Tax Swap: A Way to Expand the Economy While Lowering Carbon Emissions

What do such problems as global warming, air pollution, toxic waste, traffic congestion, unemployment, loss of jobs overseas, overuse of non local food sources, underground economy, lack of competitiveness of American workers, excessive small business paperwork and a complicated tax system have in common? The answer is that all of these problems can be addressed with a common solution: a tax swap that replaces payroll taxes with a tax on carbon dioxide emissions. This tax swap is a dual pronged solution to a seemingly intractable set of problems facing our nation today.

The first portion of this solution, a complete elimination of the employer portion of the payroll tax (7.65%) and a partial elimination of the employee portion of the tax as well, would have significant economic benefits. The payroll tax imposes a systemic penalty on job creators that squelches growth and sends precious jobs overseas. The second part of this solution is to replace the payroll tax revenue with a tax levied on carbon dioxide (CO2) emissions, not only reducing a potent force in global climate change but also reducing  many other problems associated with our use of fossil fuels.  The huge advantage of this approach is that both overall tax revenue and overall government spending would not change.

What are the benefits of this “tax swap”?  In short, it would help us move from a tax system that penalizes labor and work to a tax system that penalizes a form of pollution that dangerously affects our current and future life on this planet. It would reward work and thrift and penalize waste and pollution.

Global warming has been called a “planetary emergency” and many are proposing all kinds of programs to fix it. But by forcing polluters to pay for using the atmosphere as a dumping ground, a carbon tax would force a realignment of prices that we all face so we are truly paying for the impacts of our daily consumption of fossil based fuels.

One salutary benefit of the carbon tax approach is that it transfers much of the question of “how do we solve global warming’ from the government and into the free market. EPA regulations, decisions about what type of power should be favored, indeed many of the things conservatives hate about the current approach to solving global warming, could be moderated or eliminated.  The government wouldn’t have to intrude as much in the economy at the micro or local level because the price system would discourage pollution at the macro level. Mistakes such as Solyndra could be more easily avoided. Government would have less need to be involved in picking winners and losers.  We might find it easier to actually cut government spending (EPA or DOE come to mind).

The greatest benefit of a carbon tax is that it would let the market solve CO2 emissions problem. Should individuals drive alone, carpool, buy an electric car, or work from home?  A new tax based on carbon would allow each of these options to be considered and weighed based on the pricing of the activity.  Different decisions might be made based on the regional mix of electricity production or access to mass transit.  Does it make sense to buy local produce or buy the cheapest food no matter what? The carbon tax would force the impact on the environment to be directly considered in the price of the competing goods.  One would think that local and less mechanized production would be encouraged, but all of those trade offs would be reflected in market prices.

A carbon tax would dramatically change electric utility resource planning.  Should a utility continue to maintain existing coal facilities or build new nuclear, wind or solar plants? That trade off would now properly reflect the global warming damage of burning coal.  Could utilities make coal work through storage underground (sequestration) of emissions? They could evaluate that option with a simple cost/benefit calculation.  But with a carbon tax the bias in utility planning will shift dramatically toward reducing carbon pollution.

While our current tax system poses no penalty for polluters, we currently impose a systemic penalty on job creators. Each employer must pay a 6.2%% tax on the first $117,000 in wages paid.  Each employer must also pay a 1.45% tax on all wages paid. These two taxes together are called the “employer payroll tax” and are used to fund Social Security in the first case and Medicare in the second case. Of course, funding Social Security and Medicare is a laudable purpose, but it creates an added cost of labor to employers and discourages the hiring of new workers. And because the tax exempts income above $117,000 for the social security portion, it creates the perverse incentive to pile more work on the top performers who make above that amount. While these high paid earners are paid more, no additional funds are available ot support a strained social security system. In the mean time this tax system creates a disincentive to hire new workers who will incur the full payroll tax on the first dollar paid.  Elimination of the payroll tax with revenues from the carbon tax will remove this disincentive.

How would this system work?  The carbon tax would need to be administered at the extraction or import point of fossil fuels. Renewable sources of carbon such as firewood or biomass ethanol or biomass methane would be exempt from the tax because they don’t add new net carbon to the atmospheric system. Coal companies, gas companies, oil producers, and importers of oil would be charged the tax upon first sale or use of the commodity. Like the payroll tax it replaces, this tax would be paid indirectly by consumers, not directly. The tax would be levied based on the carbon content times the weight, so a standard rate per volume of coal, gas, or oil could be developed.  Offsets or tax credits could be made available to users of these commodities based on their ability to sequester CO2. This would provide an effective exemption for “clean coal” or indeed clean gas or oil, along with an incentive for the development of these options. These credits could be sold to producers to offset some of the carbon tax owed.

The tax could be easily phased in, although the administrative burden of the payroll tax would only be relieved upon its full elimination. The payroll tax could be eliminated by 1% a year over 12 years, with the employer portion being reduced to zero first and then the employee portion reduced to 3% (or so) following that. The employee portion should not be reduced to zero since we would still want to keep tracking employee contributions to Social Security and Medicare. One way to think of it would be that the carbon tax would be used to provide “matching” contributions to the employee’s own contributions to Social Security and Medicare.  Social Security and Medicare benefit formulas would not need to change at all even though the funding source would be changed.

The payroll to carbon “tax swap” has many features that go to the heart of “conservative” values.  It changes our tax system from one favoring consumption and discouraging work to one that favors thrift and encourages work. This is also a value shared by environmentalists, and opens up the possibility of an alliance between conservatives and environmentalists based on these core values.  It provides an opportunity for smaller government by using market forces to solve one of our most pressing problems that otherwise will need to be solved by big government.  There are many environmentalists that don’t like the idea of big government, but will choose big government solutions if they are the only way to save the environment from destruction.

The payroll to carbon tax swap also should be palatable to liberals because it is positive toward employment and does not add to the regressive degree of the tax system. Admittedly, a carbon tax is regressive, since presumably the rich use less energy as a percent of their income. But the payroll tax is already our most regressive tax, so swapping one for the other doesn’t necessarily change how regressive the tax system is. And because the social security portion cuts off above $117,000, swapping the carbon tax for the payroll tax might even be mildly progressive.

So what problems will a payroll to carbon tax swap create that must be cured for this to work? Two problems come to mind: (1) A successful carbon tax will result in declining fossil fuel production, which will result in declining revenue. That is after all, one of the objects of the program. (2) There will be winners and losers and the program might need to be modified to reduce the negative impact on the losers. Some thoughts on this follow.

Success of the program will sow the seeds of its demise, since success means a dramatic move toward clean energy. With the move to clean energy, tax revenues will decline but we will still need to fund Social Security and Medicare. So either we return to the payroll tax later or we find a new source of taxation to permanently replace the payroll tax.

I propose that we not return to the payroll tax. Instead, as carbon tax revenues decline we should replace them with a general national sales or value added tax which would increase as carbon tax revenues decline.  A national sales tax (“fair tax”) is the darling of some conservative circles but has been dismissed by liberals because it is so regressive. But using a national sales tax only to offset payroll tax has most of the positive economic benefits touted by conservatives and should not be toxic to liberals since it would be mildly more progressive than what we have now.

One loser we don’t need to worry about would be the underground economy. Right now, the underground economy escapes payroll taxation altogether by just not reporting income or pay. They pay no tax, or less tax than they would otherwise. And accountants have devised lots of ways for small businesses to escape paying the full payroll tax. But with a carbon tax taking the place of the payroll tax, participants in the underground economy would pay this tax the same way the rest of us will – through the embedded cost of fossil fuel carbon taxes in the products we buy. The winners in this regard will be everyone else.

A potential loser that might need some extra help would be rural areas who use much more gasoline per capita than do urban areas. Rural areas will benefit in certain ways under this new scheme, such as increased production of renewable energy which presents opportunity for new business for rural areas – wind and solar are cheaper to produce where land is less dear and firewood and biomass will be significantly favored.  The economics of local, labor intensive agriculture will be improved. Nevertheless, rural areas may be a net loser and some sort of interim transfer payment scheme may need to be worked out.

Another loser could be energy intensive domestic manufacturers that would face foreign competitors who do not have to pay a carbon tax or its equivalent.  Of course currently the reverse of this is true – some of our energy intensive manufacturers currently see an advantage because Europe is already moving to restrict carbon. Furthermore, the lost advantage we would see with respect to energy intensive industry would be made up by an improved advantage for our labor intensive industries.  Nevertheless, provisions will need to be made to penalize imports from those countries that are not acting responsibly on carbon pollution. Perhaps a new round of global climate talks could impose tariffs on countries that are not on board with the program.  This can only take place if the world’s largest importer – the USA – is on board.

Now certain other groups will claim to be losers and will need to be informed to see that they are not. One such group could be retirees who will argue that they paid payroll tax and now they are going to have to pay carbon tax as well. But the point is that retirees are actually paying the payroll tax now anyway because it is passed on to consumers by the employers that pay it.  The same will be true for the carbon tax. Prices on more energy intensive goods will go up while prices on more labor intensive goods should go down.  Overall, retirees should not face any higher prices than they do now. Since they no longer need to commute to work, they may in fact come out positively in the exchange.

Further study on these latter issues is needed.

In summary, the payroll to carbon “tax swap” helps address many of the most immediate and long term problems facing our economy. It eliminates a huge drag on employment and while providing a market mechanism to reduce CO2 emissions and the other harmful effects of using fossil fuels. It provides incentives for those things which we want to encourage such as thrift, energy conservation, employment, domestic production and renewable energy. It provides disincentives for things we want less of including carbon dioxide pollution and participating in the underground economy.  It’s a smart move that needs serious consideration now.