CREATIVE PIE SLICING AND CLIMATE POLICY

By Severin Borenstein

There are two fundamental, and fundamentally different, barriers to pricing greenhouse gases. The one economists tend to focus on is the economy-wide cost of reducing emissions: substituting to lower-carbon and (for now) higher cost production of energy and other products. That is, the hit to the size of the economic pie. The barrier less discussed by economists, but dominating the attention of politicians and voters, is how those costs are distributed among the population, that is, how the pie gets sliced. Today, I want to take a break from discussing pie-size issues to consider pie slicing.

To illustrate, think about a gasoline tax, as California legislators have been doing a lot lately.  In April they passed, and Governor Brown signed, a new law (SB1) that raises transportation funding, including increasing the state’s gas tax by 12 cents a gallon. As with any tax, the cost to the economy as a whole is not the revenue raised; that money comes out of the taxpayer’s pocket, but goes into fixing roads, building bridges, supporting public transit or other activities that benefit people in the economy. The cost to society as a whole is the adjustments consumers make to use less gasoline: switching to alternative transportation that costs more or is less convenient, or just travelling less.

 

 

If the tax is on pollution, there is also a benefit to society from reduced pollution. The point of reducing pollution – whether through taxation, cap-and-trade, or direct regulation – is that the benefits to society can outweigh the costs, making the total pie larger.

Still, to any one individual, the cost is measured in their own additional expenditures, which can be much larger for some people than for others. If you drive a lot more miles than average or drive a lot more car than average (in weight or horsepower), you obviously pay a greater share of the additional tax payments.

An obvious point to every politician, but one often ignored in economic analysis, is that individuals thinking about their costs will compare their lot after the tax is imposed to whatever they had before, whether or not the previous status quo made any sense. Even if large polluters previously paid nothing for the damage their emissions were doing, they will still feel worse off if they bear a high share of the new tax payments, and they will be likely push back against the increase.

 

 

And that’s where the fundamental separation of pie size and slice size comes in. Setting aside whether you think it is fair, the pie size goal of a gasoline or GHG tax increase, or a higher cap-and-trade price, can be achieved while compensating losers who would otherwise make the largest share of the new payments. This doesn’t eliminate the economy-wide cost of adjusting to, for instance, an increased GHG price, but it can spread the cost more evenly, likely reducing opposition from those who would otherwise be the biggest losers.

Many California state legislators are currently reluctant to support an extension of the state’s GHG cap-and-trade program beyond 2020 if it might noticeably raise the greenhouse gas price. They are responding to strong disapproval of the gas tax increase passed in April. In fact, even though it won’t go into effect until November, that tax increase has already led to a recall campaign against one California Senate member. This, despite the fact that the tax increase will raise the cost of living for an average family of 4 by less than 50 cents per day, and by less than that for the average lower-income family. California’s economy uses about one gallon of gasoline per person per day (including personal and business vehicles). Average gasoline consumption increases with household income, though the estimates on how much vary.

Still, the cost to some people is much more than the average. And many voters’ reactions to the 12 cent gas tax increase, as well as to paying for GHGs, seems to be that it’s a complete waste of funds, which will never come back to benefit them. To respond to these concerns, there have been many proposals at the state and federal level to return the funds from a price on GHGs to individuals through a per-capita rebate.

Many economists (myself included) wince a bit at such proposals, because we would like to see that money redistributed to individuals through a more value-creating process, by reducing some other distortionary tax and making the pie larger. To particularly benefit lower-income households, we could reduce payroll taxes or lower tax rates for lower income brackets.

Nonetheless, even GHG pricing proposals that return the revenue through per-capita rebates meet with strong resistance from areas or individuals who will be hurt more than the average (or believe so), but will only receive their equal share of the revenue. The “simple solution” of rebates based on how much you paid in taxes doesn’t work: if you know the tax you pay will come right back to you, it doesn’t give you an incentive to reduce your use of a good, which was the whole point. Still, it’s possible to do better than a uniform rebate without undermining the incentive that the tax is supposed to create.

 

For instance, the U.S. federal gas tax is 18.4 cents per gallon, unchanged since 1993. That’s in large part because politicians from Wyoming and other rural states recognize that their constituents consume much more gas than in urban areas. In fact, Wyoming consumes 63% more gasoline per capita than California, and more than twice as much as New York.

The efficiency (pie size) effects from raising the gas tax have nothing to do with who gets the revenue, but the political resistance sure does. So, how about increasing the federal gas tax by, say, 50 cents per gallon and rebating most of the money based on statewide average consumption? Wyoming residents would bear no more burden than New Yorkers on average, but Wyomingites would still have an increased incentive to buy more fuel efficient cars. The heaviest drivers everywhere would still take the biggest hit, but no state could claim that it is disproportionately harmed by the tax increase.

And once we go down this road, why stop at states? Rebates could be based on county-level average gasoline consumption. To the extent that county gasoline consumption is very heterogeneous within states, the rebates would even more accurately offset the increased tax burden, though cross-county gasoline purchases undermine this a bit. The point is that tailoring rebates to the impact in smaller areas can improve the match between revenue burdens and rebates without undermining the incentive effect of the tax.

(It’s worth noting that this is another advantage of using market mechanisms – taxes or cap-and-trade – to meet environmental goals. Unlike direct regulation – technology or emissions standards — they generate revenue that can be used to compensate losers.)

 

The same idea could be used in California, where the greatest opposition to gas taxes and pricing GHGs comes from rural counties.  Gasoline consumption varies substantially across counties, from densely packed San Francisco, where fewer people even own a car, to the rural areas in the Northern and Eastern parts of the state, where it’s hard to live without one. Rebates could be based on 2016 per capita fuel consumption so the high-use counties still have incentives to adopt public policies that reduce future consumption, such as EV chargers.

Likewise, rather than uniform per capita rebates of cap-and-trade revenues across the states, the rebates could be higher in GHG-intensive counties. After all, unless your goal is to punish people who have lived more GHG-intensive lives, this moves us in the right direction on climate policy while reducing political resistance, and resentment.

Emotionally, it may not be easy to separate policies that reduce fossil fuel use from penalties on those who currently emit the most, but practically it can be done and making progress politically on climate change depends on doing so.

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