Tax policy towards energy and the environment.
Metcalf, Gilbert E.
My research over the past several years has focused on the role of
taxes and other instruments in environmental and energy policy. I have
focused mainly on instrument design issues in a general equilibrium framework, as well as on the distributional implications of energy and
environmental taxation.
Environmental Policy
An influential paper by Bovenberg and deMooij touched off a large
research agenda on the optimal design of environmental taxes in a
second-best world with pre-existing taxes. (1) It had long been
understood that taxes on pollution could help to internalize pollution
externalities. Beginning in the 1980s, analysts began to argue that the
revenue from pollution taxes could be used to reduce other distortionary
taxes, thereby generating a second "dividend" with a pollution
tax. Some analysts concluded that the existence of this second dividend
argued for a higher tax on pollution than the first-best Pigouvian
prescription, where the tax is set equal to the social marginal damages
of pollution.
Bovenberg and deMooij showed that for reasonable consumer
preferences the optimal tax would, in fact, be lower than social
marginal damages. Their insight was that while an environmental tax
would enhance efficiency by discouraging pollution, it was still a
distortionary tax and could interact with other distortionary taxes with
first-best efficiency losses. Building on this initial result,
researchers began to identify the gains from raising revenue via
environmental policy instruments (pollution taxes or auction revenues
from cap and trade systems). With Don Fullerton, I showed that the
popularly held view that revenue-raising instruments were preferred to
non-revenue-raising instruments focused on the wrong point. (2) What
mattered was whether policies created scarcity rents and whether the
government received the rents and used them to lower other distortionary
taxes.
The result--that the second-best tax on pollution was below social
marginal damages--was troubling to many environmentalists who were
concerned that it implied that in a world with distortionary taxation
more pollution should be allowed. Such a conclusion confuses price and
quantity effects. That a first-best price rule ("set pollution
taxes equal to social marginal damages") is modified in the
presence of tax distortions ("set pollution taxes below social
marginal damages") does not imply anything about changes in the
optimal level of pollution. Using a simple analytic general equilibrium
model, I provide a counter-example to show that having a tax below
social marginal damages could be consistent with a higher level of
environmental quality. (3)
The analytic general equilibrium framework constructed for the
research just described was easily extended to a consideration of
monopoly behavior among polluting firms and instrument design when
policymakers cannot target pollution directly but rather must target
some proxy for pollution. (4) The interest in second-best environmental
policy design was widespread at this point and the NBER co-sponsored a
conference on environmental policy with FEEM in Italy that Carlo Carraro
and I co-organized. (5) One of the hotly debated topics during this
period was whether tradable permits for pollution (like those for
S[O.sub.2] trading under the Clean Air Act Amendments of 1990) should be
given away or sold. One paper from that conference made the important
point that this was not an either-or situation; rather, some of the
permits could be traded and some sold. (6) The paper showed that only a
small portion of permits need be given away in order to preserve the
equity value of the energy industries because most of the burden of the
permit price is passed forward to consumers in the form of higher
prices.
I also have applied insights from the literature on second-best
environmental taxation in my research on climate modeling. In
particular, an empirical analysis of European energy and climate policy
suggested that the benefits from auctioning permits from a European
carbon cap and trade system vary substantially across countries,
suggesting the need for country-specific policy guidance. (7) That
research also showed that when environmental revenues (either from a
carbon tax or from selling tradable permits) were recycled by reducing
existing taxes, certain European countries might do worse by lowering
particular taxes than by giving the money back in a lump sum. While this
is a standard theoretical result from the theory of the second-best, the
CGE modeling results confirm that it is more than an intellectual
curiosity.
In addition to considering the efficiency effects of environmental
taxation, I have studied the distributional issues that arise with
environmental taxation. Many environmental taxes are regressive. For
example, a carbon tax would raise the price of energy products, products
that are necessities in household budgets. I carried out an incidence
analysis of a mix of environmental taxes and showed that the taxes,
while regressive on an annual income basis, are less regressive when
analyzed on a lifetime income basis. (8) This is a common finding for
consumption taxes. (9) In addition, I noted that while an environmental
tax might be regressive, an environmental tax reform could have any
desired degree of progressivity. In particular, I constructed a tax
reform where the revenue from a mix of environmental taxes is used to
lower other taxes in a distributionally neutral fashion. More recently,
I've broadened the discussion of how one might use the proceeds
from a carbon tax to fund corporate tax integration. In particular, I
measure the industry impacts from such a reform. (10)
Energy Policy
In addition to work on environmental policy, I have long focused on
energy policy with a particular emphasis on energy conservation. Early
work with Kevin Hassett identified the impact of energy tax credits for
home conservation improvements. (11) That research identified an
interesting asymmetry between price policies and investment policies.
Consider a conservation investment that will reduce energy by a known
amount over some future period. A government policy to double energy
prices henceforth should have the same impact on the propensity to make
this conservation investment as an alternative policy to subsidize half
the cost of the investment. However, we found that the investment
subsidy was substantially more effective than the price policy. It may
be that consumers do not believe that future energy tax increases are
credible. Or, it may be that the publicity effects from investment
credits influence consumers' purchasing behavior.
Energy conservation will be an important component of any policy to
reduce energy consumption and to enhance energy security in the United
States. The United States already has made impressive gains in how
efficiently it uses energy. Energy intensity (energy use per dollar of
GDP) has steadily fallen from a 1917 peak of thirty-five thousand BTUs
per dollar of GDP (year 2000 dollars) to a current level of 9.3 thousand
BTUs. In recent research, I document that roughly two-thirds of this
decline can be attributed to improvements in energy efficiency and
one-third to changes in the composition of economic activity in the
United States. (12) I also investigate the mechanism through which
increases in energy prices affect energy intensity. I find that the
dominant effect is through energy efficiency rather than through an
inducement to shift from energy-intensive to non-energy-intensive
activities. In other words, whatever forces have contributed to a shift
towards a service economy in the United States, higher energy prices are
not among them.
Energy policy was at the forefront of Congressional attention in
2005 when Congress passed the first major energy legislation since 1992.
This legislation contained tax incentives worth $14 billion over a
ten-year period. Some of these incentives were extensions of existing
initiatives while others were new. I recently reviewed the new
legislation and federal energy tax policy more generally. (13) In
considering tax policy initiatives towards energy, it is worth noting
the four major reasons for government intervention in energy markets:
externalities from energy production and consumption, national security,
market failures in energy conservation, and Hotelling rent expropriation on imported oil. Federal energy policy is not well targeted towards
those four concerns. I also show in that research that current energy
tax policies make clean coal increasingly competitive with pulverized coal electricity generating plants. The initiatives also make wind and
biomass competitive with natural gas electricity generation. Finally,
despite the United States being the third largest producer of petroleum
products in the world, the federal tax initiatives towards energy supply
have a negligible impact on world supply or prices.
Taxation and Public Pricing
A third strand of research focuses on taxation and public pricing
issues more generally. One aspect of that research considers the
interplay between market structure and the appropriate form of commodity
taxation when firms produce differentiated products and thus can exert
some degree of market power. It has long been known that tax policy can
substitute for direct regulation to achieve the socially optimal market
structure. (14) Research with George Norman suggests that the role of
tax policy is more nuanced once one allows for more general market
structures and technologies. (15) Whereas the previous literature found
that positive ad valorem taxes could help effect optimal market
structure, we find that taxes may be required under some circumstances
and subsidies in other circumstances. The degree of spatial
contestability plays a key role in determining the sign of the optimal
tax rate. Once one allows for flexible manufacturing technologies, the
story changes considerably. Flexible manufacturing allows firms to
switch product specifications easily with the result that firms can
easily customize products for consumers. Flexible manufacturing can
occur in traditional industries (for example, textiles) as well as in
the Internet based economy. Internet shopping provides us the
opportunity to get our own personalized web pages at sites like Amazon.
It may well be, with some sites, that we also get our own personalized
prices. We show that with flexible manufacturing, commodity taxes are
now ineffective at helping to achieve optimal market structure.
Another example of this research agenda concerns the optimal
pricing of an excludable public good in the presence of distortionary
taxation. With Jongsang Park, I posited a model of excludable public
goods where consumers obtain utility based on the amount of the public
good provided and the number of times the public good is consumed. One
example would be an uncongested national park. (16) The government
chooses the size of the park and consumers choose how often to visit the
park. The government also uses a non-linear income tax to effect
redistribution from high-ability to low-ability types (where ability is
unobservable). The tax structure relies on a self-selection mechanism to
achieve a separating equilibrium. We show that if the public good is a
complement to leisure, then it is optimal to set a positive price on the
public good. The higher price on the public good induces more labor
supply, which discourages high-ability workers from choosing the
consumption-labor bundle designed for low-ability workers. In effect,
the public good price helps us to discriminate the high from low-ability
workers.
Summary
Much of my current research is directly or indirectly focused on
the economics of climate change. Climate change is a topic at the
intersection between environmental and energy economics and is one of
the most difficult issues facing policymakers today. Any effort to
reduce greenhouse gas emissions will require a shift in the forms of
energy we currently use as well as a reduction in overall energy
consumption. My current research focuses on how governments can best
evaluate and design policies to address this critically important
problem.
(1) A.L. Bovenberg and R. de Mooij, "Environmental Levies and
Distortionary Taxation", American Economic Review 94, 1994:pp.
1085-9
(2) D. Fullerton and G. E. Metcalf, "Environmental Controls,
Scarcity Rents, and Pre-Existing Distortions", NBER Working Paper
No. 6091, July 1997, and Journal of Public Economics 80, (2), 2001:pp.
249-67. We document the history of the double-dividend literature in D.
Fullerton and G. E. Metcalf "Environmental Taxes and the Double
Dividend Hypothesis: Did You Really Expect Something For Nothing?",
NBER Working Paper No. 6199, September 1997, and Chicago-Kent Law Review
73(1), 1998:pp. 221-56.
(3) G.E. Metcalf "Environmental Levies and Distortionary
Taxation: Pigou, Taxation, and Pollution", NBER Working Paper No.
7917, September 2000, and Journal of Public Economics 87, 2003: pp.
313-22.
(4) D. Fullerton, L Hong, and G. E. Metcalf, "A Tax on Output
of the Polluting Industry is not a Tax on Pollution: The Importance of
Hitting the Target", NBER Working Paper No. 7259, July 1999, and in
Behavioral and Distributional Effects of Environmental Policy, C.
Carraro and G. E. Metcalf eds., Chicago, University of Chicago Press,
2001: pp. 13-38; D. Fullerton and G. E. Metcalf "Cap and Trade
Policies in the Presence of Monopoly and Distortionary Taxation",
NBER Working Paper No. 8901, April 2002, and Resource and Energy
Economics 24, 2002:pp. 327-47.
(5) Behavioral and Distributional Effects of Environmental Policy,
op.cit.
(6) A.L. Bovenberg and L. Goulder, "Neutralizing the Adverse
Industry Impacts of C[O.sub.2] Abatement Policies: What Does It
Cost?" In Behavioral and Distributional Effects of Environmental
Policy, pp. 45-85.
(7) M. Babiker, G. E. Metcalf and J. Reilly, "Tax Distortions
and Global Climate Policy", NBER Working Paper No. 9136, August
2002, and Journal of Environmental Economics and Management 46, 2003:
pp. 269- 87.
(8) G.E. Metcalf, "A Distributional Analysis of Green Tax
Reforms", NBER Working Paper No. 6546, May 1998, and National Tax
Journal 52 (4), 1999: pp. 655-81.
(9) See, for example, J. M. Poterba, "Lifetime Incidence and
the Distributional Burden of Excise Taxes", American Economic
Review 79(2), 1989:pp.325-30, and E. Caspersen and G. E. Metcalf
"Is a Value Added Tax Regressive? Annual versus Lifetime Incidence
Measures", National Tax Journal 47(4), 1994: pp. 731-46.
(10) G. E. Metcalf, "Corporate Tax Reform: Paying the Bills
with a Carbon Tax", NBER Working Paper No. 11665, October
2005,forthcoming in Public Finance Review.
(11) K. Hassett and G. E. Metcalf "Energy Tax Credits and
Residential Conservation Investment: Evidence from Panel Data",
NBER Working Paper No. 4020, August 1995, and Journal of Public
Economics 57, 1995: pp.201-17.
(12) G. E. Metcalf, "Energy Conservation in the United States:
Understanding its Role in Climate Policy", NBER Working Paper No.
12272,June 2006.
(13) G. E. Metcalf, "Federal Tax Policy Towards Energy",
NBER Working Paper No. 12568, October 2006. This paper was written for
the NBER's 2006 Conference on Tax Policy and the Economy.
(14) J. A. Kay and M.J. Keen, "How Should Commodities Be
Taxed?" European Economic Review 23(3), 1983:pp. 339-58.
(15) G. E. Metcalf and G. Norman, "Oligopoly Deregulation and
the Taxation of Commodities", NBER Working Paper No. 9415, January
2003, and in Contributions to Economic Analysis and Policy 2(1), 2003.
(16) G. E. Metcalf and J. S. Park, "A Comment on the Role of
Prices for Excludable Public Goods", NBER Working Paper No. 12535,
September 2006,forthcoming in International Tax and Public Finance.
Gilbert E. Metcalf *
* Gilbert E. Metcalf is a Research Associate in the NBER's
Program on Public Economics and a Professor in the Department of
Economics at Tufts University.