UPDATE: There are two important updates at the bottom of this post.

Another striking feature of the way cap-and-trade is treated in Obama’s budget: rebates to taxpayers are administered through a payroll tax deduction. This is interesting stuff indeed.

The question of how to rebate auction revenue back to people (to offset the increased costs of energy under a cap) reveals a tension between equity and efficiency.

If the goal is equity, the payroll tax rebate is probably not the way to go. On one hand, it’s far more progressive than an income tax rebate (about a third of U.S. workers pay no federal income tax at all). On the other hand, there’s reason to believe it’s less equitable than a simply writing an equal check to every citizen. That’s what a recent report from the Center on Budget and Policy Priorities recommends. (Technically it recommends refundable tax credits, more or less the same thing).

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CBPP says flat rebates would be more equitable than income or payroll tax cuts — the latter would less regressive, but regressive nonetheless:

CBO found that if all the revenue from auctioning emissions allowances were used to reduce payroll tax rates, households in the bottom 60 percent of the distribution would get a smaller benefit from the tax cut, on average, than they would lose from higher energy prices. Those in the next 20 percent would come out even and the top 20 percent of the population would get a tax cut that exceeded their increase in energy costs. [my emphasis]

In addition, “seniors and others without earnings would receive no rebate” — no pay, no payroll tax.

To solve the first problem, you could put a cap on payroll tax rebates, so higher income workers don’t get a windfall. To solve the second problem, you could make seniors, the disabled, and other folks with no earnings eligible for a special tax credit. But if you’re going that route, why not just use the same tax credit for everyone?

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If your goal is efficiency, however, the payroll tax rebate is better. Efficiency here means emission reductions with the least macroeconomic impact. A cap-and-trade refunded through payroll taxes effectively raises one tax (an fossil energy tax) and lowers another. The idea is to get less of what you’re taxing (fossil energy) and more of what you’re taxing less (work). That’s why Obama’s people are calling it the “Making Work Pay” measure.

Still, the CBPP says it’s not worth it:

The efficiency gains are largest — although still quite small — when the rebate comes exclusively in the form of a payroll tax cut. But that approach leaves millions of low-income and senior households out in the cold.

Guess efficiency beat equity in the Obama budget team. That would be Summers and Orszag at work. Yay economists!

UPDATES: Two important notes to add:

First, there is a cap on the payroll tax deduction: the tax credit offsets payroll taxes “up to the first $6,450 of earnings.” So that does reduce the regressivity somewhat. Thanks to Kate for pointing this out.

Second, it might not be clear in the post that the tax credit’s effect is to offset payroll taxes, but the credit itself is administered via the income tax. Those who pay payroll tax but no income tax will just receive an income tax credit — a check. The payroll tax is the target but the income tax is the instrument. Why this is, I’ll leave for people who know way more about the tax code than me.