Simplicity and The Virtue of the Carbon Tax
Felix Salmon made me rethink my support for a carbon tax instead of cap and trade with his argument that a cap and trade system is more dynamic:
successful policy, he said, “has to be a dynamic hedge of fat-tail CO2 risk”. If it turns out that our carbon emissions are rising too far, too fast – or not falling fast enough – then the system has to be able to dymaically adjust to that, and that’s something a carbon tax finds pretty much impossible to do
This sounds convincing, but couldn’t one just raise the carbon tax so to suppress demand effectively? Salmon’s meta-argument for cap and trade is what, oddly enough, keeps in the carbon tax camp:
Ultimately, the most compelling argument is the flexibility/optionality argument. Think of a cap-and-trade system, Pizer says, as a big machine with a whole bunch of dials. “You can dial certainty on the cap versus certainty on the cost, and you can dial free allocations versus auctioned allocations,” he says. By fiddling with the controls, you can basically get anything you want – which is a crucial feature given that we really don’t know exactly what problems the cap-and-trade system is going to be asked to solve in the future. If Congress is worried about the price uncertainty inherent in a cap-and-trade system, they should be much more worried about the cost-of-environmental-damage uncertainty inherent in global warming mechanisms – something which demands flexibility in terms of our response.
If Felix Salmon were to replace Congress, then I wouldn’t cringe at the thought of our carbon reduction policy mechanism being compared to a large machine with dials that can be finely tuned to achieve the best outcome. In reality, Salmon doesn’t set those dials, Congress does. This means that Kentucky, West Virginia and Illinois legislators get to “turn the dials” when they slip in an amendment stipulating that coal plants should just be given permits. John Dingell gets to “turn the dial” when he uses his chairmanship of the Energy Committee to decide that automobile companies should “temporarily” have a reduced rate on the purchase of permits. And while it is certainly true that a tax can be gamed as well, the carbon tax would be much more transparent. If coal plants were paying a lower tax than everyone else, it would be readily apparent. With a cap and trade system, one could easily imagine all sorts of shenanigans going unnoticed. You do climate change legislation with the public choice dynamics you have, not the public choice dynamics you wish you had, and until Felix Salmon is Grand Lord of Energy Policy, a carbon tax is still the way to go.
Thanks for the kind words. But consider this:
Let’s say that south-eastern electricity generators, or the auto industry, or any special interest you like, gets tax breaks or rebates on the carbon tax. Then the carbon tax is less effective, and there are more carbon emissions, as a result.
By contrast, under a cap-and-trade system, the cap is the cap. You can allocate free emissions rights, you can subsidize Detroit’s purchase of carbon, etc etc — and the market copes invisibly and effectively, and so long as the cap remains, the cap-and-trade system is basically working exactly as it was designed to work: carbon emissions are being capped.
The exception to this rule is the “safety valve” which would effectively raise the cap when emissions reached a certain price. But since that price is surely higher than the price that a carbon tax would be set at, even then you can be sure that a cap-and-trade system would be better than a carbon tax.
Felix
November 14, 2007 at 1:49 pm
Felix,
You seem to have accepted the totally unsupported argument Jon Anda made at yesterday’s debate that the cap price will surely be higher than the price at which a carbon tax would be set.
First, a carbon tax can be implemented much more quickly than a cap-and-trade marketplace. Since a carbon tax could be implemented years earlier than a cap-and-trade program, during the cap-and-trade development years the tax would obviously be higher than the non-existent cap-and-trade price. The carbon tax would result in real carbon dioxide emissions, while the “in development” cap-and-trade scheme would have relatively little, if any, impact.
Second,at any given time, once a cap-and-trade scheme is finally in place, in order to obtain the same reductions the price on carbon should be approximately the same under cap-and-trade or carbon tax. That, of course, means the same increased prices to consumers since the price on carbon will be passed through to consumers whether a cap and trade or a carbon tax is implemented. In fact, a revenue-neutral carbon tax could be higher. The fact that cap-and-trade provides huge windfalls to the fossil fuel industry, at least in the version given the most chance of ever passing, would make high cap-and-trade prices very unpopular. In addition, based upon the European carbon trading experience and what we’re hearing about RGGI, there is every reason to be concerned that too many allowances would be made available and the cap-and-trade price would be too low.
Regarding your concern about south-eastern electricity generators or the auto industry obtaining tax breaks or rebates, I suppose that is theoretically possible. It’s equally possible that the south-eastern generators and/or the auto industry could game the system and obtain offsets of some sort that breach the cap. More importantly, your assumption is that the cap is the cap because the ultimate goal is to obtain a desired level of reductions. The same could be true for a carbon tax. If tax breaks or rebates you hypothesize were made available to special interests, the tax rate could be correspondingly increased in order to obtain the desired reductions.
Finally, you pass over the “safety valve” issue very quickly. In fact, it is a major flaw in the cap-and-trade approach. As you do acknowledge, a “safety-valve” would effectively raise the cap. That means that with a “safety valve” you’ve lost your “cap is a cap” argument. Again, there is no basis for saying that the capped price “is surely higher than the price a carbon tax would be set at.”
Dan Rosenblum
November 14, 2007 at 9:23 pm
Matt,
You make some good points here. I am going to respond, but before I start I want to acknowledge that a lot of what is under discussion here are opinions (or assumptions) about the politics, and particularly which system Congress is likely to screw up less.
couldn’t one just raise the carbon tax so to suppress demand effectively?
In theory, yes. But I think it’s likely that the Congressional finance committees (or the IRS) that are going to have jurisdiction over a carbon tax are not going to have a lot of interest in constantly revisiting the tax level in order to ratchet down emissions. On the other hand, the environment committees (or, more likely, the EPA) that will have jurisdiction over a cap-and-trade system will likely be managing the program with a focus on environmental outcomes.
while it is certainly true that a tax can be gamed as well, the carbon tax would be much more transparent.
I think debates about which system is more susceptible to special interest politics are not tremendously productive, because clearly both of them are. But I will say that I think the advantage that cap and trade holds over a tax here is that in a cap-and-trade system you can probably buy off special interests by giving them free allowances. This has distributional consequences — ones we may not like, such as windfall profits — but it doesn’t effect the efficiency of the program. In a tax system, on the other hand, there will be pressure to grant exemptions, which will be distortionary and lower the efficiency of the program. Now obviously the either set of buy-offs could go the other way: industries could be excluded from the cap-and-trade system (producing similar distortions to the tax exemptions) or the government could use tax rebates to buy off affected industries (which would have distributional consequences but would at least influence behavior at the margin). But I think the risks of efficiency-sapping special interest politics are greater for a tax — exemptions are worse than a few years of windfall profits. Regarding the transparency of taxes, I do not have a detailed understanding of, for example, U.S. corporate tax law (or even energy tax law specifically), but it is not my impression that “transparent” would be a word you would typically associate with it.
Dan,
a carbon tax can be implemented much more quickly than a cap-and-trade marketplace
Very likely. Which can be legislated first, however?
in order to obtain the same reductions the price on carbon should be approximately the same under cap-and-trade or carbon tax.
Very true. Cap-and-trade advocates should be making this point much more clearly. I try to do my part.
the price on carbon will be passed through to consumers whether a cap and trade or a carbon tax is implemented. In fact, a revenue-neutral carbon tax could be higher.
I think this is one of the very good arguments for a carbon tax. If you could eliminate the regressivity of the program through increasing the EITC (along the lines Metcalf has proposed), this would be a big advantage for the carbon tax. I am deeply skeptical that this would be how revenues were used, however.
there is every reason to be concerned that too many allowances would be made available and the cap-and-trade price would be too low.
Well, there are a few less reasons when you compare the U.S. to Europe, starting with better baseline data. I’m not terribly concerned about the possibility of short-term over-allocation, however, since I view any climate policy as a marathon rather than a sprint.
Regarding your concern…
Regarding tax versus cap-and-trade exemptions, and my thoughts on adjusting a tax over time, see my comments to Matt above.
you pass over the “safety valve” issue very quickly. In fact, it is a major flaw in the cap-and-trade approach
Arguing for a carbon tax by criticizing the safety valve strikes me as disingenuous at best. The safety valve allows a cap-and-trade program to mimic a tax!
My proposal? A relatively tight cap with a safety valve that is phased out over the next 10-20 years by steadily raising the safety valve price until the cap “bites.” I think the institutional lock-in we will experience with either system, combined with the fact that in the long run we are likely to need quantity controls — if only for international cooperation and not also for environmental reasons — make a cap-and-trade preferable, a point I make in more detail here.
Daniel Hall
November 14, 2007 at 11:34 pm