May 13, 2008
HOW CBO ESTIMATES THE COST OF CLIMATE-CHANGE LEGISLATION
Explaining the "25 Percent Offset"
By Chad Stone, James Horney, and Robert Greenstein
When the Congressional
Budget Office prepares cost estimates for climate-change legislation, those
estimates reflect what is known as a “25-percent income and payroll tax
offset.” As a result of this offset, the net revenue estimated to be
generated by an auction of emissions allowances under a cap-and-trade program or
by a carbon tax is 25 percent smaller than the estimated gross proceeds
from the auction or carbon tax alone.
This offset arises because, consistent with longstanding cost-estimating
procedures, CBO assumes that the overall amount of revenue the federal
government receives from income and payroll taxes will decline by an amount
equal to 25 percent of the proceeds it gets from auctioning emissions allowances
or imposing a carbon tax.
This paper explains why
the Congressional Budget Office “scores” climate-change legislation in this
manner. Before doing so, we note several key implications that the 25-percent
offset holds for the design of climate-change legislation, including S. 2191,
the cap-and-trade bill sponsored by Senators Joseph Lieberman (I-Ct) and John
Warner (R-Va) and reported by the Senate Environment and Public Works Committee
in December 2007.
In a CBO cost estimate, spending any
more than 75 percent of the proceeds from federal auctions of emissions
allowances (or a carbon tax) will add to the budget deficit and violate
Pay-As-You-Go and other budget rules. That is because, for every $100 of
receipts raised from auctioning allowances (or imposing a carbon tax), income
and payroll tax receipts will be estimated to decline by $25, leaving a net of
$75 for deficit-neutral expenditures or tax reductions.
The 25-percent offset cannot be avoided by
giving away allowances for public purposes. CBO has determined that the
25-percent offset applies regardless of whether the government auctions the
allowances and uses the proceeds directly or the government gives the allowances
to utility companies, state governments, or other entities and directs those
entities to use the proceeds for designated public purposes.
The only circumstance in which there
would not be a 25-percent offset is when the allowances are given away in a form
that effectively makes them taxable income to the recipient, such as when
existing emitters are given allowances for free. (“Grandfathering,” as this is
known, increases the profits of the companies receiving the allowances, and
those profits constitute taxable income.)
As originally drafted, the
Lieberman-Warner bill (S. 2191) did not take into account the 25 percent offset
and assumed that the full value of the allowances would be available to finance
the spending the bill contained. As a result, CBO’s cost estimate of S. 2191
showed that the mandatory spending in the bill would exceed the net revenues in
the bill. This would leave the bill open to budget points of order in the
Senate and the House of Representatives.
In response, the bill’s sponsors drafted an
amendment that would: 1) increase the portion of allowances to be auctioned; 2)
reduce the mandatory spending in the bill; 3) deposit a portion of the auction
proceeds into a Climate Change Deficit Reduction Fund; and 4) make spending from
that fund subject to future appropriations legislation. CBO has estimated
that with the proposed amendment, the increase in mandatory spending under the
legislation would be $78.4 billion less than the revenues the legislation would
generate over the 2009-2018 period. Mandatory spending would continue to
be less than net revenues in the years after 2018 as well.
CBO has also reported that
under the bill as the sponsors propose to amend it, $93.4 billion would be
deposited in the climate-change deficit reduction fund and could be tapped for
appropriations bills. Since spending that the legislation makes contingent upon
the enactment of future appropriations legislation is not scored as a
cost of the legislation — it will be scored if and when appropriations bills
that use these funds are enacted — CBO estimates that with the proposed
amendment, S. 2191 would reduce the deficit both over the next ten years and in
years after that. (See the box for an explanation of the difference between
mandatory spending and spending that is subject to appropriations legislation.)
The remainder of this paper explains the
25-percent offset as it applies to climate-change legislation.
Mandatory versus Discretionary Spending
expenditures fall into one of three broad categories:
discretionary spending, mandatory spending, and net interest
payments on the federal debt.
Discretionary spending is subject to, and controlled by, the annual
Mandatory spending, such as spending for Social Security and Medicare, is
not subject to or controlled by that process.
Most spending in the Lieberman-Warner climate bill is mandatory
The 25-percent Income and Payroll Tax Offset
CBO, the Congressional
Joint Committee on Taxation, and the Treasury Department’s Office of Tax
Analysis have long applied an “income and payroll tax offset” when estimating
the revenue effects of changes in excise taxes or equivalent policies. The
offset derives from a longstanding convention used in making budget estimates,
which is that policy changes do not change the total amount of income in the
This estimating convention implies that any additional revenue collected from
imposing an “indirect business charge” (such as a tax on energy or its
equivalent) will come at the expense of wages and profits elsewhere in the
Specifically, to the extent
that the producers of a commodity (like energy) that is subject to an excise tax
or other indirect business charge absorb the charge themselves, their own income
goes down, and they have less money to pay as wages or to take as profits. To
the extent that it is the consumers of the commodity who absorb the
charge rather than the producers, they will have less income to spend on other
goods and services; as a result, incomes — and hence wages and profits — will
fall in the economic sectors where the demand for goods and services declines.
In either case, some taxable wages and profits will be “crowded out” by the
indirect business charge. And since taxable wages and profits will be lower
than they otherwise would be, less income and payroll tax revenue will be
collected. It is this decline in income and payroll tax revenue that
constitutes the “income and payroll tax offset.”
Rather than trying to prepare a complicated
estimate of the exact percentage offset that would result from each individual
legislative proposal that would impose an indirect business charge, the revenue
estimators long ago agreed to apply a standard 25-percent offset to most such
proposals. The Joint Committee on Taxation has explained that, “This
[25-percent] factor may be thought of as an average marginal tax rate on factors
In other words, when cost
estimates of excise tax proposals (or their equivalents) are produced, the
estimates take into account the likelihood that such policies will reduce
taxable income elsewhere in the economy. The net revenue raised by an
excise tax or an equivalent charge is assumed to be 25 percent smaller than the
gross revenue that the excise tax or equivalent charge is expected to raise.
Implications for Climate Change Policy
The implication of the
25-percent income and payroll tax offset for a carbon tax is clear: CBO will
estimate that the net receipts a carbon tax will generate will equal 75 percent
of the gross receipts the tax is expected to raise.
Although it might not be as obvious, CBO applies the same principle to a
cap-and-trade system — and estimates that the net receipts such a system will
generate will equal 75 percent of the gross receipts that are raised by
auctioning emissions allowances.
CBO applies this offset to
a cap-and-trade system as well as to a carbon tax because economists generally
believe that as long as a cap on emissions allowances is binding and limits the
supply of fossil-fuel energy, energy prices will rise and the economic effects
will be comparable to those of a carbon tax. For this reason, the revenue
raised by auctioning emissions allowances is treated by CBO as having the same
effects on income and payroll taxes as a carbon tax would have. CBO
consequently applies the 25-percent offset to the gross receipts from an
auction. In other words, the net government receipts under a cap-and-trade
system will be estimated to equal 75 percent of the gross receipts the auction
is estimated to raise. Thus, if legislation establishing a cap-and-trade system
calls for the use of more than 75 percent of the auction receipts, CBO’s cost
estimate will show that the legislation increases the deficit, and the
legislation will violate various budget rules.
What If Allowances Are Given Away Free?
CBO has concluded that the
25 percent offset should not be applied in the case of allowances that are given
away free to energy companies, without conditions. However, CBO will
apply the offset in the case of allowances that are given free to entities that
are required to use, for designated public purposes, the proceeds they obtain
from selling these allowances.
When existing emitters receive allowances for
free, those companies are, in effect, given the ability to impose the equivalent
of a tax on consumers by raising energy prices, with the companies allowed to
keep the proceeds. However, because the resulting “excess profits” that
the companies secure are taxable, there is no crowding out of taxable income.
In other words, the increased energy prices, operating as the equivalent of an
excise tax, will, under CBO’s cost-estimating convention, lead to lower
wages and profits elsewhere in the economy and hence to a loss of tax revenue.
But the lower revenue from these other economic sectors will be offset by the
higher tax revenues collected from the companies that have been given allowances
for free, since those companies will be taxed on their additional profits.
Since the revenue losses and gains are assumed to balance out overall, there is
no 25-percent offset in this circumstance.
The story is different if
allowances are given away for public purposes, such as in the case of the
allowances that the Lieberman-Warner bill would give to electricity and natural
gas retailers to provide relief to low- and middle-income consumers and
encourage energy efficiency. In this case, even though the government is, in
effect, allowing the recipients of the allowances to collect the equivalent of
an excise tax from the entities to which they sell the allowances, the
government is requiring these recipients to use those proceeds in a particular
way. Hence, the proceeds from the allowances do not represent
additional, taxable company profits. For this reason, the revenue effects
of giving away the allowances for public purposes would be no different from the
revenue effects that would result if the government auctioned the allowances and
used the proceeds to carry out the public purposes itself.
In either case, under the assumptions that CBO and the other revenue estimators
use in estimating the costs of legislation, there would be a 25 percent
offsetting reduction in income and payroll tax revenue.
CBO thus will apply the
25-percent offset to the value of allowances that are given away for public
purposes, just as it will apply the offset to allowances that are auctioned
off. Accordingly, the effect on the budget will be no different whether the
government auctions the allowances and directly expends the resources or gives
the allowances free to other entities to use for public purposes.
Other Ways of Estimating Budget Impacts Likely
Would Yield Similar Results
A cost estimate of
climate-change legislation is different from an analysis of the economic
effects of such legislation. As noted, a longstanding assumption used in
making cost estimates is that tax changes do not have economy-wide macroeconomic
effects. An economic analysis, in contrast, is not bound by that convention.
Economic analyses that CBO (and other institutions) conduct will be separate
from the cost estimates they produce and could well show some changes in the
level of economic activity and overall inflation as a consequence of
climate-change legislation. As a result, in such an analysis, the estimated
“offset” in income and payroll taxes from the imposition of a cap and trade
system (or a carbon tax) could be smaller than 25 percent.
But the overall
impact of climate-change legislation on federal budget deficits would likely be
similar. To the extent that an economic analysis concludes that the overall
level of prices in the economy would change because of higher energy prices,
programs with cost-of-living adjustments such as Social Security, veterans’
benefits, and civil service and military retirement would become more expensive
and the cost of federal purchases of goods and services would increase. The
Congressional Budget Office has estimated, using a different set of approaches
and assumptions than those it uses in producing its official cost estimates,
that the total costs borne by federal and state and local governments as
a result of climate-change legislation — on both the revenue and spending sides
of the budget — would equal roughly 30 percent of the value of the allowances
under a cap-and-trade system (or of the receipts under a carbon tax).
The bottom line is that
climate-change legislation will impose some budgetary costs that will need to be
taken into account when policymakers and stakeholders consider what level of
resources will be available under the legislation to devote to other purposes.
The 25-percent offset that CBO applies is probably a reasonable proxy for the
impact of climate legislation on the federal budget.
There is, however, no comparable automatic recognition of the budgetary effects
that state and local governments will experience. As a result, to avoid driving
states (which are required to balance their budgets each year) into deficit and
forcing state and local governments to cut services or raise taxes, those
governments would need to receive aid from the federal government. Such aid
could be provided by giving a modest share of the allowances to these
None of this alters the
findings of various economic analyses that well-designed climate change policies
are likely to provide significant long-term benefits to the economy and the
public that exceed the policies’ costs. Nor does it change the conclusion that
failure to address climate change could have serious and potentially
catastrophic effects over time. Climate change could reduce standards of living
— and budget receipts — below CBO’s “baseline” estimates, while increasing the
government expenditures needed to address the consequences of those adverse
program and a carbon tax are two alternative ways to achieve cost-effective
reductions in greenhouse gas emissions. For a discussion of their
similarities and differences, see Chad Stone and Matt Fiedler, “The Effects
of Climate-Change Policies on the Federal Budget and the Budgets of
Low-Income Households: An Economic Analysis,” Center on Budget and Policy
Priorities, October 24, 2007,
below, cost estimates of proposed legislation that CBO produces are
different from analyses that CBO may issue on the potential economic impacts
of such legislation.
The higher the
percentage of allowances that is given away free to existing emitters, the
smaller is the percentage that is available for public purposes and the
larger are what CBO has termed the “windfall” profits of the grandfathered
Congressional Budget Office, Budget Estimates: Current Practices and
Alterative Approaches, January 1995.
is composed primarily of the compensation of employees (wages, salaries, and
benefits) and the profits of businesses; income and payroll taxes are
collected from this part of national income. Excise taxes (and tariffs), in
contrast, are collected at the point of production or sale. As a matter of
national income accounting, they are part of the market value of goods and
services produced in the economy and hence are a part of national income.
If excise taxes increase, then the portion of national income remaining for
wages, salaries, benefits, and profits must decrease correspondingly. The
same accounting applies to a carbon tax or the value of an emissions
allowance, whether or not they are strictly regarded as excise taxes.
For most tax
legislation, CBO uses estimates provided by the congressional Joint
Committee on Taxation (JCT) and CBO may consult with JCT on non-tax
legislation such as cap-and-trade legislation that has indirect tax
effects. For simplicity, this memo attributes all estimates to CBO.
speaking, in producing its cost estimates, CBO records as net revenue an
amount equal to the value of the allowances given away for a public purpose
minus the 25 percent offset. CBO also records the full amount of
these allowances as government outlays or expenditures. This procedure
produces a net cost to the Treasury equal to 25 percent of the value of the
allowances given away for public purposes.
Since the cost
estimating assumption that overall price levels (like other economic
variables) would not change is frequently relaxed in such an economic
analysis, that analysis could find that higher energy prices would raise
overall prices in the economy. In that case, total national income measured
in nominal terms (i.e., before adjusting for inflation) would
increase. Such an increase in nominal income would reduce the offset in the
income and payroll taxes that would occur under CBO’s official cost
estimates (which, as noted, would assume that overall price levels and
national income would not change). But, as the text explains, if the
overall level of prices in the economy goes up, the government’s costs for
various programs will rise. An increase in overall prices also would reduce
tax revenues, relative to what they otherwise would be, because various
features of the federal income tax code are adjusted annually for inflation.
of unchanged macroeconomic conditions that CBO uses in its cost estimates
implies that increased government costs for higher-priced, energy-intensive
spending will be offset by lower costs for lower-priced,
non-energy-intensive spending, so that the entire net impact on the federal
budget comes from the loss of income and payroll tax revenue. If, however,
the overall level of prices in the economy rises, then the reduction in
income and payroll tax revenues will be smaller, but the government will
incur increased costs in other areas, such as for higher cost-of-living
adjustments in Social Security and other programs.
Such aid would
need to be given to states, which in turn could address local government
needs. It would not be practical for the federal government to try to deal
directly with the thousands of local government entities.