Friday, February 27, 2009

Spending Cap & Trade's Proceeds

The new administration submitted its first federal budget to Congress yesterday. It projects a cumulative deficit of $8 trillion from 2009-18, even after the inclusion of two substantial new revenue sources: It increases taxes on the top quintile of income-earners, who already account for 86% of the revenue collected by the personal income tax, and for the first time it includes revenue from the auctioning of permits for greenhouse gas emissions under a cap and trade system, the enabling legislation for which has yet to be drafted, let alone introduced. Since this is an energy blog, not a tax policy blog, I will focus on cap & trade, the full implications of which for the economy hinge on the details of its implementation and the disposition of funds it collects.

Seeing that cap & trade has become sufficiently imminent for it to be included in the federal government's income and expense budget evokes an odd feeling. I've been thinking about cap & trade for more than a decade, and I've been writing about it for at least the last five years. Yet as convinced as I am of the necessity of setting a price for carbon dioxide and other GHGs emitted to the atmosphere, and of a market as the best means of determining that price, I can't avoid the sense that the timing is off. We had all better hope that the economy will be recovering strongly by 2012, when the President's budget assumes auctioning of emissions permits will begin. Yet if that were truly certain, the significant expenditures beyond the 2009-10 period in the recently-passed economic stimulus bill would have been unnecessary. The degree of risk posed by this new tax--which it surely is, no matter how it is labeled--depends on how its revenues are recycled into the economy.

The President's budget contemplates spending $15 billion per year of the proceeds from cap & trade on energy research, development and deployment, with the lion's share going to renewable energy and the so-called smart electricity grid. (The assumption of higher taxes on oil and gas production reinforces my concern that the administration misunderstands the importance of new hydrocarbon sources in enabling the transition to a greener energy economy.) The budget proposal also indicates that much of the balance will be returned to taxpayers and to lower-income Americans who would be most affected by the energy price increases that cap & trade will cause. Congress may have other ideas, however, as evidenced by the debate over last year's Boxer-Lieberman-Warner cap & trade bill. And therein lies the problem.

In a perfect world, the sole purpose of cap & trade would be to monetize the environmental externality cost associated with GHG emissions, and then to refund 100% of the revenue to taxpayers, resulting in no net drain on the private sector. Advocates of this approach call it "cap and dividend." In the context of trillion-dollar deficits and expanded social programs, I am skeptical that consumers, who will ultimately pay the new levy on carbon in higher prices for energy and a wide variety of goods and services, will get much of it back in tax cuts or rebates. The political dynamic now in place makes that unlikely; the need to fund new programs and the urgency of reducing the budget shortfall will probably prove irresistible to the diverse coalition within the majority party, including a key swing group of deficit hawks.

If cap & trade will not be implemented as cap & dividend, but as a new source of funding for government programs, the timing of its onset looks crucial for ensuring the sustained recovery of the US economy. I understand the urgency behind enacting cap & trade. Concerns about the risks of climate change are increasing, and the administration would like to be able to demonstrate tangible US leadership at December's Copenhagen climate summit. Yet if our economy continues to shrink, we may not need cap & trade to meet the President's near-term climate goals, and if cap & trade is seen as harming the economic recovery, it would be less likely to be preserved by subsequent administrations. Better to delay the auctioning of permits for a year or two, or make it contingent on a threshold level of economic growth--with negligible incremental impact on the environment--than to wager the sustainability of tough climate policy on a premature start date.

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