Several bills have been introduced in the U.S. Senate to create a cap-and-trade system to reduce carbon emissions. At a recent forum on the topic hosted by the Urban Institute in Washington, DC, debate over the regulation of greenhouse gases focused on the advantages and disadvantages of implementing either a carbon tax or a cap-and-trade program, both of which are market-based approaches to reducing global warming.
A carbon tax is straightforward in that it requires firms to pay a fixed amount for each unit of carbon emissions they produce. This increases the cost of fuels for the producers and is passed down in the form of higher prices to consumers. Both producers and consumers then have the incentive to either consume less, consume more efficiently or find alternate fuels. Firms that use these alternatives avoid paying the tax and reduce their emissions. Firms that don't use the alternatives pay the tax. As with any tax on consumption, a carbon tax burdens people of low incomes disproportionately, making this tax regressive. The tax revenue generated could go toward compensating those impacted most harshly, although it might be difficult to target such compensation towards those affected.
A cap-and-trade program works by setting a limit on total emissions and then distributing allowances for firms to pollute corresponding to that limit. The firms can then trade these allowances, the idea being that this will lead to a more efficient outcome. Firms that can reduce emissions cheaply will do so, and then sell excess permits to firms for which it is costly to reduce emissions. As with a carbon tax, the added cost to firms of buying allowances would cause the price of fuels to increase. This would force consumers to alter their behavior, and also place a heavy burden on low-income families, making this option just as regressive as a tax. However, the government could initially auction off allowances, which would be extremely valuable, and use the revenues to try to target those hardest hit by increased prices.
Both programs are flexible in that the amount of tax, emissions cap, or amount of allowances could be adjusted after implementation. Both programs are likely to have regressive impacts since they would raise consumer prices, and it remains to be seen how this problem might be resolved. The cap-and-trade program seems to be more politically acceptable to many lawmakers who fear anything resembling a tax increase, while many economists favor the carbon tax because it requires less bureaucracy to implement.