How to Love the One You’re With : Changing Tax Policy to Fit Cap-and-Trade

Recognizing that a federal cap-and-trade program will affect the tax system both directly and indirectly, this paper will consider how the direct and indirect tax issues should be resolved. Direct tax issues include how emissions credits should be treated, the tax consequences of the receipt of emission allowances, and the tax consequences of the sale of emission allowances. A cap-and-trade system will affect the tax system in two broad indirect ways: 1) it will alter the effectiveness of energy tax incentives contained in the tax system under current law, and 2) the additional costs imposed by a cap-and-trade program will fall disproportionately on low-income taxpayers. The regressive impact of cap-and-trade could be resolved in a number of ways, which may include changing the tax system. The resolution of tax issues should maintain the environmental effectiveness of the cap-and-trade program without increasing the complexity of the tax system. The ideal solution would mitigate climate change while improving the clarity and transparency of the tax system.This paper will begin with an introduction of climate change issues, including a brief history of international mitigation efforts. The next section will give an overview of cap-and-trade systems and describe how a typical cap-and-trade system would interact with the current federal income tax system. The discussion of the interaction of cap-and-trade with the income tax will include both direct and indirect effects. This section will then compare those effects with the potential impact of a carbon tax. The direct impacts of cap-and-trade on the income tax system occur because the “trade” part of cap-and-trade creates a new financial instrument that needs to be accounted for within the tax system. A carbon tax would not create a new financial instrument. Both a carbon tax and a cap-and-trade system could cause international trade issues that could affect the income tax system. Both a carbon tax and a cap-and-trade system, by placing an additional cost on energy-intensive products, could alter the effectiveness of existing energy tax incentives and place a disproportionate burden on low-income populations