Climate Change Policy, the Federal Budget Surplus,
and U.S. Economic Growth

American Council for Capital Formation
September 1999
By Margo Thorning

Summary

The ACCF Center for Policy Research prepared this Special Report for the Centre for Global Energy Studies/Oil and Gas Journal Joint Conference held September 9-10, 1999, to help focus attention on the impact of near-term CO₂ emission reductions on economic growth and projected federal budget surpluses as policymakers attempt to reconcile fiscal and environmental goals. The report suggests cost-effective strategies which could lead to eventual stabilization of the carbon concentration in the atmosphere, if growing scientific understanding indicates such a policy is needed.

Introduction

The Kyoto Protocol to the United Nations Framework Convention on Climate Change, which the United States negotiated in December, 1997, calls for industrial economies such as the United States, Canada, Europe, and Japan (called Annex I or Annex B countries) to reduce their collective emissions of six greenhouse gases by an average of 5.2 percent from 1990 levels by 2008-2012. The U.S. target is a 7 percent reduction from 1990 levels; this amounts to a projected 550 million metric ton cutback in CO₂ emissions relative to the projected amount in 2010. U.S. Department of Energy estimates show that U.S. emissions will be 40 percent above the Kyoto target by 2010. The emissions cap will, in effect, ration the use of energy in the United States and will require very large taxes, either directly or indirectly through the purchase of "permits," to restrain the demand for energy. Many experts believe that the Kyoto Protocol (or "backdoor" implementation of the agreement through regulatory policies) would have potentially serious consequences for all Americans, and that these consequences have not been fully analyzed and understood.

This Special Report is based on ACCF's testimony before the Senate Committee on Energy and Natural Resources on March 25, 1999, as well as studies sponsored by the ACCF Center for Policy Research. Summaries of the studies are available at the ACCF/ACCF Center for Policy Research Web site; complete versions are included in the Center's new book, Climate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality (1999), available from the Center.

Four key issues for U.S. climate policy are addressed in this Special Report:

• The impact of CO₂ reductions on U.S. economic growth and the projected federal budget surplus;
• The Administration (Council of Economic Advisers [CEA])'s economic analysis of the Kyoto Protocol;
• Tax policy to encourage voluntary action to reduce CO₂ emissions; and
• Strategies for the future.

Macroeconomic Effects of CO₂ Emission Reductions

A wide range of models predict that reducing U.S. CO₂ emissions to either the Kyoto target (7 percent below 1990 emission levels) or even 1990 levels (President Clinton's pre-Kyoto target) would reduce U.S. GDP growth significantly. Research conducted over the past decade for the ACCF Center for Policy Research by top climate change scholars such as Professor Gary W. Yohe of Wesleyan University, Dr. Lawrence M. Horwitz of Primark Decision Economics, Senior Vice President Mary H. Novak of WEFA, Inc., Professor Richard Schmalensee of the Massachusetts Institute of Technology, Professor Alan S. Manne of Stanford University, Dr. Richard Richels of EPRI, Dr. W. David Montgomery of Charles River Associates (CRA), Dr. Joyce Brinner of Standard & Poor's DRI (DRI), and others, concludes that the cost of reducing CO₂ emissions in the near term would impose a heavy burden on U.S. households, industry, and agriculture. In addition, the projected federal budget surpluses, which many hope will fund a more secure retirement for the baby boom generation, are imperiled by slow growth in GDP stemming from CO₂ emission reductions.

These studies, as well as the U.S. Department of Energy's Energy Information Administration (EIA) report released in October, 1998, stand in sharp contrast to the optimistic projections contained in the Administration's economic analysis prepared by the CEA, released in July, 1998.

As CO₂ emissions are reduced, economic growth would slow due to lost output as new new energy taxes are imposed and prices rise for carbon-intensive goods-goods that must be produced using less carbon and/or more expensive processes.

In dollar terms, estimates show that near-term reduction to the Kyoto Protocol target of 7 percent below 1990 levels would reduce U.S. GDP by about 1 percent to over 4 percent annually (see Figure 1). This translates into annual losses of $100 billion to almost $400 billion (in inflation-adjusted dollars) in GDP each year compared to the baseline forecast for energy use. Starting earlier to reduce CO₂ emissions (in 2000 rather than 2005) only worsens the overall impact, according to an EIA report released in July, 1999. The EIA results show that the discounted present value of U.S. GDP falls by $1,430 billion 1992 dollars over the 2000-2020 period compared to $1,285 billion under the 2005 start date.

Figure 1	Annual Impact of Reducing U.S. CO2 Emissions on U.S. GDP, 2008-2012 Percent of GDP
Note: These estimates assume emission reductions begin around 2005. Source: Margo Thorning, "The Impact of the Kyoto Protocol on U.S. Economic Growth and Projected Budget Surpluses," testimony before the Senate Committee on Energy and Natural Resources, 25 March 1999, 106th Congress, 1st session.

Impact on Federal Budget Surplus

In light of the current debate about how to use the projected federal budget surpluses, policymakers need to consider the potentially large negative impact on GDP growth and federal budget receipts of proposals that address the potential threat of global warming by requiring sharp, near-term cutbacks in CO₂ emissions. A report by the Congressional Budget Office (CBO) shows that if economic growth slows relative to the baseline forecast and GDP were 4 percent lower in 2009, the projected on-budget (excluding Social Security contributions) surplus virtually disappears, dropping from $178 billion to only $18 billion (see Figure 2). Similarly, if GDP falls by 3 percent, the surplus declines to $58 billion in 2009 (2009 is the last year of the current CBO forecast). Therefore, implementation of the Kyoto Protocol would make it much more difficult to sustain tax cuts, "save" Social Security, promote the retirement security of the baby boom generation, or achieve other public policy goals, and could require sharp changes in fiscal policy in order to avoid deficit spending.

Figure 2	Reduction in Federal On-Budget Surplus in 2009 Due to Lower GDP Caused by CO2 Emission Reductions Dollars in billions
Note: "On-budget" surplus excludes Social Security and postal service contributions. Calculations based on "The Economic and Budget Outlook: An Update," Congressional Budget Office, July 1.

Impact of International Emission Trading

International trading of emissions permits would reduce the cost of near-term reductions considerably, although experts agree that full global trading (involving developing countries such as China and India) is unlikely in the near term and that many complexities remain. Even if developing countries agree to participate fully, two major obstacles to developing a trading system would remain: allocating CO₂ emissions rights and distributing the revenue (Ellerman 1999). In addition, both developed and developing countries may find it difficult, if not impossible, to sell CO₂ emissions credits because of energy's vital role in economic growth. The costs of tradable permits to emit a ton of carbon are another measure of the burden that near-term emissions reduction would place on the U.S. economy. These costs-in effect taxes-which vary depending upon how much trading takes place, range from about $120 per metric ton to $348 per metric ton for reducing emissions to 7 percent below 1990 levels. The Administration (CEA)'s estimated tradable permit price, which assumes full global trading, is only $14 per ton. (Note that the Administration contemplates further reductions beyond the Kyoto target.)

Impact on Wage Growth and Consumers

U.S. consumers suffer declines in wage growth and the distribution of income worsens under CO₂ stabilization policies. Professor Yohe estimates that reducing emissions to 1990 levels (President Clinton's pre-Kyoto target) would reduce wage growth by 5 to 10 percent annually, and the lowest quintile of the population would see its share of the economic "pie" shrink by about 10 percent (Yohe 1997). Texas A&M University professor John Moroney estimates that U.S. living standards would fall by 15 percent under the Kyoto Protocol compared to the base case energy forecast (Moroney 1999).

U.S. households also face much higher prices for energy under near-term stabilization. A range of estimates by various experts concludes that prices for gasoline would rise from almost 30 percent to over 50 percent and that electricity prices would go up by anywhere from 50 percent over 80 percent (see Figure 3). The Administration (CEA) predictions (a 2.7 percent increase in gasoline prices and 3.4 percent higher prices for electricity) are far below those of widely respected climate policy modelers.

Figure 3	Annual U.S. Household Energy Costs: Impact of Reducing CO2 Emissions, 2008-2012 Percent change from base case
Source: Margo Thorning, "The Impact of the Kyoto Protocol on U.S. Economic Growth and Projected Budget Surpluses," testimony before the Senate Committee on Energy and Natural Resources, 25 March 1999, 106th Congress, 1st session.

Competitiveness for Industry and Agriculture

U.S. competitiveness also declines under near-term stabilization policies. Professor Manne and Dr. Richels analyzed this question, and their model results suggest that the Kyoto Protocol could lead to serious competitive problems for energy-intensive sector (EIS) producers in the United States. Meeting the emissions targets in the Protocol would lead to significant reductions in output and employment among EIS producers, and there would be offsetting increases in countries with low energy costs. U.S. output of energy-intensive products such as autos, steel, paper, and chemicals could be 15 percent less than under the reference case by 2020 (Manne and Richels 1999). In contrast, countries such as China, India, and Mexico would increase their output of energy-intensive products. In its present form, the Protocol could lead to acrimonious conflicts between those who advocate free international trade and those who advocate a low-carbon environment, Professor Manne and Dr. Richels conclude.

U.S. agriculture would also lose competitiveness if the United States were to comply with the Kyoto Protocol. A study based on the DRI model by Terry Francl of the American Farm Bureau Federation, Richard Nadler of K.C. Jones Monthly, and Joseph Bast of the Heartland Institute (FNB) predicts that implementation of the Protocol would cause higher fuel oil, motor oil, fertilizer, and other farm operating costs (Francl, Nadler, and Bast 1999, Table 2, 188). This would mean higher consumer food prices and greater demand for public assistance with higher costs. In addition, by increasing the energy costs of farm production in America while leaving them unchanged in developing countries, the Kyoto Protocol would cause U.S. food exports to decline and imports to rise. Reduced efficiency of the world food system could add to a political backlash against free trade policies at home and abroad. Further, the higher energy costs, notes the FNB analysis, together with the reduced domestic and export demand, could lead to a very severe decline in investment in agriculture and a sharp increase in farm consolidation. Small farm numbers likely would decline much more rapidly than under baseline conditions, while investment even in larger commercial farms likely would stagnate or decline.

The FNB analysis, which concludes that U.S. agriculture would be adversely affected by the Kyoto Protocol, stands in sharp contrast to the May, 1999, report by the U.S. Department of Agriculture (USDA), which finds that the Kyoto Protocol would have "relatively modest" impacts on U.S. agriculture.

The USDA report is seriously flawed for two reasons, according to a new analysis by Mr. Francl. First, the USDA report relies on the unrealistic assumptions about the impact of the Kyoto Protocol on energy prices contained in the Administration's 1998 CEA analysis (see discussion below). Second, the USDA report makes the heroic assumption that U.S. farmers will have unrestricted access to carbon credit trading (Francl 1999).

Flaws in the Administration (CEA)'s Economic Analysis of the Kyoto Protocol

The Administration's July, 1998, economic analysis of the impact of reducing CO₂ emissions to 7 percent below 1990 levels, prepared by the CEA, is seriously flawed for three reasons.

First, the Administration (CEA)'s cost estimates assume full global trading in tradable emissions permits (including trading with China and India). Most top climate policy experts conclude that this assumption is extremely unrealistic since the Protocol does not require developing nations (who will be responsible for most of the growth in future CO₂ emissions, see Figure 4) to reduce their emissions, and many have stated that they will not do so. Second, the Administration (CEA)'s cost estimates assume that an international CO₂ emissions trading system can be developed and operating by 2008-2012. This assumption is unrealistic, according to Professor Ellerman (1999)'s analysis. Third, the cost estimates are based on the Second Generation Model (SGM) developed by Pacific Northwest National Laboratory. The SGM appears to assume costless, instantaneous adjustments in all markets; the model is not appropriate for analyzing the Protocol's near-term economic impacts, according to CRA's Dr. Montgomery (1999). As Massachusetts Institute of Technology professor Henry Jacoby observes, there are no short-term technical changes that would significantly lower U.S. carbon emissions (Jacoby 1999).

Figure 4	Global Carbon Emissions: Reference Case
Source: Alan S. Manne and Richard G. Richels, "The Kyoto Protocol: A Cost-Effective Strategy for Meeting Environmental Objectives?" in Climate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality (Washington, D.C.: American Council for Capital Formation Center for Policy Research, 1999), pp. 3-23.

Tax Policy to Encourage Voluntary Action to Reduce CO₂ Emissions

Current U.S. tax policy treats capital formation, including investments that increase energy efficiency and reduce pollution, harshly compared to other industrialized countries and to our own recent past. For example, before the 1986 Tax Reform Act (TRA '86), the United States had one of the best capital cost recovery systems in the world.

Under the strongly pro-investment tax regime in effect from 1981 to 1985, the present value of cost recovery allowances for wastewater treatment facilities used in pulp and paper production was approximately 100 percent (meaning that the deductions were the equivalent of an immediate write-off of the entire cost of the equipment), according to analysis by Arthur Andersen LLP.

Under TRA '86, the present value for wastewater treatment facilities fell to 81 percent, dropping the U.S. capital cost recovery system to near the bottom of an eight-country international survey (see Table 1). Allowances for scrubbers used in the production of electricity were 90 percent before TRA '86; the present value fell to 55 percent after TRA '86. As is true in the case of productive equipment, both the loss of the investment tax credit and the lengthening of depreciable lives enacted in TRA '86 raised effective tax rates on new investment in pollution control and energy-efficient equipment. Slower capital cost recovery means that equipment embodying new technology and energy efficiency will not be put in place as rapidly as it would under a more favorable tax code. A variety of tax incentives such as partial expensing, accelerated depreciation, tax-exempt bond financing, or more generous loss carrybacks that reduce the cost of capital for voluntary efforts to reduce greenhouse gas emissions could be more effective than the "credit for early action" regulatory framework proposal currently before Congress.

Table 1	International Comparison of the Present Value of Pollution Control Equipment As a percent of cost
	Wastewater Treatment for Chemical Production	Wastewater Treatment for Pulp and Paper Equipment	Scrubbers Used In Electricity Plants
United States
1985 Law	100.1	100.1	89.7
MACRS1	85.2	80.8	54.5
AMT2	83.0	78.0	54.5
Brazil	74.7	74.7	79.4
Canada	85.3	85.3	85.3
Germany	71.8	69.7	68.9
Japan	84.6	83.7	82.4
Korea (w/3% ITC)	95.2	93.9	92.2
Singapore	91.7	91.7	91.7
Taiwan	147.0	147.0	147.0
Notes: 1. MACRS = Modified Accelerated Cost Recovery System (current law) for regular taxpayers. 2. AMT = Alternative minimum tax (current law, Taxpayer Relief Act of 1997). Source: Stephen R. Corrick and Gerald M. Godshaw, "AMT Depreciation: How Bad Is Bad?" in Economic Effects of the Corporate Alternative Minimum Tax (Washington, D.C.: American Council for Capital Formation Center for Policy Research, September 1991). Updated by Arthur Andersen LLP, Office of Federal Tax Services, Washington, D.C., January 1998.

Strategies for the Future

If, as knowledge of climate systems increases, policy changes to reduce CO₂ emissions become necessary, these changes should be implemented in a way that minimizes damage to the U.S. economy. Above all, experts agree that voluntary measures clearly and cost-effectively reduce the growth in greenhouse gas emissions, as the U.S. Second National Communication to the Framework Convention on Climate Change noted in 1997. Modifications to U.S. tax policy that reduce the cost of capital for energy-efficient investment should be part of the voluntary measures.

Reducing global CO₂ emissions should be a gradual process, according to Pacific Northwest National Laboratory's Dr. Jae Edmonds, Mr. James Dooley, and Mr. Marshall Wise (1997). Moreover, a new study by Dr. Edmonds, Mr. Dooley, and Dr. Sonny Kim (1999) concludes that the introduction of carbon capture and sequestration from central power facilities, the introduction of hydrogen fuel cells as an option for both power generation and transport, sequestration of carbon in the soil, and afforestation and reforestation would enable the economy to rely less heavily on carbon-neutral technologies such as commercial biomass harvesting and solar power (which are at an early stage in their technological development) to achieve a particular concentration level. For example, carbon sequestration at power plants and fuel cell use for electric power generation and transportation could cut the present discounted cost of satisfying the 550 parts per million by volume constraint by more than 60 percent.

Conclusion

In short, the consensus of these noted climate policy scholars is clear. Given the need to maintain strong U.S. economic growth to address such challenges as a growing population, "saving" Social Security, the retirement of the baby boom generation, and a persistent trade deficit, policymakers need to weigh carefully the Kyoto Protocol's negative economic impacts and its failure to engage developing nations in meaningful action. Adopting a thoughtfully timed climate change policy-based on accurate science, improved climate models, global participation, and new technology-is essential, both to U.S. and global economic growth and to eventual stabilization of the carbon concentration in the atmosphere, if growing scientific understanding indicates such a policy is needed.  

References

Climate Action Report. 1997. Second national communication submitted to the Framework Convention on Climate Change by the United States. Wash., D.C.: Department of State.

Congressional Budget Office. 1999. The Economic and Budget Outlook: Fiscal Year 2000-2009. January.

Corrick, Stephen R. and Gerald M. Godshaw. 1991. AMT Depreciation: How Bad Is Bad? In Economic Effects of the Corporate Alternative Minimum Tax, 2-31. Wash., D.C.: ACCF Center for Policy Research.

Council of Economic Advisers. 1998. The Kyoto Protocol and the President's Policies to Address Climate Change: Administration Economic Analysis. July.

Edmonds, Jae, James Dooley, and Sonny Kim. 1999. Long-Term Energy Technology: Needs and Opportunities for Stabilizing Atmospheric CO₂ Concentrations. In Climate Change Policy: Practical Strategies, 81-107. Wash., D.C.: ACCF Center for Policy Research.

Edmonds, Jae, James Dooley, and Marshall Wise. 1997. Atmospheric Stabilization and the Role of Energy Technology. In Climate Change Policy, Risk Prioritization, and U.S. Economic Growth, 73-94. Wash., D.C.: ACCF Center for Policy Research.

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Jacoby, Henry D. 1999. The Uses and Misuses of Technology Development as a Component of Climate Policy. In Climate Change Policy: Practical Strategies, 151-169. Wash., D.C.: ACCF Center for Policy Research.

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Montgomery, W. David. 1999. Commentary. In Climate Change Policy: Practical Strategies, 141-147. Wash., D.C.: ACCF Center for Policy Research.

Moroney, John R. 1999. Energy, Carbon Dioxide Emissions, and Economic Growth. In Climate Change Policy: Practical Strategies, 41-62. Wash., D.C.: ACCF Center for Policy Research.

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Yohe, Gary W. 1997. Climate Change Policies, the Distribution of Income, and U.S. Living Standards. In Climate Change Policy, Risk Prioritization, and U.S. Economic Growth, 13-54. Wash., D.C.: ACCF Center for Policy Research.