Wednesday, April 25, 2007

CBO on Cap-and-Trade

The Congressional Budget Office has just released a report on allocating carbon allowances under a cap-and-trade system. In keeping with CBO tradition, it does not officially take a position. But any intelligent reader will end up believing that the allowances should be sold rather than given away. Here is an excerpt:

The decision about whether to sell the allowances and use the proceeds in ways that would benefit the economy could have a major impact. For example, one study estimated that a 23 percent cut in CO2 emissions could cost the economy nearly twice as much if allowances were given away than if they were sold and the revenues used to cut taxes. Another study found that the economywide cost of reducing emissions by 10 percent would vary by a factor of three, depending on how the allowance value was used. Some researchers even suggest that relatively modest cuts in CO2 emissions could provide net gains to the economy (in addition to the benefits from emitting less carbon dioxide) if the allowances were sold and the revenues used to reduce individual income taxes.
Of course, selling emission allowances under a cap-and-trade system makes the system equivalent to a comparably-sized Pigovian tax.

One part of the report that looks suspicious to me is CBO's analysis of what would happen if we used the revenue from selling allowances to cut corporate income taxes. This footnote explaining Figures 1 and 2 strikes me as odd:

This estimate by Dinan and Rogers does not distinguish between the gains in economic efficiency associated with reducing corporate taxes and the gains associated with reducing payroll taxes. It implicitly assumes that capital and labor respond similiarly [sic] to changes in the taxes on them and that increases in marginal tax rates on capital and labor have similar costs to the economy.
Standard models of economic growth offer ample reason to doubt this implicit assumption.