We assess the welfare implications of imposing a revenue-neutral carbon tax, where the use of crude oil emitting carbon is taxed and the revenues are used to supplement the reductions in revenues from a lower income tax rate or sales tax rate, in the presence of the Renewable Fuel Standard (RFS) in Washington, Oregon, and Idaho. Simulations conducted using data from Washington, Oregon, and Idaho indicate that the imposition of a revenue-neutral tax raises state welfare, an estimate of the combined well-being of producers and consumers, by 19% to 20% and increases the cellulosic biofuel sector marginally at a rate of 1% to 2%. Also, raising the input ratio requirement for cellulosic biofuel from the RFS will have little impact on state welfare and the revenue-neutral tax rate chosen by the regulator to control pollution. However, changes to the cellulosic biofuel waiver price, which can be used to circumvent the input ratio requirement, reduces the revenue-neutral tax because less pollution is emitted.
This report is a condensed version of Skolrud and Galinato (2015) entitled “Welfare Implications of the Renewable Fuel Standard with a Revenue-Neutral Tax.” Unlike Skolrud and Galinato (2015), we emphasize in this report the similarities and differences for three Pacific Northwest States: Washington, Oregon, and Idaho.
A carbon tax is touted by economists and environmental scientists as an effective and efficient means of reducing greenhouse gas (GHG) emissions (Tol 2005), but considerable opposition exists in the U.S. at the national level to adopting such a program. However, when the tax revenue from a carbon tax is used to offset an existing distortionary tax policy, public support across political groups increases drastically (Amdur et al. 2014). Representative John Delaney recently announced that he would introduce federal legislation taxing GHG emissions and using the revenues to reduce the corporate tax rate (Congress John Delaney 2015). California, New York, Massachusetts, Oregon, and Washington have proposed initiatives for a revenue-neutral carbon tax that reduces an existing distortionary tax leading to zero net increase in tax revenue. In Washington, the group CarbonWA was successful in collecting enough signatures for their revenue-neutral carbon tax initiative to appear on the November 2016 ballot (CarbonWA 2016). Thus, there appears to be growing support to impose a revenue-neutral tax system to control GHG emissions at both the national and state level in the U.S.
Congress passed the Energy Independence and Security Act (EISA) of 2007 which imposes increasing consumption mandates designated as RFS policies for several types of renewable fuel through 2022. The law reduces GHG emissions by substituting energy feedstock that emits less carbon dioxide than fossil-based sources. The law mandates an increasingly important role for advanced biofuels derived from cellulosic feedstocks, such as woody biomass or crop residue. By 2022, the mandate calls for the consumption of approximately 16 billion gallons of cellulosic biofuel; a significant increase from 33 million gallons produced in 2014 (RFSP 2015). There are two important RFS policies relating to the cellulosic biofuel requirement: the input ratio requirement, which imposes a lower bound on the amount of cellulosic biofuel used in the production of blended fuel, and the price of EPA-issued cellulosic biofuel waivers, which can be purchased by fuel producers and importers to circumvent the input requirement (GPO 2011). It remains to be seen whether these federal regulations will be sufficient to reduce GHG emissions.
Our research question analyzes how a revenue-neutral carbon tax can be imposed to induce the optimal level of carbon dioxide pollution in the presence of the RFS policies. We analyze the effect with two different tax types: a revenue-unconstrained tax, and a more politically palatable revenue-neutral tax, where the revenue collected from the environmental tax is used to offset an existing tax in such a way that guarantees that overall government revenue remains at the same level. By comparing results across the two tax types, we have a benchmark with which to compare the revenue-neutral tax, both in terms of pollution reduction and overall welfare enhancement.
We build a model where a tax is placed on fossil fuel use in the fuel production sector and the tax revenue is used to offset an existing distortionary tax on a currently taxed item. We provide a numerical simulation to show the effect of such a policy in Washington, Oregon, and Idaho—states that could be significant providers of cellulosic feedstocks for biofuels due to their abundance of agricultural land and woody biomass (Yoder et al. 2010). We compare and contrast the effects of a revenue-neutral tax in states with different existing taxes. In Washington, which has no state income tax, sales taxes are offset. In Oregon and Idaho, state income tax is offset.
Three effects are identified in the literature when a revenue-neutral tax is imposed (Parry 1995). First, there is what is called a Pigouvian effect that improves welfare because the pollution tax makes the good more expensive, leading to lower