Big Money in Cap-and-Trade

by Donald Marron

Saturday, July 04, 2009 at 11:13 AM EDT

On Friday, the House of Representatives passed its climate change bill by a slim margin. The bill’s key feature is a cap-and-trade system for greenhouse gases. That system would set national emission limits and would require affected emitters to own permits (called allowances) to cover their emissions.

The number one thing you should know about this bill is that the allowances are worth big money: almost $1 trillion over the next decade, according to the Congressional Budget Office, and more in subsequent decades.

There are many good things the government could do with that kind of money. Perhaps reduce out-of-control deficits? Or pay for expanding health coverage? Or maybe, as many economists have suggested, reduce payroll taxes and corporate income taxes to offset the macroeconomic costs of limiting greenhouse gases?

Choosing among those options would be a worthy policy debate. Except for one thing: the House bill would give away most of the allowances for free. And it spends virtually all the revenue that comes from allowance auctions.

As a result, the budget hawks, health expanders, and pro-growth forces have only crumbs to bargain over. From a budgeteer’s perspective, the House bill is a disaster.

The following table illustrates how much revenue the bill would raise and compares it to the alternative of auctioning all the allowances:

Revenues under the House Bill

The first column shows the revenue implications of the House bill. Over the next ten years, the bill would auction only 28% of the allowances; the rest would be given away for free. CBO estimates that those auctions would raise $276 billion.

But that doesn’t mean that overall revenues rise by that much. Because firms would have to pay for allowances, they would have lower profits; some firms might even layoff workers or reduce their pay. As a result, the government would receive lower revenues from income taxes (both individual and corporate) and payroll taxes; CBO estimates this offset as $116 billion.

The House bill would thus increase revenues by a net of $159 billion ($276 billion – $116 billion) over the next ten years.

Revenues if All Allowances Were Auctioned

The second column shows what would happen if, instead, the government auctioned all of the allowances (CBO doesn’t report these figures but they are implicit in the cost estimate for the bill). In that case, the auctions would raise $989 billion over the next ten years, just shy of the trillion mark. That revenue gain would, in turn, be offset by a $247 billion reduction in income and payroll taxes.

Auctioning all the allowances would thus increase revenues by a net of $741 billion ($989 billion – $247 billion) over the next ten years.

Bottom line on revenues: Auctioning all the allowances would generate $582 billion more in revenue ($741 billion – $159 billion) than would the House bill. That’s real money, even in Washington.

I should emphasize that the idea of auctioning all of the allowances is almost certainly impossible as a political matter. Affected industries have enough clout to oppose anything quite that ambitious. And, indeed, one of the beauties of a cap-and-trade system (from an environmental point of view) is that politicians can use free allowances as currency to reduce opposition to the policies. Unfortunately, such horse-trading can easily transform into the pure power politics of pork.

When that horse-trading gets done, it’s important that the taxpayer have a voice at the table. But when you see more than 70% of the value of the allowances going out the door — netting to almost $600 billion dollars in a time of incredible budget challenges — you have to wonder whether the taxpayer is even in the same room as the table.

Spending under the House Bill

That conclusion is reinforced by the fact that, as noted above, almost all of the net revenue gets spent and thus isn’t available to cut the deficit, pay for health care, or improve the economy:

Bottom line on spending: This trillion dollar bill improves the budget outlook by a minuscule $9 billion over the next ten years. That’s rounding error relative to the size of the bill and relative to our budget challenges.

In fairness, I should note that the main spending items are efforts to help the poor adjust to the higher cost of energy that would result from this bill. There’s logic to that. But it doesn’t take away from my larger point that the bill does nothing to address larger budget or macroeconomic concerns. I should also note that the fraction of allowances given away goes down in subsequent decades; but that doesn’t address our near-term economic and budget needs either (and seems to be an invitation for future lobbying).

Economists have spent decades demonstrating the potential benefits of using environmental taxes to help finance the government (and make no mistake, a cap-and-trade system is a tax; the Congressional Budget Office, much to its credit, even scores it that way). But that economic logic works only when a substantial fraction of the revenues are used to improve fiscal policy — e.g., reducing deficits or reducing distortions from the tax system. The House bill does neither. Let’s hope the Senate does better.