Economic Impact Analysis: Washington s Initiative 732

1 P a g e O c t o b e r 10, 2 0 1 6 Economic Impact Analysis: Washington s Initiative 732 Introduction Washington s Initiative 732 (I-732) will be on the ballot this November for Washington voters. The initiative, if it passes, would establish an escalating carbon tax on fossil fuels in Washington. Carbon taxes are viewed to be a marketbased environmental policy tool to reduce greenhouse gas emissions by imposing a direct cost (a tax) on emissions of carbon dioxide (CO2). The intent of the tax on the carbon content of fossil fuels is to increase the price and create an economic incentive to reduce the use of fossil fuels. For example, as gasoline prices rise, consumers have an incentive to purchase more fuel-efficient cars, carpool, combine trips, or find alternative ways to commute to work. For businesses, it might mean investments in new technology to avoid the higher electricity prices and higher natural gas prices. On September 19, 2016, the Washington Department of Commerce released a new version of its Carbon Tax Analysis Model (CTAM). The economic analysis and results contained in this report provide an update to the September 12, 2016 version of the report and accounts for changes in CTAM that have resulted in new estimates of the impact I-732 will have on energy prices. While carbon taxes are intended to change behavior by imposing an additional cost on fossil fuel consumption, some consumers and firms may not have any options for conservation, fuel switching, or investments, and may simply experience higher costs, without the environment benefitting from any reduction in greenhouse gas emissions. A carbon tax, sets a known cost on the entity who is emitting CO2, but it does not mandate the amount of emissions reductions. Carbon taxes tend to be most effective at the federal level, because if they are implemented at the state level, some businesses have the option to expand or move their business operations to states without the carbon tax. Differential tax rates are often a factor for firms deciding where to locate a business, or invest capital in plant and equipment. When a policy pushes businesses and associated emissions out of the area, the effect is often referred to as economic leakage. Since a carbon tax will be a significant new tax on Washington businesses and citizens, I-732 attempts to mitigate the effects by using the revenues from the tax to reduce certain other taxes, and funding the Working Families Tax Exemption. As designed, I-732 is intended to be a tax swap, with the goal of being revenue neutral to the state budget. However, there is no language in the initiative that requires revenue neutrality, and legislators are free to adjust tax rates, or adjust the Working Families Tax

2 P a g e O c t o b e r 10, 2 0 1 6 Exemption rate, regardless of carbon tax revenue amounts. And while there is the intent to be revenue neutral at the state level, carbon taxes are never intended to be expense neutral to any one household or business. The explicit intention behind a carbon tax is to make it more expensive to continue burning fossil fuels, and the proposed tax swap will inevitably lead to winners and losers in the economy. The Carbon Tax I-732 s carbon tax would be set at $15 per metric ton of CO2 beginning July 1, 2017. It would rise to $25 per metric ton CO2 on July 1, 2018. Thereafter, it would rise at 3.5% per year plus inflation, to a maximum of $100 in 2016 dollars. The proceeds must go into the state general fund, not the highway fund. The tax will cover the carbon content of the fossil fuels sold or used in Washington, plus the carbon content of imported electricity that is consumed in Washington. The Department of Revenue will administer the carbon tax. Refineries, fuel importers, and utilities will be the point of regulation, meaning these entities (and not consumers) will file the necessary documents and directly pay the appropriate tax. Fuel intended for export outside the state is exempted. Electricity generated in Washington and exported outside the state is not exempted. There are a number of phase-in categories that would not see the full impact of the carbon tax immediately. For these categories, only 5% of the tax would apply beginning July 1, 2017, rising to 10% of the tax on July 1, 2019, and so on, rising 5 percentage points each biennium until 100% of the tax applies in 2055. These categories include farm diesel, fuel purchased for public transportation systems, and fuel purchased for private, nonprofit transportation providers. Changes in Other Taxes There are three offsetting reductions involved in the proposed tax swap. The first is a reduction in the state sales tax rate. The sales tax rate would fall from 6.5% to 6.0% beginning July 1, 2017, and from 6.0% to 5.5% beginning July 1, 2018. The second reduction involves the state s Business and Occupation (B&O) tax. The B&O is a gross receipts tax on business activities that occur in state, regardless of whether the product is for export or consumption in state. The rate would be reduced to 0.001% from various higher rates (0.138% to 0.484%) for a number of businesses such as manufacturing and the sale of commercial airplanes. The third part of the tax swap is a funding of the Working Families Tax Exemption (WFTE). Since Washington has no state income tax, the WFTE is equivalent to an exemption (or rebate) from state sales tax remittances. The WFTE was created in 2008 but has never been funded. The WFTE rebates an amount to qualifying filers that is a percentage of the federal Earned Income Tax Credit (EITC). When created in 2008, the WFTE was set at 10% of the EITC. I-732 would increase this to 15% in calendar year 2017, and

3 P a g e O c t o b e r 10, 2 0 1 6 25% in calendar year 2018 and thereafter. I-732 also removes certain funding restrictions. In the 2008 authorizing legislation, it was explicit that the funding for the WFTE must be approved by the legislature in the state omnibus appropriations act. I-732 would strike that language, implying that there will no longer be a need to authorize funding every two years. Revenue Neutrality I-732 requires the Department of Revenue to file annual reports until 2027, and biennial reports thereafter, disclosing all relevant amounts such that the revenue neutrality of the measure can be determined. The reports are submitted to the governor and the legislature. The intention behind this reporting requirement is to provide decisionmakers with the information needed to determine whether tax rates need to be adjusted to maintain the revenue neutrality of the carbon tax policy. However, there is nothing in I-732 that requires revenue neutrality or requires any adjustment to the sales tax, the B&O tax, the WFTE or other tax rates. Contrasting I-732 with British Columbia s Carbon Tax British Columbia instituted a C$10 per metric ton carbon tax in 2008. The tax was raised C$5 each year until it reached C$30 in 2012, where it has remained since. In contrast, the I-732 carbon tax increases to $25 after the first year and will increase annually until it hits $100 in real terms in approximately 2060. In British Columbia, the law requires the carbon tax to be revenue neutral. The government must adjust tax rates if the annual reports show that carbon taxes have increased revenues to the province. The I-732 carbon tax would have no such requirement for revenue neutrality, and the reports to the governor and legislature may simply be informational, and not result in any adjustments. The impact of a carbon tax on electricity prices would be quite different in Washington than in British Columbia. Nearly 100% of British Columbia s griddelivered electricity is carbon free (hydroelectric), so there has been little to no impact to electricity rates. Energy Price Impacts I-732 s proponents provide some highlevel guidance on the energy price impacts of I-732. For example, yeson732.org reports that the $25 per metric ton carbon tax means an increase of $0.25 per gallon of gasoline, and the Revenue Neutral Carbon Tax Calculator at carbon.cs.washington.edu shows the additional cost as $0.22 per gallon. Both of these estimates are likely a result of the simple calculation of the $25 per metric ton carbon tax (or 1.1 cents per pound) multiplied by the carbon dioxide emissions rate for a gallon of gasoline (about 20 pounds per gallon). These rules of thumb are handy for the earliest years of the carbon tax, but they don t reflect the later years (as the carbon tax will increase at 3.5% per year plus inflation) nor do they reflect the economic impact

4 P a g e O c t o b e r 10, 2 0 1 6 on the state economy of higher energy prices. Developing a more accurate assessment of the long-term impacts I-732 will have on energy prices required Energy Strategies to employ the most current version of Washington s Carbon Tax Assessment Model (CTAM). The model relies on energy price and consumption forecasts from the U.S. Energy Information Administration and various price elasticity of demand values (a measure of how consumer demand changes when prices increase) to evaluate the impact of a carbon tax on energy prices. The Washington Department of Revenue used this same model in its Fiscal Note for I-732, and we have adopted their assumptions in our analysis. Also, adjustments were needed to make the nominal carbon tax values in I-732 match the assumptions in CTAM (that is, the values were adjusted to represent 2015 dollars). Energy Strategies ran CTAM for a baseline case of energy prices and consumption, and then for an I-732 case that included the proposed escalating carbon tax. We then calculated the percent increase in energy prices for natural gas, electricity, diesel, gasoline, and total energy. The results are summarized in Table 1. The price of natural gas across all sectors is expected to be 29%, or $3.00/MMBtu, higher in 2040 under I-732 than it would be absent the carbon tax. Table 1 Direct Energy Price Impacts Model With % Baseline Year I-732 Increase Natural Gas Prices in 2015 $/MMBtu 2020 $9.55 $10.65 15% 2030 $9.27 $12.37 21% 2040 $10.39 $13.39 29% Electricity Prices in 2015 cents/kwh 2020 9.01 9.50 5.4% 2030 8.83 9.28 5.1% 2040 8.85 9.45 6.9% Diesel Prices in 2015 $/gallon 2020 $3.15 $3.41 8.1% 2030 $3.81 $4.17 9.4% 2040 $4.59 $5.10 11% Gasoline Prices in 2015 $/gallon 2020 $2.87 $3.09 7.8% 2030 $3.29 $3.60 9.5% 2040 $3.95 $4.39 11.2% Motor gasoline sees an impact very similar to diesel, with prices estimated to be a little more than 11% higher with a carbon tax than without in 2040. Note that for gasoline prices, with the carbon tax escalating every year, this difference is $0.44 per gallon in real terms (no inflation) in 2040. On average, electricity prices are expected to be 5.4% higher in 2020 and 6.9% higher by the end of the study period, 2040, due to the I-732 carbon tax. For households who receive electricity service from Puget Sound Energy and Pacific Power the increase in electricity prices in the near term will be higher due to the larger amount of fossilfired generation in their resource portfolios compared to the state average. For example, Energy Strategies estimates the percent increase in electricity prices for customers of Puget Sound Energy will be 10% in 2020.

5 P a g e O c t o b e r 10, 2 0 1 6 Washington households will experience the most immediate and direct effects of the carbon tax. The increase of electricity, natural gas, and gasoline prices is estimated to increase a typical Washington household s expenditures on energy by more than $37 per month in 2020, or $448 per year. The increase in household energy expenditures will grow each year as the amount of the carbon tax increases. By 2040 households will be spending $695 more per year in energy because of the I-732 tax. These are only the direct effects of the increased energy prices that would result from the carbon tax; these values do not include the price increases that consumers would face for all goods and services. Table 2 illustrates the impact to an average household s energy bills as a result of the carbon tax. Table 2 Impact on Average Household Energy Expenditures with I-732 Energy Expenditure Increase in Average Washington Household s Annual Energy Expenditures (2014$) In 2020 In 2040 Electricity $56 $72 Natural Gas $109 $215 Motor Gasoline $282 $409 Total $448 $695 Impacts to Washington s Economy I-732 s carbon tax will have wide-ranging effects on the Washington economy. Higher energy prices the most direct effect of the carbon tax is only part of the story. I-732 will affect all consumer and producer prices throughout the economy. As energy prices increase, those higher prices are reflected in the goods and services produced by the Washington economy and passed through to consumers. Using the example of a steel manufacturing firm, rising energy prices will cause the firm to increase the price of their steel, passing on their increased costs to their customers. One of their customers might be a structural steel fabricator; that firm would then increase the price of their steel products, again passing on the costs. This process continues through to the construction of buildings and prices charged for products and services sold by the buildings owners. In order to model the impacts of I-732 on the Washington economy, Energy Strategies used a computable general equilibrium (CGE) model, calibrated with production, employment, income, sales and other economic data from the 2014 Washington IMPLAN 536-industry model. In a functioning economy, household consumers purchase various goods from firms, pay taxes, and receive income. Firms purchase labor and use non-labor inputs in order to produce final goods that they can sell to households and government. Firms also pay taxes to the government. The government receives tax revenues, provides services (e.g., police, roads) and makes transfer payments to households. The CGE model accounts for the economic transactions and interactions that take place between all of

6 P a g e O c t o b e r 10, 2 0 1 6 these sectors. It also accounts for domestic and foreign trade. The model is particularly useful in estimating how changes in policy can impact prices, employment, output, and tax revenues throughout the economy. For this analysis Energy Strategies compared the performance of the Washington economy without I-732, and with I-732, which includes the carbon tax (accounting for the phase-in for agriculture and public transportation), the reductions in the B&O tax rate on manufacturing, the reduction in state sales taxes, and the transfer payments to low-income families. The economic results in the following discussion are a reflection of the new economic equilibrium that would be expected in the Washington economy after the carbon tax and other fiscal adjustments were enacted. One simplification of the model is that it assumes adjustments throughout the economy are made instantaneously. Effect on Gross State Product By 2040, the CGE model results indicate that adoption of I-732 would reduce the gross state product (GSP) by nearly $3.6 billion compared to the baseline case. The loss of GSP is a result of the economic restructuring that occurs due to the policy. The decline of $3.6 billion of GSP by 2040 represents approximately 1% of Washington s current GSP of $428.6 billion. The sector hardest hit, in percentage terms, is mining, with a loss of 16% of the sector s current GSP. It is not surprising that this sector sees the largest percentage decline, since mining is an energy dependent industry. Note, however, that the mining sector constitutes only 0.15% of the current GSP. The services sector, which is largely unchanged by the policy, constitutes 55% of the state s economy. In terms of dollar GSP losses, the manufacturing sector reflects the greatest loss, at $3.7 billion. Manufacturing is 13.3% of the state s current GSP. This sector is a primary consumer of energy; thus, a price increase in energy will greatly affect manufacturing s ability to be competitive in the domestic and foreign markets. The net overall impact of I-732 is a reduction in manufacturing output and contribution to the state s GSP. Table 3 provides detail by sector for the changes in GSP. Table 3 GSP Changes by Sector in 2040 with I-732 Industry Current GSP $Millions GSP Change $Millions % Change Manufactur g $57,112 - $3,741-7% Utilities $6,375 -$924-14% Agriculture $9,263 -$446-5% Services $233,733 -$378 0% Trade $41,128 -$120 0% Mining $637 -$105-16% Forestry $791 -$49-6% Construction $17,590 +$181 1% Gov t/misc. $61,999 +$2,017 3% Total $428,629 -$3,565-1% Effect on Returns to Capital Results of the CGE model also predict that imposition of the I-732 carbon tax will reduce returns on firms and businesses capital investments in the Washington economy. Reduction in returns (profits)

7 P a g e O c t o b e r 10, 2 0 1 6 are projected to be approximately $300 million in 2018 with losses increasing to $2.8 billion annually by 2040, representing a 1.9% loss. The longterm effect is to move the economy away from capital-intensive industries and towards labor-intensive economic activities. This process has implications for the direction future economic growth may take in Washington. Reducing returns on invested capital in manufacturing and primary industries will make the state less attractive to firms engaged in these sectors and looking to locate in Washington, and slow the rate at which existing Washington firms will expand. Slower rates of investment in the economy have important negative impacts on the rates of growth of employment and wages. The move towards more labor-intensive industries could mean expansion of highskill, high-paying technology service jobs, but it is equally plausible that it could mean expansion of low-wage retail trade and service jobs. Aircraft manufacturing and related industries, for example, employ nearly 100,000 workers with an average compensation package of over $140,000 per year and $82 billion in output (sales). If aircraft manufacturing were to leave Washington, the highskilled workers would likely follow suit, as demand for their skill sets would be greatly reduced. As the skilled work force leaves the state seeking employment elsewhere, there would be a corresponding decline in the opportunity for new, aircraft manufacturing and supporting industries to enter the Washington economy. Over time, Washington could permanently lose its skilled aircraft manufacturing and assembly workforce and the ability to produce aircraft many types of related manufactured products. Effect on Employment I-732 will also shift employment patterns in the state, from manufacturing and industrial jobs to more labor-intensive jobs in the services and government sectors. Overall, the model shows the net difference in employment between the business as usual case and the I-732 scenario is negligible by 2040, at a gain of 4,777 jobs or 0.12%. However, over the same time period, there is a loss of 22,690 private sector jobs, and a gain of 27,468 jobs in the government and miscellaneous economic sectors. The industries showing the largest loss in employment are manufacturing, agriculture, and utilities. Most of these jobs are living wage or better. In percentage terms, manufacturing declined by 4.7%, or roughly 15,000 jobs in that sector. Utilities declined by 17.6%, and mining, 16.7%. The utility sector is particularly sensitive to energy price shocks. Due to the economic links between the energyreliant sectors, the impacts of an increase in energy prices will reverberate throughout the economy. Table 4 shows the employment changes with I-732 by the year 2040.

$ billions 8 P a g e O c t o b e r 10, 2 0 1 6 Table 4 Job Changes by Sector in 2040 with I-732 Industry Current Jobs % Total Jobs Change Change Manufactr g 315,895-14,923-4.7% Agriculture 125,459-6,024-4.8% Utilities 12,707-2,238-17.6% Trade 537,911-959 -0.2% Mining 4,085-681 -16.7% Forestry 6,904-458 -6.6% Services 2,069,129-164 0.0% Construction 209,629 +2,428 1.2% Gov t/misc. 775,446 +27,468 3.5% Total 4,057,165 4,777 0.1% Effect on Trade Balance Our modeling shows I-732 will also negatively impact Washington s trade deficit by nearly $18 billion by 2040, and increase the state s dependence on goods and services from foreign and out-of-state domestic sources. Figure 1 shows the net increase in the trade deficit for selected years. Figure 1 Trade Deficit Increases with I-732 $0 ($5) ($10) ($15) ($20) Net Change in Washington Trade Deficit 2017 2018 2021 2026 2031 2036 2040 ($11) ($11) ($11.5) ($12.5) ($14) ($15) ($17) While the reduction of the manufacturing and industrial output in Washington may reduce GHG emissions in state, it could also result in economic and environmental leakage. Even small energy price changes can have a great influence on competitive advantage, since firms in most other states will not be subject to a carbon tax. The effect may be that energyintensive manufacturing and industrial firms move out of state in the long run, and there is no net reduction in GHG emissions. Leakage is an important consideration for policies to reduce greenhouse gas emissions. A Washington-only approach to reducing GHG emissions creates an incentive to merely shift greenhouse gas emissions to another state, while negatively impacting the performance of Washington s economy. Effect on Consumers and Households The CGE model also estimates consumer surplus, which is a measure of consumers and households purchasing power. I-732 s most direct effects are on energy prices and the CGE model is able to estimate how energy price increases will affect the production and costs of all the goods and services throughout the entire economy, and measure the loss of Washington households purchasing power due to I-732. The CGE modeling shows that I-732 results in an erosion of consumer purchasing power in all income classes except the lowest income class (i.e., less than $10,000 per year). This income class receives the largest benefit in terms of the I-732 tax swap. The result is an increase in the purchasing power for

9 P a g e O c t o b e r 10, 2 0 1 6 households in this income class that ranges between $1,683 and $2,592 per year, and averages $2,168 per year over the study period. From 2017 to 2040, nearly all other Washington households in the remaining income classes experience an average loss of purchasing power of $20 in 2017, growing to an average loss in purchasing power per household of $1,299 by 2040. Table 5 shows the changes in consumer purchasing power per household for various income classes and for select years. Table 5 Changes in Purchasing Power of Washington Households with I-732 Income Class 2021 2031 2040 < $10,000 $1,847 $2,313 $2,592 $10,000 to $49,000 $50,000 to $99,000 $100,000 to $150,000 -$28 -$264 -$603 -$63 -$578 -$1,367 -$25 -$778 -$1,960 > $150,000 $97 -$875 -$2,429 Weighted Avg. Loss For Classes $10,000 + Conclusions -$24 -$527 -$1,299 Washington s I-732 initiative would establish an escalating carbon tax in Washington, and use the revenues to reduce other taxes and fund the Working Families Tax Exemption. The other goal of the initiative is to provide a price incentive to reduce the use of fossil fuels and lower CO2 emissions. While the intent is to create a tax swap that is revenue neutral to the state, there is no requirement in I-732 that the reports provided to the legislature and governor result in any adjustments. Long term, the tax swap may result in a budget hole or a surplus. The direct energy price impacts show an increase of about 11% to motor fuels through 2040. Natural gas prices increase more dramatically, with a 29% increase in 2040 compared to what would otherwise occur absent I-732. Average electricity prices are estimated to increase by 6.9% in 2040. Electric service customers of Puget Sound Energy and Pacific Power will experience much higher price increases in the near term. However, in the long term, as coal plants that provide power to Washington consumers close the effect of the carbon tax on electricity prices will diminish. These energy price increases translate into an average monthly household increase in energy expenditures $37 in 2020, $448 more per year. By 2040, the increase in energy expenses for the average Washington household due to the I-732 carbon tax is estimated to be $695 per year. The economic impacts of the policy reflect the ripple effects of higher energy prices and the tax reductions throughout the Washington economy. The CGE model shows that the net overall impact of I-732 is a reduction in GSP of $4.3 billion for the manufacturing sector in 2040. However,

10 P a g e O c t o b e r 10, 2 0 1 6 the overall reduction in state s GSP is $3.6 billion in 2040, because the losses in manufacturing and other sectors are offset by growth in construction and government sector. The model shows a significant reduction in private sector jobs and an offsetting increase in government jobs. Returns on private sector invested capital see a reduction under I-732, and the economy in general moves away from capital-intensive industries towards labor-intensive industries. The foreign and domestic trade deficit increases. The effect on households is a loss of purchasing power in all income categories except the lowest (less than $10,000 per year). This analysis represents the results of one model s estimate of the complex economic effects of I-732. All such models are based on a particular set of assumptions and scenarios, which, if varied, can change the results. I-732 would potentially result in a measurable shift of Washington s economy from capital-intensive industries to labor-intensive industries. Our modeling also shows that it is likely to lead to an increase of jobs in the government sector, but a loss of private sector jobs, and it would increase Washington s reliance on goods and services from out-of-state producers. Washington voters and decision-makers should carefully consider the potential near- and long-term impacts of this initiative on both households and Washington s economy. The economic analysis contained in this report was prepared by Energy Strategies, LLC, with the assistance of Steven Peterson, a research economist and faculty member in the College of Business and Economics at the University of Idaho, and Timothy Nadreau, research economist. This report represents the conclusions of Energy Strategies and our consulting economists and does not reflect the views of the University of Idaho. Questions regarding this report should be directed to Jeff Burks at jburks@energystrat.com.