CBO Report Says Carbon Tax Is Most Efficient

In Policy Options for Reducing CO2 Emissions, the Congressional Budget Office (CBO) says a tax on emissions would be the most efficient incentive-based option for reducing carbon dioxide emissions.

The study was written by Terry Dinan of CBO’s Microeconomic Studies Division under the guidance of Joseph Kile and David Moore. Robert Dennis, Douglas Hamilton, Robert Shackleton, and Thomas Woodward provided comments. Outside CBO, William Pizer of Resources for the Future, Reid Harvey of the U.S. Environmental Protection Agency, and Martin Weitzman of Harvard University provided comments.

Prepared for the Senate Committee on Energy and Natural Resources, the study compared policy options that rely on economic incentives for reducing carbon dioxide emissions. The team reviewed the following options: a tax, a cap on total annual level of emissions combined with a system of tradable emission allows, and a modified cap-and-trade program that includes features to constrain the cost of emissions reductions undertaken to meet the cap. These options were compared according to their potential to reduce emissions efficiently, to be implemented with relatively low administration costs, and be consistent with incentives in other countries.

The CBO drew the following conclusions:

• A tax on emissions would be the most efficient option and could be relatively easy to implement. If this policy option was coordinated among major emitting countries, it would help minimize the cost of achieving a global target for emissions by providing consistent incentives for reducing emissions around the world. If other major nations used cap-and-trade programs rather than taxes on emissions, a U.S. tax could still provide roughly comparable incentives for emission reductions if the tax rate each year was set to equal the expected price of allowances under those programs.

• An inflexible annual cap (one whose level was not affected by the price of emission allowances and under which firms would not be allowed to bank or borrow allowances) would be the least efficient option among those considered here, although it could be relatively easy to implement, depending on key design features. Linking the cap-and-trade programs of various countries could create significant concerns, however: Nations would give up sovereignty over the price of the allowances traded in their programs and the extent to which emissions were reduced in ways that met their programs’ criteria.

• A cap-and-trade program that included a price ceiling (safety valve) and either a price floor or banking provisions could be significantly more efficient than an inflexible cap, although somewhat less efficient than a tax. It might also be relatively easy to implement, depending on specific design decisions. If major emitting countries agreed to establish such programs—and to set their safety valves at roughly the same level—they could create similar incentives to reduce emissions without formally linking their cap-and-trade programs. Alternatively, if other developed countries taxed CO2 emissions, a safety valve in a U.S. cap-and-trade program could be set at a level consistent with that tax.

• Moderating the price of allowances by altering the stringency of a cap—or the extent to which firms could use banked and borrowed allowances—would be considerably more difficult to implement than setting a price floor or ceiling directly. Price volatility in the allowance market could make it difficult for policymakers to know when to alter the supply of allowances and would mean that no particular price outcome could be guaranteed. One particular form of price-sensitive cap—a cap-and-trade program with a circuit breaker—could be more efficient than an inflexible cap. However, such a program would be less efficient than the other policy options that CBO examined.

To access the full report, visit  www.cbo.gov/ftpdocs/89xx/doc8934/02-12-Carbon.pdf.

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