The Taxation of Emissions Permits Distributed for Free as Part of a Carbon Cap-and-Trade Program

Abstract

The Obama administration has proposed a cap-and-trade program to regulate carbon emissions. If the program is adopted, the government will cap carbon emissions at a specified level and require certain firms to surrender emissions permits to cover their emissions. The permits will have significant value, and firms will be able to buy and sell them on a secondary market. The government could raise substantial revenue by auctioning permits, but it seems likely that Congress will instead give away a large share of permits to industries affected by the program.

An important unresolved issue is whether the receipt of carbon permits will trigger federal income tax. One possibility is that the government will follow the rule that currently applies to sulfur dioxide permits created as part of the acid rain cap-and-trade program. Under IRS guidance, firms receiving sulfur dioxide permits can exclude them from income. Because of this exclusion, a firm that holds its permits for use or sale in a future year can defer paying tax, a benefit similar to receiving an interest-free loan from the government.

This article argues that the government should not extend this benefit to firms receiving carbon permits. Instead, carbon permits should be taxed when received. The permits will be valuable assets, and in many cases, giving them to firms will benefit shareholders. Additionally, giving permits away is similar to making a cash grant to recipient firms. If a grant is bad policy, then taxing the grant may be desirable because it reduces the government's net cost. Similarly, because, as the article argues, it is difficult to justify giving away carbon permits in the first place, taxing the permits makes sense. It will allow the government to capture at least a portion of permit value for other uses, e.g., deficit reduction.

Keywords: cap-and-trade, emissions permits, climate change, tax, global warming, transition policy