REBUILDING AMERICA WITH CARBON GRANTS TO STATES

Executive Summary

This paper explores a specific approach to carbon pricing, called “Price and Block Grant,” where the federal government prices carbon and states take the lead in spending decisions.

Under the proposal, U.S. states receive the majority of revenue in the form of block grants. The balance is reserved for reducing federal taxes or funding select new federal spending. The Price and Block Grant approach allows the U.S. to address key national and state priorities without massively increasing the federal budget deficit.

Price and Block Grant has a number of benefits:

• It builds on the strength of the U.S. federalist system. A federally imposed price ensures that the policy is harmonized across the U.S. economy. Meanwhile, grants to states maximize economic and social benefits by allowing state governments to tailor spending to best match their unique needs.
• It raises much-needed revenue. Price and Block Grant could go a long way toward paying for infrastructure and tax reform—the top two priorities of the Donald Trump administration. Even a modest $25 per tonne fee increasing at 2% annually would generate at least $1 trillion over its first decade (Figure ES-1). More than $750 billion would be distributed to states under a 75/25 revenue-sharing program.

• It is an efficient way to reduce U.S. emissions. Experts on both sides of the ideological spectrum agree that pricing carbon and other GHGs is likely the most efficient way to reduce emissions. It is also far more cost-effective than top-down regulations such as the Clean Power Plan.

This carbon pricing approach represents an enormous new revenue stream while remaining consistent with conservative principles of limited government and local control. It eschews top-down federal regulations in favor of a market-based approach, promotes efficient and sound environmental policy and puts local actors in charge of key spending decisions. It is simply smart policy.

Figure ES-1: Revenue and GHG Emissions under Illustrative Carbon Price

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Introduction

Shortly after winning the election, Donald J. Trump identified his two top legislative priorities for the first 100 days in office: 1) invest $1 trillion dollars to restore America’s economic competitiveness by modernizing airports, repairing roads and bridges, and building-out national infrastructure, and 2) promote economic growth through a major overhaul of the U.S. tax code. The Trump tax plan would lower corporate income taxes, eliminate the estate tax, cuts personal income taxes for certain individuals, and do away with many traditional deductions and loopholes. Independent tax experts predict these fiscal reforms would reduce U.S. tax revenues by $6.2 trillion over the next decade.¹

Deficit hawks and fiscal conservatives in Congress are likely to ask Trump to propose spending cuts and/or revenue enhancements to pay for his new tax and infrastructure policies. The President-elect, in addition, will need to attract sufficient support from progressives and moderates to move his proposals through the Senate. Many Democrats are likely to oppose spending cuts and Trump has ruled out cutting social security and other entitlement programs. Democrats might be more open to other fiscal solutions, however, particularly if they advance progressive priorities.

Trump has also promised to do away with regulations that constrain economic growth. High on his list is repealing President Obama’s Clean Power Plan, a new Environmental Protection Agency (EPA) regulation on greenhouse gas emissions from power plants. The Clean Power Plan is currently being reviewed by the Supreme Court. The Trump administration has numerous avenues to repeal or amend the regulation, before or after a decision by the Court.

The Supreme Court previously ruled unanimously that the Clean Air Act requires the Executive Branch to control carbon and other greenhouse gases if they are considered dangerous. The Obama EPA determined greenhouse gases (GHGs) are dangerous and the Trump administration is unlikely to be able to muster the science needed to undo that judgment. New congressional attempts to remove GHGs from the Clean Air Act are unlikely to make it through the Senate without simultaneously approving some alternative emissions control policy. Trump is likely to face significant domestic and international pressure to put forward a credible climate plan, particularly if he does away with the Clean Power Plan.

These forces swirl together to yield a very surprising insight. In the Trump era, the prospects for a federal carbon price are higher than in previous administrations. Even a modest price on carbon would likely generate $1 trillion in new revenue over its first decade. That would go a long way toward paying for new infrastructure investments and making a real dent in financing the Trump tax reform plan, all while filling the hole created by scrapping the Clean Power Plan. While no one solution alone can halt climate change, most experts on both sides of the ideological spectrum generally agree that pricing carbon and other GHGs—i.e. requiring polluters to pay a fee or tax, or buy a permit, for every ton² of GHG emitted—is an essential part of success and likely the most cost-effective means of reducing climate pollution in an efficient manner.

A strong majority of Americans believe that climate change is real and that the government should do more to address it.³ Ordinary citizens recognize in their own experiences the growing frequency of heat waves, storms, floods and droughts, and they know that without new action their children will inherit a more hostile and dangerous world.

Today, GHG emitters are not required to pay for the adverse impacts of their actions on human health, the economy and communities. When properly designed, carbon prices can efficiently use market forces to incentivize emissions reductions and the development of new clean technologies. In addition, carbon-pricing policies can produce new government revenues from the collection of fees or taxes, or auctioning of pollution permits.

Despite the widespread agreement on the wisdom of carbon pricing policies, the United States has yet to adopt carbon pricing at the federal level.⁴ Most Republicans and moderate Democrats in Congress have resisted past attempts to price carbon, in part because prior proposals were antithetical to conservative principles of small government and local control, and were seen as highly inefficient and costly. In 2009 and 2010, the Senate declined to adopt a climate bill approved by the Democratically controlled House of Representatives. That bill would have created billions of dollars in new federal spending and given away billions more to special interests (in the form of valuable emissions permits), all while giving state and local governments very little say in one of the largest expansions of the federal government in years.

This paper explores the potential of a specific approach to carbon pricing policy—which we call carbon grants to states. This approach would help pay for the Trump infrastructure and tax reform agenda while remaining consistent with conservative principles of limited government and local control. It would also reduce U.S. carbon emissions far more cost-effectively than the top-down approach taken by the Obama EPA in the Clean Power Plan.

1. Nunns, J., et al. (2016). An Analysis of Donald Trump’s Revised Tax Plan. Tax Policy Center. 18 October. Available at: http://www.taxpolicycenter.org/sites/default/files/alfresco/publication-pdfs/2000924-an-analysis-of-donald-trumps-revised-tax-plan.pdf.
2. Throughout this paper, we use “ton” as shorthand for “metric ton.”
3. EESI, 2016. Fact Sheet: Polling the American Public on Climate Change. Available at: http://www.eesi.org/papers/view/fact-sheet-polling-the-american-public-on-climate-change-2016.
4. Although a number of states, including California and New England, have adopted carbon pricing at the state and regional level.

The Basics of a Carbon Fee

A number of key design issues arise in any federal policy to price GHG emissions, including which sources and sectors to cover, what types of entities must comply, how environmentally or economically ambitious the policy should be, and whether and how to modify or suspend other federal and state climate policies (such as EPA’s GHG regulations under the Clean Air Act).

The two GHG pricing options most frequently discussed are cap and trade and a carbon tax or fee. Each has pros and cons, but they have much in common. Given the recent interest in tax reform and infrastructure spending initiatives, we focus here on a carbon fee or that policymakers could include in a broader fiscal policy package. However, the approach we describe could also work with a cap and trade program in which the federal government raises revenue by auctioning emissions permits.

A carbon tax requires polluters to pay for every ton of pollution emitted, usually at a fixed price during any given year, with the tax rate rising in a predictable manner over time. A U.S. carbon fee would be simple to administer, in part because the federal government already imposes excise taxes on some fossil fuels. A fee approach would let regulated parties project their likely liabilities by establishing the per-ton rate in advance. Likewise, investors in low-GHG technologies can anticipate the market advantage of their products relative to the dirtier competition. Yet, while carbon fees offer predictable prices, they do not guarantee specific environmental outcomes, i.e. hitting a particular emissions target in any particular year. Rather, fees guarantee a level of economic cost per unit of pollution, leaving the quantity of pollution to be set by the market in response to the value of the fee.

If a carbon fee policy underperforms environmentally, policymakers can raise it, or if the costs to the economy prove greater than expected, policymakers can lower it. Such adjustments can be automatically incorporated into the fee design, or they can be left to future lawmakers.

A few principles or best practices should apply to any policy design. Namely, the policy should:

Have broad coverage: Under any carbon pricing system, economists generally advocate for the broadest possible coverage of GHGs in the economy (across economic sectors, pollution sources and GHG types), contingent on the feasibility of identifying a responsible party and measuring their emissions. While broader coverage also results in larger macroeconomic impacts (more companies are required to pay for their emissions), it also achieves a given amount of pollution reduction at the lowest possible cost. Broad coverage ensures that the lowest-cost abatement opportunities across the economy are realized first, thus lowering the overall cost of achieving an emissions reduction goal. An economy-wide carbon price signal also incentivizes technology development across a wide range of emissions-reducing applications and sectors. Finally, broader coverage also means that the policy can have a bigger environmental benefit—driving down emissions across a larger number of sectors and companies.

Address competitiveness concerns: Some companies cannot pass along the cost of a carbon price to their customers, most notably companies facing competition from countries without an analogous policy. The set of industries that would face this problem is narrow (cement, pulp and paper, metals, glass and chemicals), but the issue is of keen concern to affected companies, workers and communities. Policymakers can help avoid the unnecessary loss of American jobs in several ways.

The best approach is to leverage the U.S. carbon fee policy diplomatically to encourage major trading partners and competitors to adopt similar measures. An inducement to successful negotiations is to establish a border carbon adjustment that would impose a carbon-based tariff on emissions-intensive goods from countries that have less stringent emissions policies. It could also rebate the carbon fees for emissions-intensive U.S. exports. Another option would be to use some of the revenue to reduce existing federal or state taxes that make U.S. firms less competitive. Finally, as it might take time for these other strategies to take effect, it would be advisable to set the initial carbon price at a modest level and ramp it up gradually and predictably, but not so low as to justify retaining more-costly regulatory burdens.

Offset the burden on low-income households: Although the tax liability would fall on businesses, much of the cost to businesses will be passed down to consumers in the form of higher prices for GHG-intensive energy and goods. Poor households spend relatively more of their income on things whose prices will likely go up, such as electricity and gasoline, making a carbon price especially burdensome for them. Economic research suggests that a small share of the revenue, targeted appropriately to these households can hold them unharmed, and still leave plenty of revenue for other policy objectives.

Generate revenue: A carbon fee that is large enough to significantly reduce emissions will raise substantial revenue. Policymakers can allocate the revenue to uses that foster economic growth (such as reducing other taxes or investing in infrastructure), bolster measures that benefit working households (such as the Earned Income Tax Credit), or meet other priority needs.

Federal and State

The Case for Shared Leadership

Federalism has a long tradition in the political norms and fiscal architecture of the United States. Indeed, it is an essential part of the U.S. Constitution and how our country works best. A system of rights and responsibilities shared between the federal government and state governments makes sense. In some contexts, the federal government is in a better position to collect revenue (such as with border tariffs or customs fees) or provide services efficiently (such as national defense or airline safety regulation). In others cases, state governments’ superior knowledge of the preferences, opportunities and needs of their citizens allows them to raise or spend revenue better than the federal government. Education is the classic example where citizens prefer local control.

Still in other areas, revenue is best raised by the federal government but spent by state or local governments, sometimes with a few strings attached. Under this approach the federal government tends to distribute revenue to states in large blocks, known as “block grants.” States are then free to distribute revenue further to their cities, towns and rural communities, as well as spend the resources at the state level. The United States now has a system of over 200 block grant programs that collectively account for about 17 percent of all federal outlays. Some of these intergovernmental transfers, particularly for social safety net programs like unemployment benefits, Medicaid and food stamps, primarily serve to redistribute resources to areas where they are needed most. Others, like grants for infrastructure, help compensate for states’ inadequate incentives to make investments whose benefits extend beyond their borders.

A block grant approach is the best way to implement an economy-wide U.S. carbon price. The federal government is in the best position to ensure that incentives to abate GHG emissions are harmonized broadly across the U.S. economy—covering all sources, sectors, and states. This minimizes the cost of achieving any given environmental goal, while easing compliance by companies that operate in multiple states and reducing the economic distortions that could arise from different carbon prices in different jurisdictions. A federally imposed carbon price also allows for an upstream approach to pricing carbon, meaning the price can be imposed at the chokepoint of the fossil fuel distribution channels. This minimizes the number of regulated companies, broadens the scope of coverage, and lowers the administrative burden of the policy. A federal carbon price can also piggyback on existing federal levies on fossil fuels, such as the tax on coal that funds the Black Lung Disability Trust Fund, or existing federal GHG reporting requirements. This creates economic efficiencies that would not be achieved at the state level alone. Finally, the United States can best leverage a federal carbon pricing policy diplomatically to ensure other nations do their fair share to tackle climate change too. A federal policy best demonstrates political will and provides a predictable indicator of overall U.S. action for other nations to follow. Importantly, a federal carbon pricing policy can give individual states the option to pursue more ambitious abatement measures, but that would be their choice and not an artifact of a piecemeal state-by-state approach.

A much different question arises in how best to use the revenue from a carbon-pricing policy. A wide range of proposals has suggested giving households rebates, lowering existing federal taxes like payroll taxes and corporate income taxes, reducing the federal budget deficit, spending on energy or climate-related priorities and more. This paper argues that states may be in the best position to decide how much of revenue should be used and which activities this revenue should fund. Specifically, this proposal envisions the federal government retaining about one quarter of the projected revenue from the program, as estimated by the Congressional Budget Office and Congress’ Joint Committee on Taxation.¹  The remainder of the projected revenues would be transferred to states. The benefits of this approach are discussed below.

1. To avoid worsening the federal budget deficit, some of the gross receipts collected by the federal government would be used to compensate for any revenue-reducing effects the carbon pricing policy might have on other federal taxes.

Conclusion

Implementing an economy-wide price on carbon through the Price and Block Grant approach is one of the most efficient means of raising revenue and reforming U.S. tax policy while remaining consistent with the conservative principles of limited government and local control. It is also a far more cost-effective way to reduce U.S. carbon emissions than the top-down approach taken by Obama’s EPA in regulations such as the Clean Power Plan.

In particular, carbon pricing offers an attractive mechanism to raise revenue for massive new investments in U.S. infrastructure, adopt substantial pro-growth tax reforms, shield American industry from potential border adjustments and promote the ongoing transition to a clean and competitive economy.

While many details of such a scheme will have to be worked out, and several tough questions answered, putting a price on carbon and returning the revenue back to states builds on the strength of the U.S. federalist system. It eschews top-down federal regulations in favor of a market-based approach, promotes efficient and sound environmental policy and puts local actors in charge of key spending decisions. It is simply smart policy.

The Policy

The “price and block grant” proposal incorporates the best practices identified above and embraces a Federalist approach—with the federal government pricing carbon but states taking the lead in allocating revenue. Under the proposal, U.S. states would receive the vast majority of carbon pricing revenue in the form of block grants to do with as they see fit (within certain reasonable guidelines). The balance of the resources would be reserved for reducing federal taxes or funding new federal spending. An in-depth discussion of spending options follows below. Pricing carbon at the federal level would spur action across the entire U.S. economy and do so efficiently with minimum economic distortions. Block grants to states would maximize the economic, social and political benefits of allowing state and local governments to tailor spending to best match local circumstances and needs.

1) How does this proposal price carbon? This paper proposes placing a simple fee, one that escalates annually, on each ton of carbon dioxide emitted. However, the proposal would work with any reasonable approach for pricing carbon, including cap-and-trade or fixed-price emission permits without an emissions cap, as long as the applicable scheme generates revenue. Not all policies generate revenue: regulations and other command-and-control approaches to limiting GHG emission may produce what economists call a “shadow price” on carbon by creating a measurable economic cost for polluters, but they generally do not involve an explicit or visible carbon price and they do not generate public revenue. Similarly, a cap and trade system that gave away or “grandfathered” emissions permits to polluters would also not create public revenue. Consequently, those schemes are not compatible with the “price and block grant” approach. Just about all other carbon pricing systems would be compatible, including the majority of carbon pricing approaches in effect around the world today. [See Appendix A for an overview of global carbon pricing schemes.]

2) Why should states determine how to use the revenue? Each state has unique needs, opportunities and priorities. Some states have budget holes or unmet spending needs, and others have burdensome taxes that warrant reform. Still others have underfunded pension plans or aging infrastructure. Rather than channel carbon revenues toward a specific but limited set of federally determined uses, this proposal gives control over the majority of the funds to those who know their needs best: state governments. States would have the option to re-grant a portion of revenues to cities, towns and rural communities (see Box: The Role of Cities).

3) How much grant money would each state get? The total funds available for states will be determined by three factors: (a) the total revenue generated from the carbon pricing policy, (b) the exact proportion of total revenue that is granted to states and (c) the system for allocating revenue among the various states. These three variables deserve some discussion.

• The total revenue generated from the policy will depend of the value of the carbon price and the scope of coverage. A larger carbon price will result in greater revenue, but it will also produce larger costs. Section V provides a quantitative example with a starting price set at $25 per ton of emitted CO2.
• The exact proportion of total revenue that is disbursed to states can be determined by policymakers at a later date; however, it should represent a significant majority of all funds. Here, we propose a 75/25 split between the state and federal share of the carbon tax revenue.
• The method for dividing the revenue set aside for states among the states is called the apportionment formula. In determining this formula, policymakers should take multiple factors into account such as the likely burden of the carbon price in different states, the prospective cost of emissions abatement in each state and the overall population of each state. Some states are far more carbon-intensive, for example, will bear proportionately more of the carbon price burden. This would argue for allocating funds to states based on their historical emissions.¹ On the other hand, many of the lowest-carbon states have previously made costly investments in clean energy and this approach will effectively penalize them for past abatement efforts. This would argue perhaps for allocating revenue based on population.

In Section V we model for illustrative purposes the economic impact of a simple apportionment formula that balances these two approaches over a ten-year period. Effectively, this means that we calculate each state’s share of the revenue pool set aside for states by averaging its share of national emissions and its proportion of the total U.S. population.

Importantly, the apportionment formula is not static. After the initial ten-year period, Congress can choose to update the apportionment formula. The price and block grant approach motivates all parties to reach agreement to secure needed resources. To guard against a possible stalemate in future periods, the policy could adopt a default formula, such as a per-capita basis, to apply if policymakers do not reach an alternate agreement.

4) What must each state do to be eligible for the grants? To be eligible for a block grant, each state must submit a plan, updatable every five years, describing how it will use carbon revenues consistent with a broad set of federal guidelines. If a state declines to submit a plan in a timely manner, or if its plan violates the federal guidelines, the federal government will distribute that states’ block grant sum directly to the residents of the state on a per-household basis, adjusted for household size. Economic research suggests that this approach would help ensure that, on average, low-to-middle income households are not penalized by carbon pricing policies.

5) How can states use the funds? When preparing state revenue allocation plans, each state would have wide latitude to determine how to use its block grants subject to reasonable restrictions. States could spend their block grants on some of the following general uses [this list is not all-inclusive. Please see Appendix C for a fuller set of spending categories]:

• Adopt tax substitution or reform
• Address fiscal shortfalls (e.g., health, education, infrastructure, law enforcement, public transport, etc. These account for roughly 65 percent of state budgets)²
• Protect the lowest-income households (taking into account the use of federal funds)
• Enhance adaptation and resilience

Federal guidelines would prohibit states from spending their block grants in ways that undermine the environmental effectiveness of the program. For example, the guidelines would instruct states to avoid reducing their existing gasoline and diesel excise taxes and avoid increasing subsidies for fossil fuel industries to remain eligible for grant funds.

6) How will the federal government use its funds? While block grants to states are the dominant feature of this proposal, the federal government would still retain a minor share of projected carbon pricing revenues. As shown in the quantitative example in Section V, even a quarter of total carbon tax revenue would still amount to a sum sufficient to advance multiple policy objectives. Congress would determine how to allocate those federal revenues through the normal appropriations process. Possible uses of funds include:

• Lower or substitute federal taxes
• Reduce the national debt and annual budget deficits
• Assist in the economy-wide transition of coal workers and coal-reliant communities (supplementing local programs run by states)
• Invest in basic research and development of low-GHG technologies
• Provide disaster assistance
• Ease some of the burdens of the carbon-pricing policy on low-income households

7) How does this approach prevent expansion of the federal government? Under Price and Block Grant, the federal government does retain a portion of the revenue, and states will have significant leeway in how they spend their grants that may not include cutting taxes. However, this proposal is clearly the approach to carbon pricing that is least likely to grow the federal government. In fact, depending on how the federal government decides to use its share of the revenue, the policy may be revenue-neutral. Moreover, because the federal government retains revenue specifically to serve functions that are most efficiently provided at the federal rather than state level, some of this revenue could be returned to households through federal tax credits for low-income households, disaster assistance and the like.

8) What changes would apply to existing federal and state climate and energy programs? The price and block grant approach is neutral on whether a new federal carbon price should supplement or replace existing climate policies.

If prices were set high enough initially and designed to rise steadily over time, a new federal price on carbon could take the place of—i.e. in legal terms, pre-empt—less efficient federal climate policies, including existing GHG regulations under the Clean Air Act. One argument for pre-emption is that a sufficiently ambitious fee would make some current policies redundant. As an example, a price of $30 per ton of CO₂ or more would actually exceed the expected impact of the Clean Power Plan.³ Alternatively, a relatively low carbon price may not encourage enough abatement or drive sufficient investment in new clean energy technologies. For this reason, a new price and block grant law could coexist alongside existing federal climate policies, thereby helping to drive U.S. emissions lower.

A Federal carbon price could also take the place state and regional carbon pricing laws to ensure a uniform national approach. States with existing renewable energy standards or other programs to promote low-carbon investments may keep them, revise them, or scrap them as they see fit. Those with carbon pricing schemes, including the cap and trade program in California and the Regional Greenhouse Gas Initiative in the Northeast, could keep their existing programs if they wish, but the firms regulated under those programs would still be subject to the federal carbon price. In short, state and regional measures would provide environmental benefits above and beyond those of the federal program, allowing ambitious states to contribute disproportionately to the protection of the climate.

Environmentally and economically, either approach at both the federal and state level could work so long as carbon prices were set at the right level. Politically, one approach or another may prove more feasible.

9) How does this policy protect the competitiveness of US industry? To adequately protect domestic industry, experts often suggest implementing a border carbon adjustment that would impose a carbon-based tariff on emissions-intensive goods from countries that have less stringent emissions policies. It could also rebate the carbon fees for emissions-intensive U.S. exports. It could be argued, however, that establishing a domestic carbon pricing policy would actually benefit U.S. industry because it would harmonize policies between the United States and some of its key trading partners.

The country’s top three export markets, Canada, Mexico and China, have all indicated an intention to adopt a domestic carbon-pricing scheme in the next two years. China announced plans to launch a national emissions trading program in 2017 while Canada recently committed to implementing a national carbon price beginning in 2018. Mexico also intends to launch a national carbon market in 2018. Although it is not yet clear how these countries plan to protect their industrial competitiveness, some type of a penalty, in the form of a tariff or another border adjustment, on imports not subject to carbon pricing is possible. This will increase the relative price of U.S. goods and make them less competitive in the country’s top three export markets. While adopting a carbon-pricing scheme in the U.S. will also increase the cost of some goods and services within the economy, the cost will be offset with a pool of revenue that can be used to protect the most vulnerable households and provide additional services or tax relief.

10) How does this policy protect disadvantaged communities? Under this proposal, low-income households can be held harmless through a combination of federal and state programs. Congress could choose to fund low-income assistance programs or provide transition support for workers impacted by declining use of fossil fuels with a portion of the revenue retained at the federal level. The federal government could also require each state to show how its revenue allocation plan would help low-income communities and households.

1. Best practice recommends against updating the formula based on actual emissions because this could create a perverse incentive for states to keep emissions high in order to receive a larger portion of the revenue.
2. Center for budget and policy priorities. Available at: http://www.cbpp.org/research/policy-basics-where-do-our-state-tax-dollars-go.
3. Hogan, W. (2015). Electricity Markets and the Clean Power Plan. John F. Kennedy School of Government. 21 September. Available at: https://www.hks.harvard.edu/fs/whogan/Hogan_CPP_092115.pdf.

National Revenue and State Grants

Placing a modest fee of $25 per ton on carbon emissions can raise nearly $1 trillion in new revenue over the first ten-years of the program. More than $750 billion of these funds would be returned to states in the form of block grants. A year-by-year summary of is provided in Table 1.

Overall, the fee would reduce emissions by 8% over the first decade of the program. The decrease from business-as-usual levels would be even higher. Revenues, on the other hand, would increase annually owing to the escalation of the carbon tax rate (see Figure 2).

These results show that states stand to gain substantial revenue even from a modest carbon tax trajectory as illustrated here, which arguably represents the lower end of carbon price paths legislators would consider. The estimated average grant in the first year of the program is $1.32 billion. The smallest grant, to Vermont, would equal about $100 million. Texas would receive the largest payout—$6.7 billion in the first year. Approximately $22 billion would be available to the federal government in the first year. Full results from this analysis are shown in Table B-2 in Appendix B.

Even under the relatively low carbon price used for the purpose of this exercise, the sizable funds returned to states in each of the first ten years of the program represent much-needed revenue that can help fill important gaps in states’ operating budgets. For example budget shortfalls are forcing the governor of Wyoming to propose spending cuts of nearly $250 million for the 2017-18 biennium, including a 9% cut to the budget of the Department of Health.² At $460 million, Wyoming’s first year carbon grant would equal 170% of the state’s current health-related spending. In Kentucky, a $500 million revenue shortfall is resulting in 4.5% cuts in higher education spending over the next two years.³ In our example, Kentucky’s first-year carbon grant would represent more than 14% of the state’s current education spending. And Illinois, which may see a $5 billion budget deficit in 2017⁴, stands to gain more than $3 billion from a carbon grant annually. This sum is equivalent to about 7% of its current tax revenue.

Table 1: Summary of Revenue and Grants (bn nominal $)

Source for projected carbon tax revenues: CBO, 2016

1. The structure of the carbon tax—value and coverage—is based (with some adaptations) on the Congressional Budget Office’s 2016 analysis of options for reducing the federal budget deficit. The tax on GHG emissions is option no. 42, https://www.cbo.gov/budget-options/2016/52288.
2. Murphy, M. (2016). Gov. Matt Mead says $248 million in budget cuts “painful”. Wyoming Tribune Eagle. 22 June. Available at: http://www.wyomingnews.com/news/gov-matt-mead-says-million-in-budget-cuts-painful/article_de550638-383b-11e6-96bc-73824251ca58.html.
3. Barton, R. (2016). Kentucky Lawmakers Reach Budget Deal; Over $1 Billion For Pensions. WFPL News. 14 April. Available at: http://wfpl.org/compromise-budget-makes-cuts-puts-money-pensions.
4. McKinney, D. (2016). Illinois sees $13 billion bill backlog, $5 billion budget deficit in 2017. Reuters. 16 November. Available at: http://www.reuters.com/article/us-illinois-budget-idUSKBN13B2OZ

GHG Emissions and Revenue

Under Illustrative Carbon Price

First Year Revenue Compared to Select Budget Categories

Block grant as % of 2014 tax revenue

Block grant as % of 2014 health spending

Block grant as % of 2014 education spending

Spending the Revenue

The U.S. state and federal governments have different comparative advantages in managing the revenue from a carbon pricing program. Here, we review in greater depth some of the potential ways to take advantage of this to optimize the outcomes of the program.

State Opportunities

• Adopt pro-growth state tax reforms. Research shows that using carbon tax revenue to reduce marginal tax rates on other revenue instruments can greatly improve the macroeconomics of a price on carbon.[iv] As stated above, the most efficient form of revenue recycling would offset the most distortionary taxes, meaning the ones that create the greatest excess burden for the last dollar they bring in. In general, state and local taxes on personal income and business activity tend to be more distortionary than taxes on things that are less mobile, such as property. At the federal level, some models of some policy scenarios suggest that carbon tax swaps can produce net pro-growth economic benefits—not counting the environmental benefits.
• Address fiscal shortfalls. A number of states are experiencing fiscal stress, including states with a high dependence on the production of fossil fuels for revenue such as through severance taxes and mineral royalties. While some of these states have wisely prepared for downturns by creating sovereign wealth funds and special reserve funds, these tools will not protect against all revenue volatility or against the long-term declines in fossil fuel extraction consistent with a low-carbon future. Thus, block grants can substitute for or supplement these other revenues to meet critical needs.
• Use state programs to complement federal assistance to low income households. Very-low-income families could receive benefits from states through their existing electronic benefit transfer (EBT) systems, with which they deliver SNAP (food stamp) benefits. Supplemental EBT payments can reach households (primarily families with children) that have such low earnings that they are not required to file tax returns and do not receive Social Security or other similar federal benefits.

Case Study: Ohio

Ohio is illustrative of industrial states that have recovered slowly from the great recession. Ohio has slightly fewer jobs than it did in previous decades, but overall unemployment is low, under 5 percent in late 2016. However, unemployment is still relatively high in some areas, such as rural Monroe County (9.2 percent), and among some demographic groups (e.g., 9.5 percent for African Americans).¹ The recession resulted in years of weak wage and salary income growth, despite increases in worker productivity, but according to recent Ohio financial reports, the outlook is for “continued growth at a modest pace, fueled by a healthy household sector but restrained by weak manufacturing.”²

What could carbon block grants mean for Ohio? According to the analysis above, Ohio would receive about $3 billion per year from the program in its first ten years, or about 3.3 percent of Ohio’s FY 2016 total expenditures.³

Ohio’s revenue system is less burdensome on average than that of other states’, but overall (accounting for all its revenue sources) it is regressive. According to Policy Matters Ohio, the bottom fifth of Ohioans by income pays almost twice as much of their income in state and local taxes as those in the top one percent.⁴ This results in part from recent reductions of the state income and estate taxes and a partial replacement of those revenues with hikes in sales and cigarette taxes, which (like a carbon tax) fall disproportionately harder on lower income households as a share of their income. Thus, in a state like Ohio, it would be important to consider progressive uses of the grants, along with measures to promote economic growth.

A number of options arise. One that could be particularly important in Ohio is to bolster the funding outlook for Medicaid, which is the largest single spending category for the state; the state budget is about $66 billion a year, of which almost $23 billion is Medicaid. In 2013, Governor Kasich expanded Medicaid under the Affordable Care Act to cover more low-income Ohioans and bring in more funding for mental health and drug addiction services. As a result, nearly 700,000 more Ohioans are now covered under Medicaid. Since Obamacare was put in place, Ohio’s uninsured rate dropped almost in half. But Ohio’s funding model has faltered; federal regulators have put an end to Ohio’s sales tax on Medicaid managed care services, which is expected to cost Ohio an estimated $1.1 billion over the next two-year budget, plus another $400 million in local sales tax revenue.⁵ Moreover, the federal contribution to the Medicaid coverage expansion is set to decline over time, and some members of Congress have called for repealing the legislation. A carbon block grant program could ensure Ohio has the funds to maintain health care benefits for its residents.

Another option would be to undertake a pro-growth reform of the state’s income tax system. The Tax Foundation ranks Ohio 45^th among states in its 2017 State Business Tax Climate Index, primarily because of its corporate and personal income tax policies.⁶ The ranking methodologies are controversial, however, and Ohio’s income tax rates have gone down over the last few years. Nonetheless, arguably the block grants could help Ohio make its tax code simpler and less prone to favor certain kinds of activities and consumption patterns over others. The state could also use the grants to help local jurisdictions, which had shared in some of the taxes that were reduced. This could prevent local governments from having to increase their income taxes, thereby offsetting the benefits of the decreases in state income taxes.

Case Study: Texas

Carbon block grants could support a number of the tax and other fiscal priorities Texas lawmakers have highlighted for the 2017 legislative session. Most of the proposals tabled thus far involve reductions in existing taxes that are viewed as overly burdensome or harmful to business growth, but revenue is already tight owing to the decline in state revenues from oil and gas production. Other fiscal issues are also on the horizon that could benefit from carbon grant funds, notably underfunded pensions and highways.

One particular target is Texas’ franchise tax, which is a tax on the gross receipts of certain business activities. While it only generates 5.1 percent of state revenues, it is widely criticized for discouraging investment in the state.⁷ Some have even called it “the worst business tax in the nation.”⁸ Completing the complex return can be more costly than the tax liability itself, and because of its formula, some businesses must pay even when they lose money. Such an inefficient tax can distort business activity, lower wages, and invite litigation.⁹ Replacing it with carbon grants offers a potential pro-growth revenue swap.

Another challenge for Texas is the extreme volatility of oil and natural gas production taxes. Because Texas does not have an income tax, the state relies relatively heavily on sales taxes and revenues from fossil fuel production. A November 2014 Texas constitutional amendment shifted a significant portion of the earnings from the states “rainy day fund” (which is endowed with oil and gas production tax revenues) towards the State Highway Fund. Although Texas still has the nation’s largest economic stabilization fund, state revenues from energy production are faltering due to sharp declines in fossil fuel prices, potentially leaving transportation infrastructure underfunded.¹⁰

Another growing issue for Texas is its wide array of underfunded public pension systems. Lower-than-assumed investment returns and contribution shortfalls have accrued over the past decade, and total pension debt has grown to the extent that Truth in Accounting gives Texas a D+ for its state and local pension financial conditions.¹¹ According to that database, Texas has only $77.3 billion of assets available to pay bills totaling $137 billion. Ratings agencies have already downgraded three of Texas’ largest cities, in part because of underfunded public safety retirement liabilities. The ratings downgrades will further complicate cities’ ability to raise capital for infrastructure.

One of Texas Lieutenant Governor Dan Patrick’s top ten legislative priorities for the 2017 session is property tax reform. Local governments in Texas impose some of the highest property taxes in the U.S., with an average effective rate of almost two percent.¹² But capping local taxes would hamper the governments’ ability to deal with looming pension problems, further illustrating the complicated intersections of fiscal issues in Texas.

Our estimates suggest that Texas could receive over $76 billion in block grant revenue in the first decade of the program, the largest payment to any one state. The first year’s grant alone would represent over 12 percent of Texas’ current annual tax receipts. This revenue is sufficient to support a phase-out of the franchise tax, lower local property taxes, solvent state pension systems, and improved highway maintenance.

Federal Opportunities

• Improve the fiscal system by reducing other taxes or lowering the federal budget deficit. Adding even a well-designed carbon tax on top of the existing tax system will increase the overall economic burden of the tax system.¹³ Policymakers may, therefore, want to use the revenue in ways that reduce that burden and thus encourage economic growth. One much-studied option would be to recycle the revenues into reducing other federal taxes or towards reducing the federal budget deficit. The most efficient revenue recycling would focus on the most distortionary taxes, meaning the ones that create the greatest economic drag at the margin relative to money collected. Such efficient “tax swaps” would limit the macroeconomic harm from a carbon pricing policy. They would also make it easier to justify prices that more fully reflect the social costs of carbon emissions.
• Provide transition assistance for coal workers and coal-reliant communities. The burden of a carbon price may fall particularly heavily on workers and communities reliant on the coal industry. In the long run, workers and capital will move into other industries, but in the near term the transition will be difficult, particularly in isolated rural areas in which the coal industry dominates the economy. On both political and fairness grounds, policymakers may want to use some carbon revenue to assist the transition of these workers and communities, including protecting worker pension and health benefits, reclaiming degraded lands and training for new careers. Although the majority of this proposal allocates funding to states based in part based on their emissions, it makes sense to set aside a small subset of additional funds specifically for areas that are especially hard hit. Because the details of where and how intensely workers and communities are impacted will evolve over time, the allocation of funds should be determined at the national level. That said, the federal government does not need to directly deliver the assistance; it could grant some of these additional funds to state, local, and regional entities involved in transition activities.
• Invest in research and development of low-GHG technologies. Federal funding for basic research and development would remain important under a carbon pricing policy because those activities may be under-funded by market forces alone.
• Providing disaster assistance for extreme weather events and other damages from climatic disruption. The federal government already plays an important role in helping state and local governments and individuals prevent, respond to and recover from the damages of natural disasters like wildfires, hurricanes, droughts and floods. In a changing climate and with growing development in vulnerable areas, damages from these events are projected to grow relative to the size of the economy; accordingly, so will demands on federal resources.¹⁴ The federal government could use some of its 25 percent carbon revenues to prevent and fight forest fires, harden critical infrastructure to extreme weather events and manage the effects of sea level rise on military bases and other important federal facilities.
• Expand the Earned Income Tax Credit and other pro-poor programs. To be politically salable, any carbon pricing policy must not make poor families poorer or push more people into poverty. The most effective approach would use existing, proven delivery mechanisms, rather than create new bureaucracies, and preserve incentives to reduce fossil energy use efficiently. The federal government operates a number of social safety net programs that could help target funds to low-income households. These include the Earned Income Tax Credit (EITC), Social Security benefits and the food stamp program. Different households receive different benefits, so to reach them all will require a portfolio approach. For example, expanding benefits under the EITC can reach low-income workers, but not students, seniors or others who do not have earned income or do not file federal income taxes. Recipients of Social Security and certain other federally administered benefit programs could receive supplements to their regular payments.

1. Wilson, V. (2016). State unemployment rates by race and ethnicity at the start of 2016 show a plodding recovery, with some states continuing to lag behind. Economic Policy Institute. 17 May. Available at: http://www.epi.org/publication/state-unemployment-rates-by-race-and-ethnicity-at-the-start-of-2016-show-a-plodding-recovery-with-some-states-continuing-to-lag-behind.
2. Office of Budget Management, 2016. Monthly Financial Reports. Available at: http://obm.ohio.gov/Budget/monthlyfinancial/default.aspx
3. Ohio’s Interactive Budget, 2016. Available at: http://interactivebudget.ohio.gov/Expenses/Type.aspx
4. Zach Schiller’s testimony to the 2020 Tax Policy Commission. 26 September. Available at: http://www.policymattersohio.org/2020testimony-sept2016.
5. Siegel, J. (2016). Medicaid tax change to cost Ohio, counties. The Columbus Times. 3 July. Available at: http://www.dispatch.com/content/stories/local/2016/07/03/state-counties-facing-big-loss-of-tax-revenue.html
6. Walczak, J., et al. (2016). 2017 State Business Climate Index. Tax Foundation. Available at: https://drive.google.com/file/d/0B6586UGJDFOLNU9XbGtVejJxZkU/view.
   
7. The Morning Telegraph, 2016. Lawmakers must repeal the Texas franchise tax. 14 October. Available at: http://www.tylerpaper.com/TP-Opinion/252890/lawmakers-must-repeal-the-texas-franchise-tax.
8. Tomlinston, C. (2016). Texas needs to dump its franchise tax and come up with something better. Houston Chronicle. 5 April. Available at: http://www.houstonchronicle.com/business/columnists/tomlinson/article/Franchise-tax-needs-to-go-better-business-tax-7230109.php
9. Drenkard, S. (2015). The Texas Margin Tax: A Failed Experiment. Tax Foundation. 14 January. Available at: http://taxfoundation.org/article/texas-margin-tax-failed-experiment.
10. Wright, B. and Conte, G., The Ups and Downs of State Revenue. Available at: https://www.comptroller.texas.gov/economy/fiscal-notes/2016/november/volatility.php.
11. State Data Lab. Pension Database. Available at: http://www.statedatalab.org/pension_database
12. Texas Property Tax Calculator. Available at: https://smartasset.com/taxes/texas-property-tax-calculator.
13. Marron, D. and Morris, A. (2016) How to Use Carbon Tax Revenues. Tax Policy Center. February. Available at: https://www.brookings.edu/wp-content/uploads/2016/07/howtousecarbontaxrevenuemarronmorris.pdf
14. For example, CBO estimated the magnitude of increases in hurricane damage over the coming half century and the implications for the associated federal aid. https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/reports/51518-Hurricane-Damage.pdf.

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