From the inbox (from Dr. Alan Dove, high school friend, freelance science writer and Columbia U. PhD in microbiology--smart dude):
Tim:
Hope all is well with you. I've been enjoying the blog, and was interested to see that you favor a cap-and-trade system. This subject actually came up in my own work recently, so I wanted to run something past you. While covering a meeting in Mexico City a few weeks ago, I heard Robert Engle give a neat talk about risk analysis and climate change.
Among other ideas, he suggested a carbon tax, but with a twist. In order to make it politically palatable, he said, why not take the vast revenue from such a tax, divert a small percentage into a soverign wealth fund for Social Security, and simply give the rest back to the taxpayers, in the form of an equal payment to every citizen. Driving your SUV each way to work, you'd pay the tax at the pump (and in your monthly electric bill and so on), and then you'd get some of it back at the end of the year.
If you rode a bike or bought a smaller car, you'd pay less at the pump, but still get the same check back. The kickback makes the tax somewhat less burdensome to the poor, and most voters would probably support a plan that sends them a "bonus" each year. Putting the revenue back into consumers' hands might also help feed a market for alternative energy, in a technology-neutral way. Meanwhile, the tax would fund a solution to a looming Social Security catastrophe. This would amount to turning two huge future risks (climate change and pension collapse) into a set of mutual solutions. It would also address the fundamental problem politicians face in responding to long-term risk, which is that the risk happens long after the next election cycle.
So here's what I'm wondering. Could a cap-and-trade program also provide a secondary revenue stream to fix some other big future risk? If not, is there some other political tradeoff that could be used to make cap-and-trade more attractive than a carbon tax with a payback mechanism?
My response after the jump.
Hey Alan,
Thanks for the message (mind if I use your question as a blog post?).
I know I've come out in the past as an advocate of cap and trade over a tax, but really I see pros and cons with each. Your question gets at the heart of an interesting debate, but for non-economic reasons: How do we make either policy palatable to the public (and their representatives). This is a separate issue from whether either policy achieves the desired economic result--a reduction in carbon emissions to the socially optimal level at lowest cost to society.
In Engle's proposal, the tax is a standard tax on external damages. Tax the damaging party at the marginal cost to society and in the end you get the optimal level of carbon and correspondingly the optimal level of damages at least cost. But the tax creates a 'windfall' for the government. What should the government do with that revenue?
From an economic efficiency point of view there is only one thing the government shouldn't do: pay the victim an amount proportionate to the individual damages incurred. A proportionate reimbursement will increase the incentive for the victim to incur more damages. A classic moral hazard problem. The example I use in class is a polluting factory paying local residents for pollution damages depending on how close to the factory they live. The closer you live the higher your payment. What incentive does that create? Move closer and get paid more. So people move closer than they would if the payment were to be decoupled from damages.
Beyond that, we have to go from positive to normative analysis. For the efficiency reasoning above, most economists (and I'm probably speaking out of turn for some) would advocate redistributing the tax revenues as Engle suggests--a lump sum payment independent of the damages. The incentive properties of the tax remain: drive more, emit more, pay more, and the lump-sum redistribution makes people who value 'fairness' happy. As you mention, such a transfer might make the tax less regressive if income is positively correlated with carbon emissions.
As to the second part of the question, can cap and trade be similarly redesigned to make it politically palatable? Maybe. Full auction of all permits with the government keeping all revenues sets up the same situation as the tax. Redistribute the windfall in a lump-sum fashion and you don't create the moral hazard. So yes it's possible for a cap and trade system to mimic the properties of a lump -sum tax revenue transfer. But how likely is it that a full auction cap and trade system will ever be implemented? Slim, in my view.
To be politically palatable almost any implemented cap and trade system will have to include some free permits allocated to current emitters (similar to the EPA's Acid Rain/Sulfur Dioxide Program). How will they be distributed? If history is any indication, it would be proportional to past output of whatever is producing the emissions. In the sulfur dioxide case, permits are allocated as a prorated portion of past electricity production (KWH's). I would guess something similar would have to happen with carbon permits for a cap and trade system to pass. The government may still auction some permits to cover administrative costs of the program, but I'm guessing that not all permits would be auctioned. This would mean that the 'windfall' to the government would be smaller under cap and trade than a direct carbon tax.
Hope that helps.
