Carbon Taxes or Green Energy Subsidies?

For politicians, the choice between handing out energy subsidies imposing additional taxes is pretty clear.

With subsidies, companies and firms and research institutions get checks and tax breaks. There may be ribbon-cutting publicity opportunities at the start, and even if only one project out of every five or ten is actually successful, that’s still plenty of places to go and hold a self-congratulatory political event a few years down the road. Meanwhile, the costs of these subsidies–the opportunity cost of other priorities that don’t get funded, along with higher budget deficits or taxes in the future–are largely invisible. The tradeoffs that happen in the background when, say, the subsidies for one form of non-carbon energy like wind or solar just lead to less use of another form of non-carbon energy like hydropower, or where supporting technology from a politically favored firm crowds out better technology from an unfavored firm, won’t be noticed either.

With carbon taxes, on the other hand, consumers/voters everywhere will see the effect on gasoline and home energy prices. The costs are up-front. Meanwhile, the altered incentives that lead to innovation and growth of efforts to produce cleaner energy and to conserve fossil fuels are largely invisible. The effects happen flexibly all over the economy, but the opportunities for ribbon-cutting ceremonies and political favoritism are scarce. The benefits of additional revenue for other priorities like (choose your priority here) a permanent child tax credit, saving Social Security, rebuilding defense stocks after what has been sent to help Ukraine, cutting other taxes in an offsetting way, or reducing the budget deficit are likely to seem indirect and disconnected from the revenue gains.

But in this case, at least, the politically easy choice also imposes high costs. John Bistline, Neil Mehrotra, and Catherine Wolfram discuss the “Economic Implications of the Climate Provisions of the Inflation Reduction Act” (Brookings Papers on Economic Activity, Spring 2023, conference version of the paper), a law which is actually much more about clean energy subsidies than inflation-fighting. Their essay goes through the law in some detail: detailed provisions, costs, distributional and macroeconomic effects. (Content warning: It’s a research paper, so some of the chunks that describe mathematical modelling choices won’t be easy reading for the uninitiated.) Here, I focus on just one section of the paper, where they compare the subsidy-driven approach to reducing carbon emissions to a carbon tax approach that would have similar reductions in emissions over the same timeframe.

The authors point out various differences between how subsidies for non-carbon energy and a carbon tax affect the goal of reducing carbon emissions.

For example, carbon taxes do a better job of encouraging conservation than clean energy subsidies. “Relative to a carbon tax, subsidies encourage electricity consumption and discourage conservation. If household and industrial demand for electricity is sensitive to price, a carbon tax would have a relatively large effect on electricity consumed and hence emissions. By contrast, a subsidy policy –by encouraging electricity consumption — would partially undo the switch from fossil to clean energy by raising overall electricity consumption …”

The higher price of carbon emissions from a carbon tax focuses specifically on fossil fuel emission. However, “Under IRA, clean energy that displaces zero-carbon energy such as hydropower is subsidized at the same rate as clean energy that displaces the dirtiest resources.”

A carbon tax is also automatically scaleable–that is, those who emit more carbon bear a higher cost. However, the subsidies of the IRA are based on production, not use: “Other provisions of IRA subsidize the energy-using or energy-producing asset, irrespective of
how much it is operated. The investment tax credit for zero-carbon electricity subsidizes the
construction of the facility rather than its operation. … Similarly, the electric vehicle tax credits subsidize vehicle purchases without regard to how much they are driven. Electric vehicles that are used as second cars and driven less will offset fewer emissions than vehicles that replace a household’s only car.”

Fixed tax credits and production subsidies are relatively inflexible as technology and market conditions change: “Carbon pricing enables households and businesses to select their preferred approaches to lower emissions, which can help to reduce costs and account for other welfare-relevant considerations that vary across individuals and firms.”

Our model abstracts from many dimensions of difference between subsidies and carbon pricing. One important difference is that pricing carbon, depending on how it is implemented, could generate revenue for the government. These revenues could be used to offset other distortionary taxes (Barron et al., 2018; Goulder, 1995), address equity concerns (Goulder et al., 2019), or be directed toward other policy objectives. A subsidy-based approach costs the government the subsidy amounts and imposes the marginal cost of raising government funds on the economy.

The IRA includes various components like requiring firms producing non-carbon energy to have certain percentages of “domestic content,” meaning that they are required to buy certain inputs from American suppliers even if the price is higher than it would otherwise be. There are also rules about labor practices and wages in order to quality for the subsidies, again, even if it makes production of the non-carbon energy more expensive.

When the authors run some of these differences through their model of energy and the economy. They find that the cost of reducing carbon emissions through subsidies approach of the Inflation Reduction Act costs $83 per metric ton of reduced carbon emissions, while getting the same reduction in carbon emissions through a carbon tax would cost about $12-15 per metric ton of reduced carbon emissions. This large gap is probably an underestimate, because the model they are using focuses on differences in incentives for energy conservation and the efficiency of investment in new technology, but doesn’t include factors like the additional revenue raised by a carbon tax or the costs of added-on rules like “domestic content.”

I’m fully aware that for the US political system, a carbon-tax is a heavy lift. But for those who dislike the idea, consider that if the alternative is paintballing government subsidies for various aspects of non-carbon energy–with all their inflexible rules and administrative requirements–then the carbon tax begins to look pretty good.