A carbon tax could be the key to boosting innovation and growth

Although not everyone has acknowledged it, the central debate about climate change is over. For some time, there has been broad scientific consensus that the earth is warming, that emissions of greenhouse gases associated with economic activity are a partial cause, and that, if nothing is done, the earth is likely to suffer from catastrophic environmental costs in the distant future. Denial of climate change is no more scientifically valid than opposition to vaccines or genetically modified crops.

This scientific consensus leaves many questions unanswered, however, including what to do about the impending rise in temperatures. It doesn’t mean countries should impose drastic measures that would dramatically slow economic growth. But it does mean the United States and other nations will eventually take actions to slow greenhouse emissions. A carbon tax should be a key policy tool they use.

{mosads}Properly implemented, a carbon tax will induce additional innovation in both efficiency and cleaner sources of energy, which will lower the costs of reducing carbon emissions. Moreover, it will generate revenues, that if recycled to increase tax incentives for further research and capital equipment investment could lead to a net boost to growth.

A carbon tax addresses a clear market failure. When firms emit carbon dioxide, they increase global warming, which increases the costs of global warming. But because the connection between their individual emissions and the environmental cost is infinitesimal, these costs do not influence their decisions. Instead, they use carbon-based fuel until its cost exceeds the economic benefit of burning it. They also do not devote many resources to generating clean energy innovations.

By raising the cost of carbon-intensive energy, a carbon tax makes companies consider environmental costs, spurring both the development and adoption of cleaner technologies. But what should the tax rate be? The optimal rate would be one that reflects the total societal cost from emitting carbon into the atmosphere. Most models estimate that this would be somewhere between $15 and $25 per ton of carbon, rising over time. To put that in perspective, a $25 per ton carbon tax would mean that the price of a gallon of gasoline would rise by 22 cents.

A rise in the price of “dirty” energy will cause organizations and consumers to use relatively less of it. But it will also cause companies to invest more effort in coming up with innovations that improve energy efficiency and make low-carbon fuels cheaper, reducing the economic impact of the tax. One model shows that such induced innovation could reduce the economic cost of a carbon tax by as much as 30 percent.

Most economists believe a carbon tax is the most efficient way to reduce emissions. Traditional command and control regulation tends to be too complex and slow to change, making it ill-suited to control the myriad activities that emit carbon.

The Congressional Budget Office estimates that a carbon tax of $25 per metric ton rising in real terms by 2 percent annually would produce $977 billion in the first decade. These revenues are critical to addressing a second market failure that limits growth.

Virtually all taxes reduce economic growth to some extent. Although a carbon tax would mainly affect consumption, not investment, it would still lower GDP from what it otherwise would be. This would be true even if the environmental benefits outweighed the social cost. However, recycling the tax revenues wisely can restore much of this growth. Numerous studies show that both research and capital equipment investment play a large role in boosting economic growth, but only a portion of the economic benefit from research or capital investment is captured by the company that makes it. A large portion goes to the rest of society. Unfortunately, companies do not take these benefits into account when deciding how much to invest. Because of these spillovers, society would be much better off if companies conducted more research and boosted investment in machinery and equipment.

Using carbon tax revenues to lower the after-tax cost of research and capital investment would boost economic growth, offsetting most, if not all, of the effects of the tax increase. To do so, Congress could increase the research and development tax credit. It could make permanent the expensing of capital equipment, which is now scheduled to expire in five years. It could also implement an innovation box, whereby companies pay lower taxes on profits derived from intellectual property, provided that the research and most production occur in the United States.

Despite progress on clean technology, including solar power and wind, we are still a long way from where clean energy costs less than dirty energy. And if we are to have any hope of reducing the rate of climate change, clean energy has to be truly affordable, absent government subsidies. Speeding this transition requires policies that address the market failures that lead to environmental degradation and inadequate investment. Done right, it is quite possible that this strategy could not only reduce emissions but increase GDP growth while also placing the United States at the forefront of some of the future’s most promising technologies.

Joe Kennedy is a senior fellow at the Information Technology and Innovation Foundation, the leading think tank for science and technology policy, where he focuses on economic issues.