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Executive Summary

Effects of Environmental Tax Shifting on U.S. Capital Formation

February 2000
By William Gale And Kevin Hassett

Introduction

In the "Effects of Environmental Tax Shifting on U.S. Capital Formation," William Gale and Kevin Hassett explore the effects of an energy tax on the total capital stock in the U.S. In addition, they show that use of revenue from the energy tax to fund an economy-wide investment tax credit can probably blunt any negative effects on the macro-economy and actually increase capital stock in the long-run. And this could mean higher wages for workers since more capital (e.g., machines per worker often increases worker productivity).

This paper demonstrates that policies to control climate change can be compatible with a healthy economy, if they are designed appropriately. The distribution of benefits and costs among businesses, however, is not fully addressed in this paper, and is an important political consideration that a future paper building on this one will attempt to address.

Methodology

Using data from the National Bureau of Economic Research Manufacturing Productivity database, Gale and Hassett empirically analyze the effect of an energy price increase on U.S. business investment in equipment and structures. Macro-economic models are used extensively to consider the possible impact of various policies. So long as the future is not too different from the past, the models provide useful insights about the type of and general magnitude of macroeconomic responses to public policy.

Gale and Hassett show that use of revenue from the energy tax to fund an economy-wide investment tax credit (ITC) can probably blunt any negative effects on the macro-economy and actually increase capital stock in the long-run. And this could mean higher wages for workers....

The vector auto-regression (VAR) model Gale and Hassett construct uses historical data to project the response of the economy to a change in one or more of the parameters in the model (e.g., the price of energy, or the cost of capital). First they analyze the impact of an energy tax alone. Then they estimate the impact of an energy tax combined with recycling of 100% of the energy tax revenues through a uniform investment tax credit for structures and equipment in the U.S.

Findings

The authors find that energy taxes alone decrease annual investment initially, then increase annual investment for a few years, after which annual investment returns to about the level that would have occurred without an energy tax. Total capital stock, however, is lower after the full adjustment to the energy price increase than it would have been without an energy price increase. The reason for this pattern, Gale and Hassett suggest, is that capital investments and energy are complementary in the short run, but substitutes in the longer run. When energy prices rise, investments in energy-using machinery are deferred while the business owner evaluates whether to invest in energy efficiency or other types of machinery, or decides that the energy price increase is temporary. If the energy price increase appears to be permanent, the business eventually invests in replacement equipment at an even faster rate than if energy prices had stayed constant. This causes a temporary increase in annual investment for a few years (after an initial dip) as businesses retool.

Because increased capital accumulation is associated with increased productivity and total output, a carbon tax or auctioned carbon permits, coupled with the right form of revenue recycling, could exert a positive influence on the macro-economy and on wages through a long term increase in capital stock per worker.

This pattern easily makes sense when the increase in energy prices is unexpected. If an increase in energy prices is expected, however, the surge in retooling might occur before or even simultaneous with the actual increase in energy prices. If an investment tax credit (or other policy to reduce the cost of capital) is implemented simultaneously with the unexpected energy price increase, the VAR model shows the same pattern, but with a much smaller decrease in annual investment initially, a much faster recovery from the "dip" in annual investment, and a higher overall capital stock after the economy has fully adjusted. This is because an investment tax credit effectively decreases the cost of purchasing equipment or structures. The incentive effect of the investment tax credit creates an increase in investment that might offset the decrease from higher energy prices.

Gale and Hassett also examine the effects on investment and savings of using energy tax revenues to reduce corporate income taxes or to reduce payroll taxes. They conclude that neither of these, nor the investment tax credit, is likely to significantly affect personal savings rates. The authors instead suggest that using energy tax revenues to pay down the national debt is the surest way to raise national savings. This is because each dollar used to reduce the national debt by definition improves national savings by one dollar. Other methods that return money directly to individuals would only increase national savings insofar as those individuals choose to save the money.

Gale and Hassett also conclude that corporate income tax reductions would be less effective at increasing capital stock than investment tax credits because the benefits of corporate income tax cuts are spread across the returns on already existing capital and on new investment, whereas the benefits of an investment tax credit are concentrated solely on new investment.

Because increased capital accumulation is associated with increased productivity and total output, a carbon tax or auctioned carbon permits, coupled with the right form of revenue recycling, could exert a positive influence on the macro-economy and on wages through a long term increase in capital stock per worker. Gale and Hassett's work supports the opinion of over 2,500 economists in the "Economists' Statement on Climate Change" that policy action to control climate change can actually strengthen the economy as a whole. That is, the historical pattern of lower investment following increases in energy prices can probably be overcome with carefully designed revenue recycling policies.

Note: Executive Summary prepared by Brian Parkinson and Gary Wolff.

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