Ecological Tax Reform: Carbon Taxes with Tax Reductions in Minnesota
This study explores a novel policy strategy that promises both environmental improvement and enhancement of economic vitality. The policy is ecological tax reform, a shifting of taxes away from traditional tax bases, such as labor and business income and assets, and towards pollutant emissions and natural- resource depletion. Our study examines the effects of such a tax shift policy for Minnesota. In particular, we analyze the effects of carbon taxes with simultaneous reductions of traditional taxes in Minnesota. We examine its effects on energy use and carbon emissions on the one hand, and on employment, output, and commodity prices on the other. The study was conducted by Tellus Institute for Minnesotans for an Energy-Efficient Economy (ME3), funded by the Joyce Foundation and the W. Alton Jones Foundation. In this Executive Summary we discuss: (1) the case for ecological tax reform as an effective environmental policy; (2) the opportunities it affords for economic development; (3) its rationale at the state level; (4) the policy scenarios that we studied; (5) the methodology we employed; (6) the results of our analysis for the energy sector, and (7) for the economy; and (8) our conclusions.
Combustion of fossil fuels, while an effective intermediate activity in producing the goods and services that we consume, is also associated with many ills. The carbon dioxide emissions from coal, fuel oil, natural gas, and gasoline combustion, contribute to global warming, which has potentially catastrophic long-term consequences. Other pollutant emissions from fuel combustion degrade air quality, which causes human health problems and damages forests, waterbodies, crops, and building structures. Mining and transport of coal and oil disrupts and pollutes pristine wilderness areas as well as inhabited areas. Dependence on imported oil requires costly strategic national defense efforts and invites price shocks and economic losses.
The U.S. has committed to reducing carbon emissions as a signatory to the international Framework Convention on Climate Change. Some individual states within the U.S. have set carbon-emission reduction targets to reflect their own commitments to the goal of climate stabilization, and to begin a transition to a less carbon-intensive economy. States also pursue clean air policies, in order to satisfy federal legislation by developing State Implementation Plans, and to meet their own local and regional environmental objectives. This situation provides a strong motivation for carbon taxes, as energy use generally, and carbon-intensive fuels in particular, produce emissions of other troubling pollutants. Moreover, in the course of the ongoing deregulation of the energy sector, existing energy policies and practices that encourage more environmentally benign energy resources and technologies are being abandoned. New policies are called for in order to secure the gains achieved in the past and to make the further progress needed for sustainability. Carbon taxes can help fill this void. Through raising energy prices, taxes on carbon emissions from fossil-fuel combustion would discourage energy use and induce some switching to less carbon-intensive fuels.
Taxes on emissions have long been recognized as a powerful instrument for environmental policy. They make use of the market through the price system, an efficient transmitter of economic information, and would likely reduce emissions at lower overall cost than command-and-control regulation. Also, they carry a low administrative price tag. Yet pollution or energy taxes have not been implemented because they are perceived to be at odds with economic well-being. Higher energy prices are feared to be detrimental to the economy, by causing inflation, loss of investment and export-market shares, and a concomitant decline in employment. Especially in times of economic insecurity, people tend to place a higher priority on economic well-being than on environmental quality. This study aims to shed some light on the question whether such fears are justified or whether, to the contrary, there might be an opportunity to wed environmental and economic goals.
There need not be a trade-off between environmental policies and economic well-being. To the contrary; policies that improve environmental quality can be good for the economy as well. Ecological tax reform is a policy strategy in which this double goal is built in by design. It combines two recipes for enhancing the productivity of the economy. The first is using market-based instruments for environmental policy to reduce pollution at the lowest cost feasible. Pollution itself results from a failure of the market system; it is a significant cost (to human health and the environment) of production and consumption activities. The second is the reduction in traditional taxes, primarily on personal income and business activity. These taxes, many believe, create disincentives for valuable economic activities, thereby causing the economy to be less productive, all else equal. Decreasing these taxes is thought to stimulate economic activity. Of course, the motivation for such taxes is to meet other societal goals than solely economic efficiency; including distributive equity and the provision of public goods, some of which enhance the overall productivity of society.
Thus, while traditional taxes are decreased, the introduction of pollution taxes would not only decrease pollution, but also provide the revenues needed to sustain the legitimate purposes of our tax system. In short, ecological tax reform reduces taxes on "goods" (work effort, business activity) and increases taxes on "bads" (pollution, energy use). It offers the promise of a simultaneous improvement of economy and environment. But ecological tax reform is not a panacea for all social ills. Its scope is constrained by the societal objectives of a tax system and its functional requirements, which pollution taxes alone cannot fulfill. These include equity (whose main vehicle is a progressive personal income tax), and a reliable and steady flow of revenues which attenuates the impacts of the business cycle. Thus, a significant portion of the current tax system must be maintained. Moreover, as ecological tax reform can introduce an additional source of revenues, it invites discussion of the uses of those revenues, in addition to tax reductions, such as for technology development and diffusion, training and skills development, education, and infrastructure. The behavioral responses to a carbon tax, based on relatively modest price elasticities of demand, could be amplified by the use of some of its revenues to support efficiency improvements, infrastructure, and market transformation. Thus, while ecological tax reform appears a highly promising policy strategy, it cannot solely be relied on for environmental policy and should be complemented by other measures -- including regulation, set-asides, standards, public investments, etc. -- which can add to and amplify its environmental benefits, and by policies to enhance economic productivity.
It is important to recognize that ecological tax reform, as any policy that effects a change in the status quo, would not provide net benefits for all in the near term. By itself, ecological tax reform centered around carbon taxes would tend to result in net-cost increases for big energy users and net-cost decreases for businesses that use little energy. The state’s business climate would improve for some businesses and would worsen for others. While the overall net effect might very well be positive (our cost analysis indicates that more than half of the state’s businesses experience a cost decrease, if weighted by their output and employment), care would have to be taken that business conditions still remain acceptable even for energy-intensive businesses. Cost increases tend to be greater, in terms of percent of overall cost, for heavy energy users than cost decreases are for light ones. Thus, localized losses from the policy are not easily netted out with gains occurring elsewhere, especially as far as the severity of impacts for the workforce is concerned. Moreover, the threat of exodus of existing business is more tangible (though not necessarily more likely) than the promise of entry and growth of new environmental technology and environmentally-benign industries that would be the winners of this policy strategy. Thus, a concrete tax-reform policy would require provisions to ensure that businesses that would otherwise be hard hit by the tax reform, and the employees of these businesses, would be assisted in this transition, through measures such as targeted tax credits, subsidies for energy-efficiency investments, and retraining assistance for workers. Communities that depend on energy-intensive industries could also be given special consideration.
This is no easy task, and the consequences of ecological tax reform should not be taken lightly. Yet, the economy is continuously undergoing structural change in any case; some industries and regions are declining while others are rising, altering the sectoral mix of the economy. Structural change would not be the unique result of an ecological tax reform; rather, it is natural to the process of economic evolution. Indeed, ecological tax reform could help give direction to the process of structural change. This is a more subtle yet very important motivation for ecological tax reform.
An economy, be it the economy of a global region, a nation, or a smaller region, does not develop along a predetermined path. It is subject to technological change, the development of new technologies and products, and their applications. Technological change in turn is driving and intimately connected with structural change, the change in the industrial mix of an economy. Technological change is induced and shaped by economic, cultural, and political factors. This dynamic is widely recognized and studied by social scientists of all disciplines. Economists focus on the economic variables that influence technological change, such as prices. They argue that a high price for a certain production input steers technological change into a direction that "saves" this input more than other inputs. The type and timing of inventions may be difficult to influence, but the effort to apply them to production processes, and the speed with which they are adopted and improved within firms and industries (i.e., the rate of diffusion), can respond to price signals and other economic, as well as institutional, factors.
The existence of this dynamic implies that there is a strong role for public policy. In fact, past public policy has steered the U.S. economy towards its current configuration. This country is blessed with natural resources, and policies that subsidized their exploitation have been in effect well into this century (and some still are). These policies were meant to develop the economy and provide incentives for people to productively inhabit this vast continent.
But the world has changed, and it is time for the U.S. economy to change as well. Population has increased tremendously, and energy use puts a heavy burden on human health, and the global and local environment. Fostering energy-efficient technologies and renewable resources would benefit the U.S. economy on several accounts. It would make environmental protection cheaper, by stimulating technological learning and diffusion, and thus accelerating the decline in costs of energy-efficient and clean technologies. Furthermore, it would create domestic expertise in the manufacture and operation of these technologies, which are already among the fastest growing global markets. Thus, it would poise the U.S. well as a player in international trade.
The foregoing arguments apply at the state level as well as at the national level. States could create market niches for their manufacturers in energy-efficient, clean, and renewable-resource technologies. Several states are considering renewables technologies as future growth sectors and aim to build expertise in them; for example, Minnesota in wind, and Nevada in solar power generation and equipment manufacturing. Likewise, states could focus their efforts on energy-efficiency products, technologies, and services.
Such an objective fits well into state policy agendas. Increasingly, states are shouldering the responsibility for economic development. They conduct industrial policies with a whole range of measures. They attempt to create a favorable business climate by providing a low general tax level (with respect to personal income as well as business taxes) consistent with their fiscal responsibilities, a good education system, and an attractive environment. They also use tax policy to attract specific businesses; they grant ample tax credits and provide infrastructure services, sometimes even cash gifts, to investors. Indeed, these special economic-development incentives occur to such an extent that some states have acknowledged the need to curtail this activity because it erodes their tax revenues, and because it pits states against each other, sometimes bidding for specific firms.
Some economists have argued, and many state legislators and policymakers have agreed, that a generally lower tax level would be better for state economic development than discretionary tax breaks and incentives. With limited tax revenues available, smaller and more systematic across-the-board tax reductions for industry are preferable to ad hoc larger tax breaks for the few. Such a more effective economic development approach would reduce pressures (i.e. cross-subsidies for the few) on taxpayers generally, and would decrease the likelihood that states would compete for specific firms with large discretionary incentives.
The revenues from carbon taxes could provide the means for simplifying a state’s existing system of economic-development incentives. Carbon taxes with offsets in traditional taxes, as the core of a reformed economic-development policy, could give a clear and consistent signal to businesses as to where the state is headed. Many states are already engaged in policies to foster the greening of businesses. Ecological tax reform could enhance this policy goal, wedding environmental and economic policy objectives.
For energy-intensive businesses, the cost impact of carbon taxes could outweigh the benefits of other tax reductions. Such businesses would not benefit from an ecological tax reform based on carbon taxes. This raises fears of reduced competitiveness. For the U.S. as a whole, this would be less of a threat than for individual states. U.S. energy prices are very low compared to those in industrialized competitor nations which offer comparable quality of inputs. For states, however, the issue is more problematic; businesses could shift investments across state boundaries to avoid high energy prices. As noted earlier, special attention should be given to transition issues for industries, workers and communities that might otherwise be so affected, in order to make ecological tax reform a viable policy.
The net effect of a generally more favorable business climate is likely to be positive. Some energy-intensive businesses might very well benefit from the technological advancements that higher energy prices would likely trigger; it is common that energy-efficiency investments improve overall productivity and thus lower not only energy-related costs. Indeed, several states already maintain economic-development programs that seek to enhance general business productivity through counseling in eco-efficiency (which encompasses energy efficiency and pollution prevention).
We analyzed two levels of carbon taxes: $10 and $50 per ton of CO2. These taxes would increase energy prices markedly, especially for commercial customers, and by different degrees for different fuels. Coal is the most carbon intensive and at the same time the cheapest fuel (per unit energy content). Thus, it would experience the greatest percent price increase. The "carbon content" of electricity depends on the fuel mix used in its generation. At current energy prices, the price of coal would rise by 79 percent under a $10 tax and would nearly quadruple under a $50 tax. The price of refined petroleum products would rise on average by 8 to 38 percent, and the price of electricity (given the structure of the Minnesota electric sector) by 22 to 88 percent. (The price increases for residential customers would be in general a little lower, since these pay higher prices to begin with.) (Section 6 below lists the percent price increases for the different fuels under the tax regimes.)
To simplify the analysis, we assumed that the tax would be implemented fully in 1997. It would be assessed on fossil fuels according to their carbon content, at the point of first entry to the state. Electricity imports would be taxed based on estimated carbon content, to ensure that the tax does not cause an unwanted shift to imported electricity. (Most of the state’s imported electricity projections are actually the subject of contracts extending over the period of the analysis, from 1995 to 2015). Fossil fuels used for feedstocks, for example in plastics and steel production, were assumed to be exempt from the tax.
We assumed no new nuclear capacity additions. While carbon taxes would increase the economic attractiveness of nuclear relative to fossil generation, the cost gap would still be wide enough to keep nuclear power undesirable. More importantly, the issues surrounding nuclear power deserve separate policy attention; we have assumed for this study that the unresolved safety issues in operation of nuclear power stations, and transport and storage of spent fuels, would make new nuclear power unlikely to be an alternative to new fossil or renewable resources.
We analyzed two tax-reform policy scenarios for each tax level. Both scenarios return the entire amount of carbon-tax revenue to taxpayers through a reduction in existing taxes. In the first, Scenario I, all carbon-tax revenue is rebated as a reduction in social security contributions, as reduction in the employers’ and employees’ shares. Tax revenues in excess of social-security contributions in the high tax case are returned to households and businesses, apportioned according to their carbon tax payments. (The administrative and jurisdictional questions on how states can substitute the federal social-security tax with state tax revenues were not a subject of this study.) In the second policy scenario, Scenario II, all carbon tax revenue is rebated as a reduction in property taxes. In the high tax case, the tax revenue is larger than property-tax revenue. We assume that in addition to property-tax abatement, sales taxes are reduced. The aim of the recycling mechanisms is to grant tax reductions to the business and household sectors, which in the aggregate are equal to the amount they paid in carbon taxes.
Table ES-1 shows Minnesota’s revenue structure in 1992. Minnesota raised $16.5 billion within its borders, at the state and local government levels (this is called "own-source" revenue), and received $3.1 billion from the federal government. Most of these federal grants are received by the state and are passed through to localities. Of the $16.5 billion own-source revenue, $11.1 billion was taxes proper and $5.4 billion was "Charges and Miscellaneous" (including license taxes, permits, and so on; these revenues tend to be earmarked for specific programs).
For the purpose of ecological tax reform, we focus on tax revenue proper. Of the $11.1 billion raised in tax revenue in 1992, about one-third came from local taxes and two-thirds from state taxes. Local taxes are almost entirely composed of property taxes, which account for 95 percent of local tax revenue. State taxes come largely from sales and gross-receipts taxes and personal income taxes, which account for 45 and 40 percent of state tax revenue, respectively. In the first year of its implementation, a CO2 tax at the $10/ton level would generate revenues amounting to 9 percent of state and local tax revenues combined, and a tax of $50/ton 44 percent of state and local tax revenue. (Note that the social-security contributions are a federal tax and are not part of state and local tax revenues.) The revenue from the $10/ton tax constitutes 1.5 percent of the state’s payroll cost and 29 percent of total property taxes. The $50/ton tax would generate revenues amounting to 7 percent of payroll cost and to more than all of property tax revenue. After completely offsetting property taxes, enough revenue would be left to reduce general sales tax revenue by 62 percent.
In the energy-system analysis, we performed a sector-by-sector assessment of energy-efficiency investments, energy savings, fuel switching, and carbon-emissions reductions that would result from the tax. These effects reflect the technology costs and characteristics, and the responses to price changes by businesses and households that have been estimated and appear in the literature, as well as cost-minimizing actions in the utility sector. The energy results were passed to the economic analysis, which uses an input-output model of the Minnesota economy. We produced a detailed assessment of the cost effects from higher energy prices and assumed consumer responses to these cost effects. These changes in consumer demand, as well as changes in consumer and business spending due to energy efficiency investments and energy savings, cause shifts in economic activity.
We did not investigate changes in trade flows between Minnesota and the rest of the nation, which was beyond the scope of this analysis. Also, while we computed the impact of changes in the energy sector on the economy, we did not iterate to get the feedback effects of those changes on the energy sector. Thus, we assume that the carbon taxes would have first-order impacts in the energy sector and that the tax shifts would have first-order impacts on the economy, but that these economic impacts would, in turn, have much smaller effects on the energy sector.
Most importantly, we did not assess the impact of economic development policies on the state's economy. The technological change and market development triggered by a change in energy prices and policies supporting the adoption of energy-efficient technologies is likely to create export markets for Minnesota.. To assess such gains quantitatively was beyond the type of analysis we carried out for this study; in fact, any quantification of such a development is subject to great uncertainty.
A carbon tax would increase the cost of fossil fuels and electricity and generate tax revenues for the state. Electricity producers, industrial and commercial enterprises, and households would respond to these higher fuel prices in three ways: (1) by reducing energy-using services and activities, (2) by investing in energy saving technologies, and (3) by switching to less carbon- intensive fuels. The magnitude of these responses are a function of how easily consumers can change their energy-use patterns, the cost and availability of more energy-efficient equipment and appliances, and the ability of consumers to switch to less carbon-intensive fuels and the technologies that can use them.
For example, in the transportation sector these three impacts could be, respectively, less driving (vehicle miles traveled, or vmt), greater vehicle fuel efficiency (on road mileage), and increased use of electricity, natural gas, and alternative fuels. In the electric sector, these could be more judicious use of lighting, switching from incandescent to compact fluorescent bulbs, and a shift from coal and oil-fired generation to gas, wind and other low-carbon-intensity technologies. For the commercial and residential sectors, the impacts could be improved thermostat controls, tighter building shells, and a shift from oil to gas. For industry, these could be output changes, process-technology changes (e.g., co-generation), and shifts to gas or biomass. Industry could also respond by a reduction in electricity demand through the use of more efficient lighting, motors, and other equipment in buildings and industry.
In estimating the impacts of a carbon tax in Minnesota, we addressed these three issues -- reduction in energy-using activities, investment in energy-efficient equipment, and fuel switching -- individually in each sector. With the exception of the electric generation, we started with the baseline energy and price forecasts for each sector from Backus (1996). The electric-generation sector was modeled separately using more recent data from the Minnesota Department of Public Service, recent integrated-resource plans of the major utilities in the state, public-sector documents, and various sources from the Department of Energy (EIA 1995, EIA 1994) Using cost-of-saved-energy curves (representing the costs of energy saving technologies) and price elasticities (the sensitivity of fuel demand to price), we then estimated the amount of energy that could be economically saved under different levels of taxation, the incremental investment in conservation to achieve that level of energy efficiency, the fuel and fuel-cost savings, and reductions in CO2 emissions. For the electric-generating system, we used estimated power-plant fuel mix, CO2 emissions, and costs for the electric system as it would evolve under the various CO2 tax scenarios.
Energy and Carbon in Minnesota. In 1992, Minnesota consumed 1,310 trillion Btus (TBtu) of primary energy and emitted about 87 million tons of CO2. Minnesotans use slightly less energy per capita than the nation as a whole; about 292 million Btus (MMBtu) per capita annually, compared with the national average of 320 MMBtu. At 133 pounds of CO2 per MMBtu, its energy system is also somewhat less carbon-intensive than that of the nation as a whole. On a per-capita basis, Minnesotans use 19.4 tons of CO2, which is about 15 percent less carbon-intensive than the national average.
Minnesota energy use and CO2 emissions in 1992 are presented in Figure ES-1 from a number of perspectives. Each row shows a fuel or a sector’s share or contribution of primary energy, end-use energy, and carbon emissions. The first row characterizes the 1992 fuel mix in Minnesota’s energy sector. Oil dominates primary and end-use energy consumption and CO2 emissions, primarily through transportation (which accounts for 86 percent of the oil used in the state). Coal accounts for 29 percent primary energy and 6 percent direct end-use energy (meaning that it is used primarily for electricity generation). It is the second largest contributor of CO2 emissions in the state, accounting for a little more than a third.
The second and the third rows show the contribution of the residential, commercial, and industrial sectors to energy use and carbon emissions. The second row, ES-1b, shows transportation and electric generation separately, and the third row, ES-1c, allocates these to the residential, commercial, and industrial sectors (with the exception of air travel and freight).
Transportation and electric generation each account for about one-third of the state’s primary energy use. Allocating these to the residential, commercial, and industrial sectors (which we could do except for Air Transportation) shows that the residential sector consumes most of end-use and primary energy. However, it is only the second largest CO2 emitter, accounting for 34 percent of emissions, after the industrial sector, which accounts for 37 percent.
Price Impacts.Because fuels differ in carbon content, the carbon tax would have a different price impact for each fuel. Table ES-2 shows the year 2000 price of selected fuels, as well as the percent changes in fuel prices which the two levels of carbon taxes would cause. In terms of end-use energy, natural gas is the least affected by the carbon tax. This is because of its low carbon content. Electricity and coal are the hardest hit by the tax; coal because of its high carbon content, and electricity because of the large amount of coal in the generation mix, because of the losses incurred converting fuels into electricity (30 percent efficiency or less), and the fact that Minnesota has relatively low electric rates, which makes the tax adder a larger percentage of the pre-tax rate to begin with
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Statewide Energy And Carbon Impacts. As shown in Figure ES-2, by the year 2015, the carbon taxes reduce energy demand by 3.6 percent in the $10/ton tax case and by over 15 percent in the $50/ton tax case. In each case, the energy-demand reduction induced by the tax is marked by an initial sharp drop in demand, followed by steady growth at a rate less than that which would have occurred in the absence of a carbon tax. The shape of this response displays the initial short-run response to the price increase, including a shift in electric dispatch, followed by phase-in of more energy efficiency appliances, equipment, and vehicles.
For any given fuel, carbon-emission reductions are directly proportional to the reduction in fuel demand. This is illustrated in Figure ES-3, which is quite similar in form to the analogous figure (Figure ES-2) showing energy impacts. At a tax of $10/ton CO2, the carbon reduction slightly exceeds the energy reduction. This is as one would expect, considering that fuels with higher carbon content would experience the greater price increase, and thus the greater reduction. At a $50/ton CO2 tax, the carbon reduction is somewhat greater than the energy reduction. This occurs because of the changing fuel mix used for electric generation, from the more carbon intense coal to natural gas.
Figures ES-4 and ES-5 show how a carbon-dioxide tax would affect end-use consumption and carbon emissions by fuel type, respectively, comparing the year 2015 for the Base and $50/ton tax with one another and with the year 1995. Energy use in 2015 is still higher than in 1995, but the $50/ton CO2 tax reduces it by 15 percent (219 TBtu) relative to the base demand in that year. Transportation fuels experience the greatest energy-demand reduction in absolute terms: around 120 TBtu at $50/ton CO2 tax in 2015, or about 20 percent. In percentage terms, however, heavy oils and coal experience the greatest drop in demand. By 2015, electricity use drops by about 15 percent in the $50 tax case, compared to the base case in that year; however, carbon emissions from the electric sector decrease more, by about 19 percent, caused by some fuel switching in the electric sector.
Output and Employment Impacts. The economic analysis shows modest gains in production, income, and employment for our policy scenarios. We did not consider in our analysis the structural changes that would be induced by the tax-shift policy, which on balance we would expect to be positive, for reasons discussed in sections (2) and (3).
Table ES-3 shows the output and employment impacts of the policy scenarios. Note that these numbers are not to be understood in absolute terms, but in relation to the size of the economy in 1992, the reference year of our study. In the low-tax case, employment impacts range from less than one-tenth to one-third of a percent. In the high-tax case, employment impacts range from one-half to one-and-a-third percent. The reason that the economic impacts decline over the years (relative to the size of the economy) is that the carbon-tax revenues shrink (relative to the size of the economy), as a result of a decrease in emissions per unit of economic output in the state. This, of course, is a result of energy conservation, energy-efficiency investments, and the fuel switching induced by the carbon tax. This is less pronounced in the high ($50) tax case, which produces a greater shift to spending on labor-intensive commodities.
Under Policy Scenario I, the carbon tax with payroll-tax reductions, the $10 tax results in around 8,800 net additional jobs in 1997 and around 2,700 in 2012. The $50 tax results in 35,500 net additional jobs for 1997 and 19,200 in 2012. Output is increased by about one-third to one-tenth of a billion dollars for the $10 tax and about one billion dollars for the $50 tax. The results for Scenario II, the carbon tax with property-tax reductions, are about one-third lower for the employment impacts and about 40 percent lower for the impacts on output.
These results follow from Minnesota’s economic structure, as it is reflected in the Input-Output data, in conjunction with different mechanisms in the economy, which we captured in our analysis by implementing the results of the energy analysis and making a number of complementary assumptions. First, households and businesses shift their spending from energy to energy -efficiency investments. Spending on energy is less "productive" for the state economy than spending on energy efficiency, for two reasons. For one, energy-efficient products and services are, on average, a little more labor-intensive than energy. Thus, an increase in spending on these products would create somewhat more employment. Also, and this is a more important effect, energy-efficient products tend to be produced within the state to a greater extent, thus leading to less "leakage" (money leaving the state) than spending on energy, much of which is imported.
Second, we assumed that general tax reductions for households, and those parts of general tax reductions for businesses that are not passed on, are spent "in-kind". This means that households and businesses would increase their non-energy spending on all goods and services in a proportion that mirrors their pre-tax and rebate spending, thus in effect shifting purchases towards more labor-intensive goods and services. This is especially true for households that devote a large share of their expenditures to retail and health services. These are among the most labor-intensive sectors in the economy and do not face much out-of-state competition.
The third mechanism affecting the pattern of the results pertains to the cost effects from the carbon taxes and other tax reductions, their size, composition, and the manner in which they work their ways through the economy. We assume that cost changes are passed on to consumers in the form of price changes, to which consumers respond with small changes in the quantities they demand. Energy-intensive products experience cost increases, and would become more expensive; other products would become cheaper. We assume that consumers respond by buying less of the former and more of the latter. But energy-intensive products tend to be less labor-intensive, and vice versa. Thus, the increasing energy costs steer consumer purchases away from energy-intensive and towards more labor-intensive products. This assumption comes to bear more strongly in Scenario I, where labor-intensive products become cheaper on account of the payroll-tax reduction.
Also, cost effects have a direct and an indirect component. The direct component is the immediate cost increase or decrease that a firm experiences because of higher fuel prices or a reduction in taxes. The indirect component is the cost increase or decrease that comes from the change in the prices of production inputs that themselves have become more expensive or cheaper, depending on the immediate cost impacts they experience. Thus, the direct-cost effects are amplified, because they are passed on through the whole economy. How much a direct cost effect is amplified varies, depending on what caused it -- a reduction in payroll cost or a reduction in business taxes, for example.
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The effects of these mechanisms can be shown by a breakdown of the economic impacts by sector. Figures ES-6 and ES-7 show the employment impacts on all sectors of a $10/ton CO2 tax and a $50/ton CO2 tax under Scenario I (payroll cost reduction). Service industries experience the largest gains; in particular, Health Services and Retail Trade Services together account for more than half of the employment gains in the state. Under Scenario II, which recycles the carbon-tax revenue to "Indirect Business Taxes" (which comprises property taxes, sales taxes, and Miscellaneous Charges and Fees), the same sectors experience the largest employment gains, but in slightly different order. (See Figures ES-16 and ES-17 in the Appendix to this document.)
Recall that we did not model changes in trade flows. These would likely respond in part to changes in price differentials between in- and out-of-state products (which would result from production- cost differentials). For most industries, cost impacts of the carbon tax with general tax reductions are near zero. Some sectors experience increases in production cost, some sectors cost decreases. To the extent that trade flows respond to price differentials, this would suggest that some of Minnesota’s industries could gain market share in response to the tax policies, and some might lose market share.
Cost Effects. Figures ES-8 through ES-12 show the net cost effects of the $10 and $50 tax under Scenario I. (Note that these are the cost effects that would occur without any mechanisms to assist hard-hit industries.) Figures ES-8 and ES-9 show the 50 industries that are most affected, positively or negatively, by the $10 and $50/ton CO2 tax, under revenue recycling Scenario I (a payroll-tax reduction). In each figure, the upper half shows the industries with the greatest cost increases, and the lower half, those with the greatest cost decreases. The industry that is hardest hit is Iron Ores, experiencing a cost effect of about 4.5 and 21 percent in the two tax scenarios. (Minnesota’s Mesabi Range is home to mining of taconite, a low-grade iron ore that is very energy- intensive to extract). It is followed by several chemical industries. The industries benefiting the most include many high-tech industries, such as Computers, Automatic Temperature Controls and Engineering and Architectural Services. The greatest cost reductions are about 1 percent and 5 percent under the $10 and $50 tax scenarios. Figure ES-10 shows separately the effect on industries that use significant proportions of their fossil-fuel purchases as feedstocks, which are assumed to be exempted from the tax.
In both scenarios, the lists of hard-hit industries are very similar because for heavy energy users, the effect of the fuel-price increase far outweighs the mitigating effects of tax reduction. But the lists of industries that benefit most under each scenario differ significantly. Under Scenario II, the reduction in Indirect Business Taxes (including property taxes), many agricultural industries benefit, including Forest Products, Oil-Bearing Crops, Feed Grains, Hay and Pasture. (See figures ES-18 and ES-19 in the Appendix to this document).
The cost increases for the industries most negatively affected are about five times larger than the cost decreases for industries that gain. This is because energy use is fairly concentrated in a few sectors. On the other hand, the sectors that realize a noticeable cost increase much are far fewer than those that enjoy cost reductions. If we weight industries by their size (their total production output), then this effect is even more pronounced. The most energy-intensive sectors, which would experience a net-cost increase, tend to be small, relative to sectors whose cost would decrease.
Figures ES-11 and ES-12 show the distribution of the cost effects, weighted by total production output in the economy for Scenario I. Note that less than 40 percent of all production output in the economy experiences a cost increase in this scenario. Under the $10/ton CO2 scenario, only about 3 percent of all production output experiences a cost effect of 1 percent or greater (a cost effect of 5 percent or greater under the $50/ton tax). If we weighted industries by their employment, the picture would be even more positive, because energy-intensive industries tend to be less labor-intensive on average.
We used this cost-effect analysis to assess the degree to which the regions of the state would be affected. The regions of Minnesota differ in their industrial mix. For example, the Twin Cities area is home to many financial and business-service firms, as well as health-care and education establishments. The southern part of the State is mostly agricultural, with a lot of dairy farming. In the Northeast part of the State there is some amount of iron ore mining (the taconite mentioned earlier). Service industries, accounting for nearly three-fourth of the gross state product, are concentrated in urban areas. Manufacturing tends to be more widely dispersed through the importance of Food Products, second only to Machinery in terms of Value Added by manufacture.
Figure ES-13 shows the regions of the state. They differ greatly in their contribution to the State’s gross economic production. The Twin Cities area accounts for over 60 percent; no other region accounts for more than 15 percent of gross output, and two regions, the Northwest and the West Central regions, contribute less than 5 percent of the State’s total output.
Figures ES-14 and ES-15 show the net cost effect by each region from a $10 and $50/ton CO2 tax with other tax reductions. In each Figure, the table on the right shows the regional average cost effect. Note that the Northeast is affected worst; it experiences a net-cost effect of more than one-half percent in the low tax case and a little under 3 percent in the high-tax case (this is attributable to taconite mining). The Twin Cities area benefits from a cost decrease under both scenarios and tax levels, a result of the fact that this area is home to labor-intensive industries and service businesses. The other regions experience cost effects on the order of one-half percent and less (negative and positive). The state as a whole experiences a very slight cost decrease except under the $10 tax with revenue-recycling Scenario I. The bar graphs to the left of Figure ES-13 show the regional cost effects in absolute terms (the region’s output multiplied by the percent cost effect).
Note that a region (or the state) can still gain employment though it experiences an overall cost increase. This is a consequence of a shift to more labor intensive production. The important point to notice about the overall cost effects is not that they are (moderately) negative or positive, but that they are so small. Energy taxes are feared to cause inflation, because energy is a ubiquitous production input; thus, an initial price increase could potentially be greatly amplified. We captured this phenomenon through inclusion of indirect cost effects. While taxes on energy are rebated in full, and the direct cost effects of energy taxes and tax reductions cancel each other out, the indirect cost effects do not automatically do so. It turns out that overall, the positive indirect cost effects of energy-price increases are slightly outweighed by the negative indirect cost effects of the tax reductions; therefore, the state economy as a whole experiences a modest cost decrease in three out of four recycling scenario and tax-level cases.
Our results indicate that levying carbon taxes in Minnesota with an equal reduction in other state taxes would significantly reduce carbon emissions. With a tax of $50/ton of CO2, emissions would be 15 percent lower from what they would otherwise be by 2015. These results assume that there would be no fuel switching in the residential, commercial, and transportation sectors and only a modest amount of renewable resources used in electric generation. To the extent that such impacts would be greater, or could be increased through the design of revenue-recycling policies, the carbon reductions would be higher. Investments of some of the carbon-tax revenues in energy-efficient technologies and infrastructure could amplify the carbon-reduction impacts of the tax.
Our economic analysis suggests that such a policy would produce small positive economic impacts on the state’s economy; employment and output would rise while commodity prices would, on average, decrease very slightly. Thus, the policy produces carbon (and other pollutant) reductions consistent with maintaining overall state economic health. Impacts would differ though across regions in the state. Regions that are home to energy-intensive industries, such as the Northeast, would be more negatively affected, and the Twin Cities area, with its large share of service sectors, would be more positively affected than the other regions in the state.
However, we need to emphasize that we did not model all the economic phenomena that could occur in response to such a tax policy. Specifically, we did not model changes in trade flows resulting from cost changes, technological innovation, the spawning and expansion of green industries, and an improved environment. Moreover, the analysis assumes historical behavior patterns and no technological innovation.
The biggest concern voiced about a policy of carbon taxes with other tax reductions is that such a policy would constitute a disadvantage to in-state businesses versus competitors in other states. This is a concern for a small number of energy-intensive industries, and needs to be addressed through special mechanisms designed to attenuate the negative impacts of ecological tax reform on these industries. Notwithstanding this concern, our detailed analysis of cost effects suggests that many industries -- and in particular those industries that constitute the larger part of the Minnesota economy -- would indeed experience a net cost decrease from the policies. To the extent that trade flows respond to cost differentials, this would suggest that Minnesota's industries could gain market share in response to the tax policies. The more important point, beyond the scope of the economic analysis, is that ecological tax reform has the potential to give direction to the technological changes that the economy is undergoing, by steering it onto a path of less carbon-intensive, clean, and future-oriented methods of production and consumption.
It is also important that the design of a specific ecological tax reform for the state take account of a range of equity issues. These include maintaining the society’s commitments to progressivity in the modified tax system, and transitional assistance to workers and communities.
We conclude that a CO2-based ecological tax reform would likely (1) help meet state and national climate policy goals; (2) contribute to significantly improved local, state, and regional environmental quality and public health, through a reduction in pollution from energy generation; (3) provide the opportunity for a consistent state economic development policy by yielding revenues to modernize infrastructure and support other economic development policy objectives, such as improving labor skills; and (5) foster technological progress and the development of niche markets.
Energy Group | Solid Waste Group | Risk Analysis Group | SEI-B
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