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.
- 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 45th 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.
- 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.
- 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.
- Office of Budget Management, 2016. Monthly Financial Reports. Available at: http://obm.ohio.gov/Budget/monthlyfinancial/default.aspx
- Ohio’s Interactive Budget, 2016. Available at: http://interactivebudget.ohio.gov/Expenses/Type.aspx
- Zach Schiller’s testimony to the 2020 Tax Policy Commission. 26 September. Available at: http://www.policymattersohio.org/2020testimony-sept2016.
- 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
- Walczak, J., et al. (2016). 2017 State Business Climate Index. Tax Foundation. Available at: https://drive.google.com/file/d/0B6586UGJDFOLNU9XbGtVejJxZkU/view.
- 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.
- 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
- 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.
- 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.
- State Data Lab. Pension Database. Available at: http://www.statedatalab.org/pension_database
- Texas Property Tax Calculator. Available at: https://smartasset.com/taxes/texas-property-tax-calculator.
- 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
- 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.