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.
The Role of Cities
Policymakers can also direct states to re-grant a portion of the block grant funds to cities, or distributing a share of total revenue directly to cities, in order to elevate the role of urban centers in making revenue-spending decisions. A precedent already exists for federal block grants to cities. The Community Development Block Grant Program, which counts both states and local governments as recipients, is one of the most well known and longest-running such programs. The much smaller Emergency Solutions Grant Program, on the other hand, provides funds only to local governments.
Cities and municipalities are often the engines of economic growth and the implementers of myriad federal and state programs. According to the IPCC, they also account for two-thirds of global energy consumption and are responsible for 80% of greenhouse gas emissions. In the United States, the energy and emissions landscape is similarly concentrated. Passing through a portion of the funds to metropolitan areas can increase the program’s efficiency and ensure that actors receiving funding are those that are best placed to take action.
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.
- 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.
- Center for budget and policy priorities. Available at: http://www.cbpp.org/research/policy-basics-where-do-our-state-tax-dollars-go.
- 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.