on which form of dividend is the best to use for two key reasons. Firstly, it takes time for the structure of the economy to adjust to a new tax, with increased costs for businesses onsetting potential job losses, so redistributive attempts can be tricky and insufficient if unemployment is high. Secondly, welfare effects of the policy will vary over an individual’s lifetime which causes complexity. Consider a double dividend policy where carbon tax revenue is returned though a reduction in income tax. Retired individuals will not benefit from the tax rebate as they are not working, putting this proportion of the population’s welfare at risk as their cost of living becomes more expensive relative to those who work. To soften the blow, a lump sum policy that increases with age could be effective here. However, the lump-sum method has been shown to reduce welfare of future generations. When the whole population has always lived in an economy with a carbon tax present, we will no longer need to compensate older people on low incomes to deal with the economic shock of additional tax. Therefore, some economists suggest it makes more sense to redistribute carbon tax revenues through a double dividend from a chosen future date going forward and have a lump-sum system in the meantime.
What about a combination of the two? The Canadian Province of British Columbia found this to be highly progressive. The carbon tax of $50/tCO2 which covers about 75% of their emissions is coupled with personal and corporate tax cuts, as well as credits to low-income households, demonstrating how these rebates can be successful in practice. The policy also resulted in a 5-15% decrease in emissions, so it’s effective. Canada is one example of over 50 similar carbon pricing schemes implemented around the world. It is important to recognise the complexity of this mechanism, but with considerable efforts to reduce distortionary effects, the states can take initiative and follow suit without harming welfare, or risk taking a blow to their international competitiveness.
So how does this impact the rest of the world?
Climate change is an issue that is felt all over the world, so minding how domestic policies impact other countries is important. With several carbon tax systems on earth, you would think emissions would decrease. But this is not quite the case.
When emissions decrease in one country due to carbon pricing, they often do not disappear but are instead offset by increased emissions elsewhere in the world, which is referred to as “carbon leakage”. High income countries have shifted to service provision rather than manufacturing and therefore go in search of industrial (carbon intensive) goods elsewhere, which tends to be developing countries where carbon regulation is more laxed, putting the burden of climate change upon the poorest in the world. This is potentially detrimental to the wellbeing of developing countries as they feel the effects of climate change more dramatically because they are geographically more vulnerable to climate hazards, do not have capacity to remove themselves from harm, and have poor health infrastructure.
How can the government make sure this doesn’t happen?
The carbon tax could be used alongside a Carbon Boarder Adjustment Mechanism (CBAM), which is a policy used to put a fair price on carbon emitted during the production/import of goods entering a country, and works by levying a tax on embedded carbon content of imports. This price of the imported carbon intensive goods increases such that it is more expensive than domestic carbon under carbon tax which encourages consumers to use cheaper domestic carbon or find greener alternatives. We can look to the European Union (EU) as an example, where a CBAM has only just been employed in addition to a carbon pricing system called an Emissions Trading System (ETS) which works similarly to a carbon tax. The EU CBAM is a pioneering and bold policy, but there is evidence to suggest the additional tax will successfully reduce carbon leakage and emissions. If executed properly, the EU could assert their position as a global leader in climate policy and encourage the use of climate pricing in other countries, improving welfare all around the globe. If the US wish to stay in the race for climate change policy, they have the option to layer the carbon tax with the CBAM to increase efficacy in reducing emissions without harming welfare.
But this additional policy is not without complications either. A CBAM could come at a high cost for developing countries who rely on export revenue from the US. The EU have decided to phase in the policy giving economies time to adjust. Also, A similar approach to earlier can be taken to redistribute revenues. Studies show targeting CBAM revenues fostering clean technology for energy intensive industries makes developing countries better off and increases competitiveness. With the US being such a large polluter and economic force, their ability to harm developing countries huge, making thorough execution of such policies vital.
All taken together, we can see carbon policy is complex. A carbon tax is likely to be effective in improving welfare for the US by reducing carbon emissions. However, it is clear there are domestic and global impacts on welfare. The recommendations to layer the additional policies of redistributive dividends and a CBAM are likely to improve the efficiency of a carbon tax in the US, should it ever be implemented, by protecting the welfare domestically and globally. Of course, this is dependent on the US adopting a nationwide policy to tackle climate change and improve welfare.
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