Macroeconomic Effects of Alternative Implementation Instruments

All the cases considered assume a marketable emission permit system, with a no-cost allocation of the permits based on historical emissions. In meeting the targets, power suppliers are free to buy and sell allowances at a market-determined price for the permits, which represents the marginal cost of abatement of any given emission. An alternative form of permit system would auction the permits to power suppliers. The price paid for the auctioned permits would equal the price paid for traded permits under the no-cost allocation system used for this study. However, the two systems imply a different distribution of income.

In the no-cost allocation system, there would be a redistribution of income flows between power suppliers in the form of purchases of emission permits. There would be no net burden on the power suppliers as a whole, only a transfer of funds among firms. While all firms are expected to benefit from trading, the burden would vary among firms. With a Federal auction system, in contrast, there would be a net transfer of income from power suppliers to the Federal government. The key question at this juncture turns on the use of the funds by the Federal government. If the funds were returned to the power suppliers, the effect would be the same as in the no-cost allocation scheme, but with the Federal government establishing the permit market mechanism. Another use of the funds might be to return them to consumers either in the form of a lump-sum transfer or in the form of a personal income tax cut, compensating consumers for the higher prices paid for energy and non-energy goods and services.^a

Relative to the no-cost allocation of permits, an auction that transfers funds to consumers in a lump sum would help to maintain their level of overall consumption. With the transfer, however, total investment would decline relative to the allocation system. The two effects would tend to counterbalance each other, but not completely. Returning collected auction funds to the consumer would tend to have a slightly more positive effect than the negative effect on investment for the first few years, but investment would tend to rebound faster and contribute increasingly to the recovery. As a result, real GDP would be expected to recover to reference case levels faster under the no-cost allocation system. Over the entire period, however, the net impacts on real GDP are expected to be similar in both magnitude and pattern under the two potential allocation schemes.

Another approach is to recycle the auctioned revenues to either consumers or businesses through a reduction in marginal tax rates on capital or labor. Unlike the no-cost allocation or the lump-sum payment to consumers, this approach may lower the aggregate cost to the economy by shifting the tax burden away from distortionary taxes on labor and capital toward the taxation of an environmental pollutant. Most often research on this topic is based on a general equilibrium approach, where all factors are assumed to be utilized fully, as in the work by Goulder, Parry, and Burtraw.^b Revenue recycling benefits may also apply in a setting where transition effects on the economy, such as considered in the current EIA study, are the focus.^c

^aFor a discussion of the relative merits of alternative instruments, see Perman, Ma, and McGilvray, “Pollution Control Policy,” in Natural Resource and Environmental Economics (Addison Wesley Longman, 1996).

^bL.H. Goulder, I.W.H Parry, and D. Burtraw, “Revenue-Raising Versus Other Approaches to Environmental Protection: The Critical Significance of Pre-existing Tax Distortions,” RAND Journal of Economics, Vol. 28. (Winter 1997), pp. 708-731.

^cSee also Energy Information Administration (EIA), Impacts of the Kyoto Protocol on U.S. Energy Markets and Economic Activity, SR/OIAF/98-03 (Washington, DC, October 1998), Chapter 6, “Assessment of Economic Impacts” and EIA, Analysis of Strategies for Reducing Multiple Emissions from Electric Power Plants: Sulfur Dioxide, Nitrogen Oxides, Carbon Dioxide, and Mercury and a Renewable Portfolio Standard, SR/OIAF/2001-03 (Washington, DC, July 2001), Chapter 4, “Fuel Market and Macroeconomic Impacts.”