Distributional Consequences of a Cap and Trade Program for CO2

March 13, 2009

Global climate change poses one of the nations most significant long-term policy challenges. While the potential damage from climate change is large, the potential cost of avoiding it is also large. Policymakers could help minimize that cost by using either a tax, or a well-designed cap and trade program, to motivate reductions in emissions. As many analysts have noted however, either a tax or a cap would cause prices of goods and services to increase, with larger increases for goods that entail greater emissions, such as home heating. Those price increases are essential to the success of the program, but they wouldrepresent a larger share of income forlower-income households thanfor higher-income households. Terry Dinan of our Microeconomic Studies Division discussed CBO's analysis ofthe distributional consequences of cap-and-trade programs for CO2 emissionsyesterday in a testimonybefore theWays and Means Subcommitteeon Income Security and Family Support.

I've highlighted some of the key points of Terry's discussion below.To readher full testimony, click here.

  • One approach that lawmakers could use to cushion the effects of those higher prices under a cap-and-trade program is to sell some allowances and give the revenue back to households. If, for example, the government sold all of the allowances and used the proceeds to provide the same lump-sum rebate to each household in the U.S., low-income households would actually be made better off under a cap-and-trade policy (though this rebate would not fullycompensate higher-income households for their increased expenditures).
  • If lawmakers wanted to use a more targeted approach for offsetting costs incurred by low-income households, they could choose from a variety of different strategies, including using existing transfer programs or providing rebates through the income tax system. However, no single existing system would be likely to reach all such households.
  • Delivering rebates through a combination of the income tax system and existing transfer programs would do a better job of reaching low-income households than would relying on either approach by itself. Using multiple systems to reach all households poses other challenges: it is not easy to coordinate among existing programs to avoid compensating the same household twice.
  • In choosing among options for using proceeds from the sale of emissions allowances, potentially tens or hundreds of billions of dollars per year, policymakers could face a trade-off between providing targeted assistance to low- and moderate-income households and offsetting some of the adverse effects on the economic activity caused by the price increases.