How to spur innovation? Tax carbon

Resetting the US economic engine along the lines of open-market sustainability will have outsized positive impacts.

Putting a price on carbon can become ‘a driver of prosperity and innovation’, says Patrick Doherty [GALLO/GETTY]

This is the last in a three-part essay that explores how the United States stands at a historic inflection point. The author argues that the economic engine that carried the nation out of World War II, to then outperform the Soviets, is incapable of meeting the challenge of the 21st century. While the US and some other Western economies are in the throes of a rare and disruptive debt crisis, the global economy is in the midst of three additional challenges: rapid economic inclusion, ecological depletion and a resilience deficit. Though distinct, these crises are inseparable in practical terms, forming a singular strategic test facing the US. Simply put, the post-Cold War international economic system is fundamentally unsustainable. Based on preliminary estimates, a pivot toward open-market sustainability will immediately deliver the certainty investors need to put American labour and capital back to work in the productive economy. Built on the bedrock of demographic demand for a new American dream and a resource productivity revolution, it will put the nation on a path to achieve climate-stabilising carbon reductions and align the American market with rising global demand. Instead of the halting multilateralism of climate change, open-market sustainability provides an opportunity to enhance our security by leading the transition to a sustainable – and prosperous – global economy.

In this concluding chapter, the author focuses on a sustainable tax shift that would generate revenue for government operations from material, energy and natural resource inefficiency and reduce the percentage of revenue that comes from traditional sources in Part Three. If you have missed it, read Part One for an introduction to the three core components of open-market sustainability – smart growth, regenerative agriculture and a tax shift – which individually represent significant gains to prosperity, well-being and sustainability, and Part Two for the need for switching to regenerative agriculture.

Tax shift: From taxing income to taxing inefficiency

In 1942, in order to pay for the war effort, the US government extended the income tax from a high-earner tax to a universal tax on income from labour. In 1950, national security advisers recommended to President Truman that the wartime income tax be continued, based on the experience gleaned in World War II, in which a productive, highly employed economy was able to generate considerable revenue for national defence.

Today, more than 80 per cent of the federal government’s revenue comes from individual income and social insurance taxes, while we subsidise resource consumption, yet another legacy of the inherently industrial strategic challenges of the 20th century. Reversing the relative prices of labour and resources – taxing waste not wages – takes smart growth and regenerative agriculture to the next level, harnessing them to form an innovation juggernaut that can capture the resource productivity prize for the US.

Though important 60 years ago, the universal income tax has created perverse incentives, most importantly, an incentive for businesses to conserve labour and waste resources. Under our present-day system of taxing work and subsidising resource use, total per capita consumption of material in the US rose by 23 per cent from 1975 to 2000.

Today, American material flows are 50 per cent higher than the average of 15 European nations, and unemployment is chronically high. With 675 million people arriving in Asian cities and an additional 3 billion entering the global middle class over the next 20 years, commodity prices will only continue their steep rise, making resource efficiency the key driver of competitive advantage for businesses and nations alike.

US government to extend payroll tax cut

When the relationship between tax and subsidies is as dysfunctional as it is today, the opportunity for a tax shift is clear. With minimal pricing of carbon ($30 per metric tonne of CO2 equivalent) and unsubsidised water, the McKinsey Global Institute estimates that approximately $3.3tn in resource productivity gains are waiting to be harvested by the private sector.

A sustainable tax shift would generate revenue for government operations from material, energy and natural resource inefficiency – or waste – and reduce the percentage of revenue that comes from traditional sources, most especially individual income, payroll taxes and business income from small- to medium-size enterprises. Needless to say, reducing the tax burden on hard-working Americans and job-producing small businesses would likely prove popular politically.

Under open-market sustainability, the approach is to shift the tax base to throughputs and away from income and payrolls. Former World Bank economist Herman Daly wrote, “Shifting the tax base onto throughput induces greater throughput efficiency, and internalises, in a gross, blunt manner the externalities from depletion and pollution.”

Different from either a consumption or value-added tax, throughputs are those resources – oil, minerals, fertilisers or renewable resources like forest products – that are essential material inputs to economic production but not the products themselves.

At a time of domestic recession and low-cost overseas labour competition, reducing the cost of working while supporting small businesses and the entrepreneurs who start them will simultaneously boost employment and innovation. With prices established for keystone resources, prices in the market will reflect our strategic necessity. With a phased and predictable introduction, such a shift will allow the marketplace time to work through which technologies are appropriate, while ensuring that the US leads the way to a resource productivity revolution.

Applied in the context of the simultaneous resets in housing, transportation and agriculture, under the tax shift, families will be assured of higher-efficiency options to reduce their household footprint, workers will enjoy a strong job market, employees will experience the increase in take-home pay, and industry will be powered by a new engine of innovation and investment around resource productivity. Combined with long-needed tax simplification, the package is positioned to win popular and bipartisan support.

“Taxing waste provides the first opportunity to price environmental costs in the economy, ending one of the greatest market failures in human history.”

The tax shift described in the “Innovation Tax Shift” sidebar embraces this long-overdue opportunity, creating a predictable schedule of prices that will allow businesses to plan their own strategies to compete and win. Income taxes are ended for 79 per cent of Americans, who also receive a break on payroll taxes, while the income cap on social security is lifted.

Business income taxation is fixed to encourage the small entrepreneur, with no taxes on firms with less than $5m net business income and a flat tax on all other businesses thereafter. Taxing waste provides the first opportunity to price environmental costs in the economy, ending one of the greatest market failures in human history. Toxic releases, water withdrawals, carbon, forest services and municipal waste all get a starting price that increases over time to push innovators while paying down the national debt.

Innovation tax shift

Reward hard work

  • End the universal income tax: Repeal individual income tax for 79 per cent of earners making under $100,000.
  • Reform social insurance taxes: Reduce FICA taxes on earners making less than $100,000 by 40 per cent; end the cap on income above $106,400.
  • Enact a 25-35-45 wealth tax: End loopholes by taxing adjusted gross income. Then tax incomes of $100,000-499,999 at 25 per cent, $500,000-$2,000,000 at 35 per cent, $2,000,000+ at 45 per cent.

Help businesses succeed

  • Reward entrepreneurs: End taxation of businesses with less than $5 million in net business income.
  • Go flat: Repeal the graduated business tax and replace it with a flat tax of 35 per cent on net business income over $5m.

End perverse subsidies

  • Be consistent: End subsidies for fossil fuels, nuclear, “alternative energy” and fossil water (groundwater that has been sealed in an aquifer for a long period of time).

Internalise ecosystem costs

  • Fix the market failure: Phase in taxes on toxic releases, municipal waste and carbon emissions. Set the starting carbon price at $83, the price at which all carbon-abatement technologies become profitable. Federally price resource use for forest ecosystem services and nonresidential water draws.

Leverage US’ market power

  • Level the playing field: Phase in a price on the embedded inefficiency in imported goods, equivalent to the increased prices set in the domestic US market.
  • Use trade to promote sustainability: Encourage all nations to exercise the World Trade Organisation’s Article XX to advance resource productivity. A cornerstone of the free-trade system overseen by the World Trade Organisation, Article XX allows members to establish a price on imports “to protect human, animal or plant life or health”, or to address threats “relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption”.

Potential impact

Resetting the US economic engine along the lines of open-market sustainability should have outsized positive impacts on jobs, national security, health, innovation and the global ecosystem.

Jobs, jobs, jobs

At the time of writing, approximately 14 million Americans are unemployed and another 11 million underemployed. Open-market sustainability, by resetting the market to build a demand-driven new American Dream, should return American unemployment rates to the 4.9 per cent average of the boom period of the last market reset, from 1950 to 1968.

US companies increase the insourcing of jobs

The last time the US enjoyed this level of unemployment was in April 2008. Using this calculation, we can anticipate an increase in 6.5 million jobs with the current U.S. population, and if we extrapolate to those marginally attached to the labour force, we can estimate a reduction in the underemployed by an additional 5 million.

This level of job creation is conservative, but consistent with other calculations of the level of jobs produced through macro policy changes. Economists Alan Blinder and Mark Zandi estimate that the $1.8tn in fiscal response after the financial crisis of 2008 created 10 million jobs. The Apollo Alliance’s 2008 New Apollo Programme report estimated that $500bn of new spending in the clean tech sector would yield 5 million high-wage jobs.

Actual results will likely be stronger. The tax shift will begin to change the relationship between the price of labour and the price of resources, encouraging businesses to employ more of the former and less of the latter. Furthermore, the three components of the market reset – smart growth, regenerative agriculture and the tax shift – together will activate considerably more private and foreign capital than the Apollo Alliance prescribes in federal largesse.

There is $3.6tn sitting on the sidelines of Wall Street waiting to be invested. If the market reset described here only activated half of that pool, or $1.8tn, a straight-line estimate would give 10-18 million new jobs just from adopting smart growth. Further, the total income returned to taxpayers would amount to slightly more than $1tn, implying another 5 million jobs created, given that the majority of these citizens will spend, not save, that savings.


For the purposes of this exercise, James Hansen’s target of 350 parts per million of atmospheric carbon is the planetary goal. Hansen and his colleagues articulated the broad outline of what it will take to achieve this goal:

A practical global strategy almost surely requires a rising global price on CO2 emissions and phase-out of coal use except for cases where the CO2 is captured and sequestered. The carbon price should eliminate use of unconventional fossil fuels, unless, as is unlikely, the CO2 can be captured. A reward system for improved agricultural and forestry practices that sequester carbon could remove the current CO2 overshoot. With simultaneous policies to reduce non-CO2 greenhouse gases, it appears still feasible to avert catastrophic climate change.

Setting an effective price on carbon in the US first requires executing a market reset that places both the built environment and the agricultural sector on more prosperous and sustainable footing. With the nation reoriented to exploit today’s substantial pool of demand for smart growth, establishing a price on carbon and resource inefficiency generally can become a driver of prosperity and innovation, not a drag on GDP.

“Setting an effective price on carbon in the US first requires executing a market reset that places both the built environment and the agricultural sector on more prosperous and sustainable footing.”

All three components of this strategy, however, will have substantial impacts on our carbon emissions, not just the advent of a carbon price. Smart growth will greatly reduce transportation and building emissions, which together account for 62 per cent of US emissions. The policies articulated here would require metropolitan regions to reduce vehicle miles travelled by 50 per cent while incentivising the construction of green buildings or deep renovation of existing buildings.

While architects such as William McDonough and others demonstrated years ago the ability to produce zero-emitting residential and commercial buildings, the Leadership in Energy and Environmental Design (LEED) criteria have achieved high-end market acceptance of designs that reduce emissions by up to 39 per cent. This would render an off-the-shelf reduction of 1.55 gigatonnes of annual emissions, or approximately 27 per cent of US emissions.

Regenerative agriculture on its own, similarly, could reduce agricultural emissions by 29 per cent over business as usual, according to the latest Rodale Institute findings. Taking biochar to scale, however, has the potential to sequester a full 30 per cent of total US carbon emissions, while accelerating the restoration of soil volume, fertility and water retention and reducing eutrophication of our waterways. Together, the total would be approximately 1.83 gigatonnes of CO2 equivalent, or an additional 33 per cent reduction in US emissions.

The tax shift will do the rest, making markets work for the US’ long-term health. While smart growth and regenerative agriculture policies will act as “pulls” in the market – offering better products to consumers – new waste pricing, led by a carbon price, will act as a push. Pricing municipal waste, toxic releases, forest ecosystem services and non-municipal water draws will reinforce the market reset, driving a new era of innovation for sustainability.

Specifically, the carbon tax would start in the first year with an $83 per metric tonne price on CO2 equivalent and ratchet up $15 each year. This starting price was chosen based on McKinsey Global Institute estimatesthat all carbon-abatement technologies will break even and allow for profitable reductions of the full 38 gigatonnes of carbon emissions.

Texas leads push towards wind-power

At this rate, the average annual family car gas bill would increase $416 and home electricity costs would go up $537. These costs would then be offset with an elimination of income tax on households making less than $100,000 and a nearly 40 per cent reduction in the employee payroll tax for the same group. A family of four living on the median annual income of $50,000 would see a net boost of over $2,200, not to mention an improved employment outlook.

By 2030, carbon reductions attributable to the tax would come in at 3.9 gigatonnes below the business as usual carbon total for that year. Combined with smart growth and regenerative agriculture, we would be well on our way to ensure the US’ contribution to achieve 350 parts per million of atmospheric carbon. With a levelling price on imported goods, these domestic policies will signal to our trading partners the arrival of the post-carbon era and provide a powerful platform for a new era of American leadership.


One of the most exciting findings in recent years came from the Centres for Disease Control and Prevention (CDC). In a 2007 evaluation of smart growth, the CDC stated that individuals living in smart-growth communities would see a dramatic reduction in heart disease, obesity, social isolation and asthma.

Part of this is due to the transition from a car-dependent lifestyle to a walking lifestyle. Furthermore, smart-growth policies, by creating walkable village centres, re-create the economic logic – foot traffic – for small grocers and outdoor markets, along with additional time to acquire and prepare fresh food. Not only would overall health improve, but health-care costs would go down considerably, reducing insurance premiums.

While the human and household impact is primary, the productivity lost to poor health is enormous. Total lost economic output from heart disease and diabetes alone amounts to $385bn per year. In the scheme described here, hypertension would be reduced as diets improve and exercise increases.

Mental disorders due to social isolation, especially critical with aging patients, would diminish as communities are reknit. Cancers, many of which are triggered by exposure to environmental carcinogens, would be reduced as toxic releases fall. Together, these three chronic diseases cost American businesses $722bn in lost output.

“Mental disorders due to social isolation, especially critical with aging patients, would diminish as communities are reknit.”

Smart growth presents a big opportunity for health-care cost containment in what is called team-based care coordination. Pioneered by the Cleveland Clinic, team-based care is an approach where a patient is served by a team of medical professionals who work in the same primary-care location.

Recent experiments in the US have shown that team-based coordination of primary care can reduce hospitalisations of the high-cost chronically-ill by as much as 40 per cent. Implementing this approach across the nation through primary-care facilities located in new walkable communities could save additional hundreds of billions of dollars for patients, insurers, and the federal government.

Super committee results

If the complete policy package for open-market sustainability were to be implemented simultaneously and scored against the deficit-reduction “Super Committee” test, preliminary budget estimates (based on OMB, IRS and Treasury Department data) over the 10-year period, and assuming the mandatory $400bn in 10-year defence sector savings, it would yield the following deficit reduction: $1.75tn.

Conclusion: Strategic innovation

The three core components of open-market sustainability – smart growth, regenerative agriculture and a tax shift – individually represent significant gains to prosperity, well-being and sustainability. Working together, however, they become the world’s most powerful engine of innovation, aligning market prices with our global objectives.

Once these three strategies are firmly rooted, scheduled calibration through tax policy will drive ever-higher levels of resource productivity – productivity we need to achieve to hit our strategic objectives. By gradually increasing efficiency standards over a predictable schedule, tax policy, rather than stimulus or the mythical “invisible hand”, can drive resource productivity and launch a new era of materials science and manufacturing processes, along with the profitable business models that flow from them.

Harnessing our market democracy to drive innovation aligned with our strategic imperatives is what made the US a leader among nations. In World War II, our assembly lines outproduced two continental empires – simultaneously. In the Cold War, the American Dream was the envy of the world. Our space programme defined the future and changed how humanity understands itself. And we turned a requirement for communications that could survive nuclear war into the internet and revolutionised human relations. Global unsustainability, the great challenge of the 21st century, requires only that we tap into this greatest of American traditions once again.

Patrick Doherty is deputy director of the National Security Studies Programme and director of the Smart Strategy Initiative at New America Foundation.

A version of this article was first published on the Solutions Journal.