A majority of economists agree that carbon taxes can provide incentives for businesses and households to reduce greenhouse gas emissions at minimal cost. But getting a precise estimate of how much a tax will reduce emissions, or predicting how the public will respond to a particular prise presents methodological challenges. Multiple carbon pricing bills before Congress attempt to alleviate some of this uncertainty by including environmental integrity mechanisms, which automatically adjust policy if actual emissions differ from prescribed benchmarks.
Now, in a new issue brief, RFF’s Marc Hafstead and Wesley Look, alongside Susanne Brooks and Nathaniel Keohane of the Environmental Defense Fund, explore possible policy designs of “tax adjustment mechanisms,” one type of environmental integrity mechanism that can automatically adjust the price of carbon to align with emissions reduction goals. In this accompanying Q&A, Hafstead discusses how tax adjustment mechanisms can be structured and whether they should be considered essential to the success of carbon tax policies.
Resources: Can you give a quick summary of the issue brief?
Marc Hafstead: There's some concern from environmentalists that carbon taxes cannot guarantee that certain emissions targets will be hit. So, one of the proposals has included an automatic tax adjustment mechanism. There's not a lot of research on what well-designed tax adjustment mechanisms would look like, and this issue brief summarizes some of the research that we've done in the last couple of years.
What motivated you to start working in this area?
Some policymakers on the Hill were actually thinking about designing these types of policies based on a proposal by Gilbert Metcalf from 2009, and we immediately realized there was no thorough technical analysis of how you should design tax adjustment policies. One of the interesting things we've found is that you can get a lot of different outcomes based on how you design it.
What is a “tax adjustment mechanism,” and what purpose does it serve in the context of carbon pricing?
What this mechanism does is it evaluates actual emissions relative to a prescribed benchmark path, and then it makes adjustments to the tax rate depending on how far the emissions are off the path—whether the emissions are above or below the path. There's a lot of different ways these things can be designed.
What are some of the types of emissions uncertainty inherent to carbon taxes that a well-designed tax adjustment mechanism could help relieve?
We don't know the rate at which emissions would grow in the absence of a tax; we call this “trend uncertainty.” Trend uncertainty can come from uncertainty in how fast the economy is going to grow or how fast the economy is going to decarbonize.
We also have “cyclical uncertainty,” something we're seeing now—there are less emissions given the coronavirus outbreak than we would have had, otherwise. A shock to the economy can cause changes to emissions levels.
Then, while we have a lot of models that will tell us how much emissions will be reduced by a carbon tax, those models give us different answers. There's a range of potential outcomes depending on what models you look at, because there's a lot of uncertainty about the extent that people will reduce emissions in response to a carbon price in different sectors. Our research shows that variation in model outcomes is the most important uncertainty.
When is a two-sided tax adjustment mechanism preferable, and when is a one-sided tax adjustment mechanism preferable?
One-sided mechanisms are mechanisms that only adjust the price upward. If we are not reducing emissions as much as we predicted, and we raise the price, what that does is reduces the probability of really high-emissions outcomes. But it doesn't do anything in the cases where maybe emissions are declining more than we expected, so then we would still have a higher price than we need to achieve our goals.
A two-sided mechanism allows for adjustments if observed emissions are below the prescribed benchmark path. So, if we're doing better than expected, we can lower the price; and by lowering the price, on average, we're lowering the expected costs.
So, if we care about reducing really high-emissions outcomes at a low cost, we might want a two-sided mechanism, because it does reduce emissions in the high-emissions cases, while at the same time, when we have low-emissions outcomes, we can set a lower price, which reduces the expected costs.
However, we also find that a two-sided mechanism could actually decrease the probability that a specific emissions target is met, which would occur if the carbon price already has a low probability of meeting the target. Ultimately, trade-offs often exist among design choices, including one-sided and two-sided mechanisms. Policymakers need to weigh these trade-offs when designing these types of mechanisms.
Who is impacted most by your research? Who stands to benefit from your findings?
We think this issue brief is really targeted toward policymakers who are thinking about designing carbon tax policies. We've actually seen a few bills that have tax adjustment mechanisms, such as the 2018 and 2019 MARKET CHOICE Acts. This issue brief is to help inform the design of these mechanisms in future policies.
Given your findings that tax adjustment mechanisms can reduce emissions uncertainty and increase the probability of hitting particular emissions targets, do you think all carbon taxes should include these mechanisms?
These mechanisms can play a role as insurance to help us keep on the emissions path that we want to be on. I don't think they are mandatory, but I think that they can play an important role. And I certainly don't think they should be used to drive emissions reductions. Some of the research we've done has shown that the initial carbon price in the first year, and the rate it grows over time, are still the most important drivers of future emissions.
Your issue brief stresses that “while tax adjustment mechanisms can significantly reduce uncertainty over emissions outcomes, they cannot fully eliminate it.” How should policymakers design carbon taxes with this in mind?
If policymakers are really concerned, I think they can layer on additional types of mechanisms to help further reduce uncertainty. An example of this would be a regulatory backstop, so that if emissions with the adjustment mechanisms still aren't in line with emissions goals, we can put in new regulations.
Also, if we have more emissions than expected under a carbon tax, we actually have more revenues than expected, so another mechanism could be to use the unexpected revenues to invest in clean technology.
For more, read the full issue brief.