Fight Climate Change with Tax Cuts

by Benjamin Studebaker

A few days ago, I wrote a rather depressing post about climate change. There was, I concluded, very little that can be done to reduce emissions short of a comprehensive international treaty (which the signatories actually abide by) or the creation of a superstate to enforce strict emission regulations. Then yesterday, I had this idea. We can actually help business and fight climate change simultaneously. Here’s how.

So if you read my previous post, you’ll recall that the reason climate change is so difficult to deal with is that when we try to reduce emissions they tend to transfer instead.

If two companies, A and B, are competitors with similar costs and prices, and company A decides to spend a considerable amount of money to reduce its emissions, its costs and prices will rise, and even if company A might be in a more sustainable position down the line, company B will get the better of it in the short term, possibly decisively. Since A’s products will cost more, A’s sales will fall and B’s sales will rise. Instead of reducing emissions, emissions will transfer from A to B, as B increases its production to capitalise on A’s loss of market share.

The same thing happens among governmental units. If California introduces a cap and trade system, companies that face higher costs are undermined in the short term. Their sales might reduce relative to companies located outside California, or they might flee to another state (like Texas) where their costs will be lower.

Some people respond with national policy, but that just raises the scale. Companies located within say, the United States would see their sales diminish relative to foreign competitors or would choose to relocate to foreign countries (like China) to escape the additional costs. Emissions are still being transferred rather than outright reduced.

In the previous post, I said only an international solution that puts the same punitive measures in place across all countries would be effective, and that remains true if the policy solution is punitive. If you want to raise costs for emitters so that they take on board the future costs of combating the climate change they will produce, you need to do it internationally.

But what if you don’t have any attachment to the notion of being punitive at all? Instead of trying to punish emitters, we should try to reward companies that reduce emissions. There are already some policies in place that do this. Sometimes states partially subsidise the cost of sustainable technology or count it as tax deductible, but while these measures reduce the cost of combating emissions for businesses, they do not eliminate them, let alone provide them with a reward.

What if, instead of talking about carbon trading or carbon taxes, we talked about carbon tax cuts? Let me use an example to illustrate:

Company X is a heavy emitter and pays 30% in taxes. A carbon tax would raise this value, increasing X’s costs, while carbon trading would increase X’s costs with the money going to X’s potential competitors instead of the state. In either case, X loses. But say that instead we replace a portion of X’s tax rate with carbon taxes, connected to the amount X emits:

Carbon Tax Cut


Case 1 represents the current rate of tax for X, around 30%. In case 2, we have replaced a chunk of X’s tax rate with carbon taxes. As X cuts X’s emissions, X shrinks the carbon tax it is obliged to pay, until it reaches the conditions represented by case 3, the case in which X’s emissions are so negligible that X has managed to eliminate its carbon tax altogether. Note that even if X doesn’t reduce emissions, X cannot pay more in tax than it presently pays, and any emissions X does manage to reduce will only result in a reduction in its tax rate and consequently a reduction in its costs. Under this system, unless the costs of reducing emissions are somehow larger than the available tax cut (which, if this system were designed correctly, should not happen), it will always be in the immediate short-term interests of an emitter to reduce emissions. Emissions reduction = tax reduction = more profit available for investment.

By tying our taxes to emissions without increasing the total tax take, we create an incentive whereby businesses can be in a superior financial position by reducing their emissions. The state takes on the entirety of the cost of emission reduction and then some, enabling business to turn a profit on combating climate change. The dichotomy of money versus dealing with climate change is eliminated for the private sector and the two goals merge into the same thing.

Now, there are a few concerns with this system I can envision arising:

  1. What do we do for companies that have already eliminated or reduced their emissions? Wouldn’t this system advantage their competitors and punish them for having already taken action?
  2. What if a company increases its emissions? Do its taxes rise?
  3. How does the state pay for this?

If we want to avoid punishing companies that have already reduced their emissions, we would need to make the tax retroactive. So for instance, imagine company Y used to be a heavy emitter in 2009 but has reduced its emissions substantially since then. What we’d need to do to avoid hurting company Y is to retroactively act as if this system were around in 2009. So if 2009 represents Y’s peak emissions, it should see a cut in its tax rate to reflect the amount it has reduced its emissions from the peak.

What about companies that never were heavy emitters in the first place? In most cases, those companies are in industries where emissions are not significant in the first place–those industries I would exempt from the programme. If however there are companies that compete with heavy emitters that have somehow never themselves emitted, I would propose giving them the full tax cut in the interests of competitive fairness.

There are two answers to the company whose emissions rise:

  1. We could proportionally increase the size of the tax to match the increase in emissions from the date the law came into effect. This could potentially offset the cost of cutting taxes elsewhere, but it has the risk of leading to emission transfer because it is punitive.
  2. Alternatively, we could leave put a maximum rate on the size of the tax and simply say that emissions above and beyond that level do not raise taxes, but that access to the tax cut can only come when emissions drop below the level they were at when the law came into effect. So if X emitted at level 50 at the time of the law, and X increases emissions to level 60, X doesn’t see a tax increase, but will still only see a tax cut if emissions are reduced below 50. The law will not reward X for increasing pollution, but it will avoid punishing it as well.

As for offsetting the state’s costs? The state could view this as stimulus programme in light of weak economic growth and accept the losses. It could also argue that any losses it takes now will be far smaller than the losses it would take in future if it did nothing to combat emissions and had to pay the costs of fighting the consequences of climate change. The state isn’t like private enterprise, it can justify this policy in terms of long-term costs decades into the future without being undermined by competition. Bear in mind that the larger the cost in lost revenue is to the state, the more companies must be cutting their emissions. A larger cost means that in terms of combatting climate change, the system is successful. If costs don’t rise, the programme has failed.

If however we really were committed to making this revenue neutral and we did not want the state to pay the cost out of its own lost revenue, we could raise taxes elsewhere (raise income tax/corporate income tax/reduce loopholes) or add in new taxes (VAT, federal property/sales tax) as offsets. The trouble is that if these tax increases hit business, they remove the advantage to the system for business. By contrast, if they hit consumers, they undermine demand and reduce sales, indirectly hitting business again. At least until the economy recovers, I would recommend the state just take the loss and vow to make it up later.

Only the sternest of deficit hawks has reason to oppose this policy. It’s a win for business, a win for the economy, and a win for a sustainable future.