Energy Taxes and Global Warming David Barker January 12, 2009 Summary: A carbon tax equivalent to $22 per gallon of gasoline is required if the problem of global warming is taken seriously. If revenue from this tax is used to offset other taxes, it is possible that carbon dioxide emission reduction targets can be achieved without economic catastrophe. 1. Introduction If carbon dioxide emissions cause global warming, then the only realistic way to keep the planet cool is to reduce emissions, which requires a reduction of fossil fuel consumption. Economists believe that the most efficient way to reduce the consumption of any good is to raise its price, and the simplest way to raise the price of a product is an excise tax. More complicated solutions, such as cap and trade, mandatory conservation, alternative energy subsidies, etc. are attempts to mask the true cost of reducing carbon dioxide emissions. Government planners are poor judges of the relative efficiency of alternative energy strategies, while decentralized markets do a good job of efficiently allocating resources, given prices of basic resources. If burning fossil fuels causes a market externality (global warming) which is not properly priced, then the solution is to tax these fuels and let markets decide how to rearrange economic activity. 1
2. Constraints on Carbon Taxation Having established that an excise tax is the best method to reduce carbon dioxide emissions, the question that remains is how large the tax should be. Two constraints on the tax seem reasonable; first, it must be large enough to have a chance of reducing the threat of global warming, and second, it must not be so large that it causes economic catastrophe. A number of environmental scientists have called for reductions in carbon dioxide emissions to 20% of 1990 levels, arguing that reductions less than this amount will fail to prevent a tipping point where disastrous climate change is inevitable. Reduction of this magnitude is also the goal of the Global Warming Pollution Reduction Act (S. 309), so I will calculate the tax required to achieve this level of emission reduction. The readjustment required to reduce emissions by this amount is bound to have serious economic costs, but these costs might be manageable if they do not represent a net tax increase - in other words, if the revenue from the fossil fuel tax is used to eliminate other taxes. Energy taxes involve deadweight losses to the economy, but so do other taxes, so it is possible that substituting one for the other might not cause an economic disaster. Fossil fuel taxes might be somewhat regressive, but revenue from the tax could be paid to people with low incomes, and the revenue could be used to cut or eliminate other regressive taxes, such as sales, property, and payroll taxes. The two constraints are therefore, first, that the tax be high enough to reduce emissions to 20% of 1990 levels, and second, that total fossil fuel tax revenue be less than or equal to current revenue from taxes of all kinds. Total current carbon dioxide emissions from the United States are estimated to be 6.05 billion metric tons per year. In 1990 these emissions were 5.06 billion metric tons per year. A reduction to 20% of the 1990 level therefore requires that emissions be cut to 1.01 billion metric tons per year. Assuming that the carbon dioxide output per unit of energy is roughly the same for different fossil fuels, this would require an 83.3% 2
reduction in fossil fuel use. According to the Bureau of Economic Analysis, total tax revenue from all sources in the United States, federal, state and local, including income, payroll, excise, estate, sales, property, and other taxes is approximately $6.5 trillion. An ideal carbon tax would therefore reduce fossil fuel use by 83.3% and raise no more than $6.5 trillion. 3. Estimation of Required Tax The key parameter required to estimate revenue from an excise tax is the price elasticity of demand; how much demand goes down when the price goes up. Suppose, for example, that total U.S. oil consumption is 7.5 billion barrels per year. A tax of $100 per barrel will not produce revenue of $750 billion per year, because people will respond to the tax by consuming less oil. The price elasticity of demand tells us how responsive demand is to a change in price. If the price elasticity of demand for oil is -0.7, this means that a 10% increase in price will cause a 7% decrease in demand. Demand is usually more elastic in the long run than in the short run, since since adjustment to higher prices is harder to do in a short period of time. A number of studies have found long run price elasticities of demand for energy to be in the neighborhood of -0.7, but we can compute the tax required for a range of possible elasticities. A simple demand function for fossil fuel would look something like equation 1. Q represents total fossil fuel demand measured in billions of metric tons of carbon dioxide emitted per year, P is the price per metric ton of carbon dioxide, ɛ is the price elasticity of demand, and α is a constant that we will estimate from data. Q = αp ɛ (1) 3
We know that Q is currently equal to 6.05 billion metric tons of carbon dioxide per year. Price obviously varies between energy sources such as coal, gasoline, natural gas, etc., but for simplicity we will use the price of gasoline to represent all fossil fuel prices. One gallon of gasoline produces approximately 20.097 pounds of carbon dioxide, or 0.0091158 metric tons. At the current price of $1.85 per gallon, P measured in dollars per metric ton of carbon dioxide is $202.94. Next we can solve for alpha as a function of ɛ, substituting in the current values of Q and P. α = Q P ɛ (2) α = 6.05 109 202.94 ɛ (3) We can substitute this expression for α into equation 1 to obtain Q as a function of P and ɛ. Q = 6.05 109 202.94 ɛ P ɛ (4) Next we can solve for P so that we can calculate the price required to obtain any desired level of consumption. P = 202.94 Q 1 (6.05 10 9 ) 1 ɛ (5) ɛ Since we want Q to be equal to 1.01 billion, we can substitute this value in for Q and solve for P as a function of ɛ. 4
202.944 P = (6.05 10 9 ) 1 ɛ ( 1.01 10 9 ) 1 ɛ (6) Up to this point P has been the price measured as dollars per metric ton of carbon dioxide. Our results will be easier to interpret if the price is expressed in more familiar units, such as dollars per gallon of gasoline. Since one gallon of gasoline produces 0.0091158 metric tons of carbon dioxide, we can convert this price by multiplying it by 0.0091158. The price of energy in terms of dollars per gallon of gasoline required to reduce carbon dioxide emissions to 20% of 1990 levels is therefore: 202.94 P = 0.0091158 (6.05 10 9 ) 1 ɛ This expression can be simplified to: ( 1.01 10 9 ) 1 ɛ (7) P = 1.85 ( ) 0.16694 1 ɛ (8) For example, if the price elasticity of demand is equal to -1, then the required price 1.85 would be, or $11.08. To make the price of gasoline equal to $11.08, the tax would 0.16694 need to be 11.08 1.85 or $9.23 per gallon. If, as numerous studies suggest, the price 1.85 elasticity of demand is -0.7, then the tax would need to be 0.16694 0.7 1 gallon. 1.85 or $22.02 per How much revenue would this tax raise? Total revenue would be the tax multiplied by energy use. Since the tax was calibrated to set energy use at a level that would result in 1.01 billion metric tons of carbon dioxide per year, we can convert the tax back into dollars per metric ton of carbon dioxide and multiply by 1.01 billion, as shown in equation 9. 5
Revenue = 1.01 10 ( 9 202.94 ( )) 0.16694 1 ɛ (9) Next we can set revenue equal to $6.5 trillion and solve for the largest elasticity that will equate carbon tax revenue and current total tax revenue from all sources. This elasticity turns out to be -0.513. This means that as long as the price elasticity of demand for fossil fuels is less than this amount, then it will be possible to raise taxes on fossil fuels enough to reduce carbon dioxide emissions to 20% of 1990 levels while not raising the overall level of taxation, as long as carbon tax revenue is used to lower other taxes. Studies generally agree that in the long run, demand for energy is more elastic than this critical value. In the short run, demand for energy is much less elastic than in the long run, so a carbon tax should be phased in over time, perhaps over 10 years. 4. Conclusion Carbon taxes on the order of $22 per gallon of gasoline are required if global warming is a serious threat. Taxes of this magnitude would have huge negative effects on the economy. Even a Toyota Prius getting 45 miles to the gallon would cost $55 to take on a 100 mile trip, and the cost of hybrid cars would certainly rise, since automobile manufacturing is energy intensive. Air travel would probably be out of reach for nearly everyone. Heating and air conditioning at comfortable levels would become unaffordable luxuries for many people, as would many manufactured goods. On the other hand, revenue from this tax could nearly eliminate all other taxes, creating tremendous new business opportunities. Research into alternative energy sources would certainly accelerate, and might eventually allow lifestyles to return to normal. 6