Carbon tax vs cap-and-trade: response to Mankiw

I read my own required reading. First, I read Mankiw's Economic View piece advocating a global carbon tax.

Mankiw (me):

• A tax would reduce carbon and mitigate climate change (yep, and so would cap-and-trade)
• A tax would raise revenue that can be used to reduce income taxes (in fact, the "double dividend" of a Pigovian tax is more general, the increased government revenue could be used for lots of things, such as covering the deficit instead of using social security taxes for that purpose.)
• A tax would be easier to negotiate internationally than cap-and-trade (maybe so, but I'd say the negotiations are significantly difficult that the difference in difficulty is minor; also, implementation of a carbon tax in the U.S. seems near impossible with the strong opposition from business)

As always in this debate, I'm blown away by the way economists pit a carbon tax against cap-and-trade as if it were an academic exercise (in graduate school it was the great macro debate "money matters, no it doesn't"). The contrasts in the two approaches are presented as stark but this isn't so. A carbon cap-and-trade system with an auction and safety value is similar to a carbon tax. It raises revenue and etc. Economists state this similarity and then ignore it and revert back to stating that a carbon tax is a much superior policy*.

Suppose we economists push for cap-and-trade in the power sector** with an initial giveaway of permits and a gradual ratcheting up of auctions? Since we are playing for keeps with Congress seemingly ready to implement cap-and-trade, playing the name game, i.e., gradually moving from cap-and-trade to a carbon tax might be one way to make all economists happy and actually get some sort of sensible climate legislation passed sometime soon.

Second, I read the WSJ piece. I found a balanced comparison of the economic issues with a clear statement that most of the differences in the two proposals are about distribution and not efficiency.

*The only really good reason to favor a carbon tax is the idea that regulating prices (i.e., taxes) works better with uncertain benefits.

**An increased gas tax, er, carbon tax on transportation, covers the other big carbon sector.

Comments

[Charles Young]

Certainly cap-and-trade with all permits auctioned is very similar to a carbon tax, differing only as per John's first asterisk above. It, too, is in effect a form of Pigovian tax (a tax that corrects a market failure).

It is confusing to use the same designation to refer both to this variant and the variant in which permits are gifted to polluters (which is the variant that most people have in mind when they discuss cap-and-trade). I am not sure which variant John is referring to in his discussion. It sounds a bit as if he is using considerations that apply only to the first in order to draw the conclusion that the second is not so bad.

If we compare two alternatives, in one of which, because an opportunity to raise Pigovian taxes is missed, non-Pigovian taxes are higher (either now or in the future), then the difference is one of efficiency, and not just of distribution.

[John Whitehead]

Charles,

You are correct. I don't the "the second" is "too bad." My climate change policy preferences in rank order:

1. carbon tax
2. cap-and-trade with auctions
3. cap-and-trade with giveaways
4. command and control
5. nothing

At this point in the US debate, wrangling over options 1-3 only gets us closer to implementation of 4 and 5, which would be a dreadful outcome when we are so close to 3.

[J Shogren]

The real difference I witnessed working at the Council of Economic Advisers was that the Cap and Trade is a great bait and switch political tatic. Offer up the cap and trade to buy off economists/business, and then gum it up with too many bottlenecks such that the market is too thin. Or alternatively, like in the EU, hand out so many permits, the effective price is zero.

[odograph]

Unfortunately, we realistically have to divide #1 above, into:

a. carbon tax with reasonable pricing
b. carbon tax with slap-on-the-wrist pricing

One of the hardest thing I think for outsiders, voters, to understand is the difference between 1a and 1b.

[Jan Tjeerd Boom]

The notion that a carbon tax would be easier to negotiate internationally than cap-and-trade strikes me as a bit overtly optimistic. Within the EU, negotiations over a carbon tax had been dragging on for about a decade when the EU finally decided to implement a cap-and-trade system. This was also caused by the fact that a tax requires unanimous agreement, while for cap-and-trade only a simple majority is necessary. However, the tax discussion is still ongoing. So if the EU countries cannot agree on a common carbon tax, then how can one reach agreement with even more countries?

[Amicus]

1. carbon tax
2. cap-and-trade with auctions
3. cap-and-trade with giveaways
4. command and control
5. nothing
==========
I'm not a pro at this.

Given that demand elasticity for gasoline is near 0.1, how high do you estimate that the "carbon tax" would have to run (a) to hold emissions steady at "normal" economic growth rates and (b) cause emissions to decline by 1%, 2%, etc.?

Do "carbon taxes" fall on both producers and consumers in most people's proposals?

In other words, a nuclear power plant pays minimal carbon tax compared to the messy plants up in the Dakotas?

[Joe Otten]

1. "How high would the tax have to be?" How much would the permits cost on the market? These are much the same questions. Even if permits are given away, the opportunity costs of using them instead of selling them will be passed on to the consumers.

So I don't see how this can be an argument against a carbon tax.

2. On the difficulty of reaching international agreements: am I missing something here, but don't different governments already levy widely varying tax rates on income, sales, etc, without the fact getting any of them terribly upset. This suggests to me that it would be quite easy to reach an agreement where some countries had higher carbon taxes than others - so long as each kept their own revenue.

On the other hand negotiating national caps amounts to negotiating a system of wealth transfers which would be virtually impossible.