Carbon Taxes Are Even Better than You Think

Executive summary

The Carbon Washington carbon tax proposal is revenue neutral, with about 70% of the carbon tax revenue going to reduce the state sales tax by a full percentage point and the remaining revenue divided between reductions in manufacturing taxes and funding for the Working Families Rebate, a state-level bump-up of the federal Earned Income Tax Credit.

Household impacts will vary by household (see the carbon tax swap calculator for detailed estimates) but in aggregate the carbon tax and the sales tax reduction will roughly offset each other for each income quintile, with most households paying a few hundred dollars a year more for fossil fuels and a few hundred dollars a year less for everything else. The dominant impact on social justice will therefore come from the Working Families Rebate, which at 25% of the federal EITC will provide up to $1500 a year for 400,000 low- and middle-income working families in Washington State.

Thanks to the sales tax reduction and the Working Families Rebate, passing the Carbon Washington revenue-neutral carbon tax proposal will be the biggest improvement to the progressivity of the Washington State tax system since the 1977 ballot measure that exempted groceries from the sales tax.

 

Introduction

There are three ways that climate policy affects social justice. The first, not surprisingly, is as climate policy: everyone seems to agree that global warming will hit the poor harder than the rich, so there is a social justice benefit to reducing carbon emissions. A carbon tax is a great way to do this, as described in my previous posts: “Carbon taxes are better than you think (Part I: Transportation)” and “Carbon taxes are even better than you think (Part II: Electricity)”.

By reducing fossil fuel consumption, a carbon tax will also provide co-benefits by reducing emissions of local air pollutants like particulate matter and sulfur dioxide; these co-benefits will be especially valuable for the low-income communities and communities of color who are disproportionately affected by local air pollution hot spots. These co-benefits are the second way that climate policy affects social justice.

The third way that climate policy affects social justice is as fiscal policy. This is especially easy to see in the case of Carbon Washington’s carbon tax swap, a revenue-neutral approach that uses carbon tax revenues to reduce the state sales tax, fund the Working Families Rebate, and effectively eliminate the B&O business tax for manufacturing.

Before diving into the policy, however, let’s provide an overview of state and local tax systems.

 

State and local tax systems

The Institute for Taxation and Economic Policy (ITEP) has a terrific website that describes the state and local tax systems in all fifty states, including a graphical depiction of the percentage of income that different income groups pay in state and local taxes. This depiction includes the bottom four income quintiles (the lowest 20%, the second-lowest 20%, the middle 20%, and the fourth 20%) and a division of the top income quintile into three subgroups, ending with the richest 1%.

The next four graphs show the ITEP results for Oregon, Idaho, California, and Washington State. The first three all have fairly flat tax systems, meaning that households across the income spectrum pay about the same percentage of their income in state and local taxes.

Washington State has the dubious distinction of having the most regressive state and local tax system in the nation, but the ITEP graphs for Tennessee and Florida look fairly similar. What all three states have in common is a heavy reliance on sales taxes and the absence of a state income tax.

This combination almost inevitably produces a regressive state and local tax structure. Without an income tax, the share of income that high earners pay in taxes is likely to remain relatively low because they allocate relatively more of their income to savings, services, out-of-state spending, and other areas that are not subject to sales taxes in their home jurisdiction. It follows that a carbon tax—which is more like a sales tax than an income tax—is unlikely to alter the fundamental structure of the Washington State tax system.

It is, however, possible to use carbon tax revenues to reduce the tax burden on the lowest income households in Washington State, and this is what the Carbon Washington policy does by reducing the state sales tax and funding the Working Families Rebate.

 

Carbon taxes and sales tax reductions roughly offset each other

The first way our policy addresses financial impacts on low-income households (and more generally on households and businesses across the state) is by reducing the state sales tax. Cutting the state sales tax by a full point reduces the burden of sales taxes by 10-15 percent, depending on how you count it. (The state sales tax is currently 6.5 percent, but local sales taxes bring the current total up towards 10 percent in many areas of the state. If you focus on the state rate, a reduction to 5.5 percent is a savings of 15.4 percent; if you focus on the total state-plus-local rate, the percentage reduction depends on the specific local rate, but a reduction from the Seattle total of 9.5 percent to 8.5 percent is a savings of 10.5 percent.)

Sales taxes are of course regressive—lower-income households pay more as a percentage of their income because they spend more of their income on items that are subject to sales tax—so reducing the sales tax is a good way to make a carbon tax swap more progressive. (Whether or not carbon taxes are themselves regressive is a matter of some debate among economists, with one of the key questions being whether you should focus on current income or on lifetime income; see here for some details.)

To a first approximation, the household impact of the carbon tax and the sales tax reduction offset each other: most households will pay a few hundred dollars a year more for fossil fuels and a few hundred dollars a year less for everything else. The exact details will of course vary from household to household (see the carbon tax swap calculator to evaluate the impacts on your household) but for aggregate results we can use the Consumer Expenditure Survey and data from the EIA (natural gas prices, retail gasoline prices, home heating oil prices, and electricity prices) to estimate that carbon tax payments for various income quintiles are roughly in line with the sales tax savings estimated from the carbon tax swap calculator: about $100 a year for the lowest income quintile, about $200 a year for the second-lowest income quintile, and about $250, $300, and $450 a year, respectively, for the higher income quintiles.

Source: Based on the 2002 Tax Structure Study Report.

 

Assuming that the carbon tax and the sales tax reduction offset each other, we can focus on the Working Families Rebate. Stated simply, the conclusion of our analysis is this: Passing the Carbon Washington revenue-neutral carbon tax proposal will be the biggest improvement to the progressivity of the Washington State tax system since the 1977 ballot measure that exempted groceries from the sales tax. (See pp18-21 of the state’s Tax Reference Manual 2010 for a history of tax changes in the state.)

 

The Working Families Rebate

The largest anti-poverty program in the United States is the federal Earned Income Tax Credit. The federal EITC is a refundable tax credit that benefits low-income working households by providing a percentage match of earned income up to a certain level. (See figure below, and note that “refundable” means that households receive a check if their tax due is less than the amount of the credit.) The EITC provides a maximum credit of $496 for households without children, $3,305 for households with 1 child, $5,460 for households with 2 children, and $6,143 for households with 3 or more children.

Source: Tax Policy Center.

 

Twenty-five states (and New York City and Washington, DC) provide local bump-ups of the federal EITC; for example, low-income households in Kansas receive from the state government a refundable state income tax credit equal to 17% of their federal EITC. The bump-up rates range from 3.5% of the federal EITC to 50% of the federal EITC.

Washington State has no income tax, but in 2008 the state government created a “sales tax exemption” for working families that equals 10% of the federal EITC. This Working Families Tax Exemption—a.k.a. Working Families Rebate—currently exists in state law as RCW 82.08.0206, but it has never been funded. (For even more details see the great work of the Washington Budget & Policy Center, but note that they’re assuming a bump-up of 10 percent of the federal EITC, while our policy provides a bump-up of 15 percent in year 1 and 25 percent thereafter.)

A 25% Working Families Rebate provides up to $1500 a year for 400,000 working families in Washington State. The impact is greatest for households with children and least for households without children and (obviously) households without earned income. The following graphics show that the Working Families Rebate has a significant impact on the state and local tax structure in Washington State for many (albeit not all) low-income households. (The red numbers in parentheses show the tax savings for a household with the average income for each ITEP income quintile.)

The graphics show that a 25% Working Families Rebate would have a tremendous impact on low-income households with children. In fact, funding the Working Families Rebate at a 25% level would provide the greatest improvement to the progressivity of the Washington State tax system since the sales tax exemption on groceries was passed at the ballot in 1977.

We can use the Consumer Expenditure Survey for a more in-depth comparison of the Working Families Rebate and the sales tax exemption on groceries. Households in the lowest income quintile spend an average of $2500 on groceries, so a 9.5% sales tax exemption amounts to $240 per household, or about $120 million for the approximately 520,000 households in this income quintile in Washington State. Households in the second-lowest income quintile spend an average of $3200 on groceries, so a 9.5% sales tax exemption amounts to $300 per household, or about $150 million for the approximately 520,000 households in this income quintile in Washington State. Total savings for households in the lowest two income quintiles therefore total $270 million a year.

Our 25% Working Families Rebate totals about $200 million a year, which is comparable to (albeit somewhat lower than) the total for the sales tax exemption for groceries.

One major difference is that the sales tax exemption for groceries was not revenue-neutral: it reduced state General Fund revenues. The carbon tax swap is intended to be revenue-neutral, with the carbon tax revenues offsetting the sales tax reduction, the Working Families Rebate, and the reduction in business taxes for manufacturing.

Another major difference is that the sales tax exemption for groceries is likely to provide roughly equal benefits to all households in a given income quintile. In contrast, the Working Families Rebate concentrates benefits on households with earned income and on households with children. (According to the Census Bureau, about 55% of people in poverty are in households with children.) The minimum Working Families Rebate is $100 a year, so qualifying households with children will receive a Working Families Rebate of between $100 and $1500. In contrast, qualifying households without children will receive a much smaller Working Families Rebate—the maximum is only $125—and of course households do not qualify for the Working Families Rebate if they don’t have earned income or otherwise don’t qualify for the federal Earned Income Tax Credit. These households will receive sales tax reductions that are likely to offset their carbon tax liabilities, and they will benefit from the climate policy impacts of the Carbon Washington proposal, but the main fiscal policy benefits will accrue to households with children.