Guest post from Jim Roumasset:
As Paul Krugman says, bad ideas are like New York cockroaches; you can flush them down, but they keep coming back. This is nowhere more the case than in the debate on carbon taxes vs. tradable permits. Taxes are better we are told because they generate more revenue. In contrast, cap and trade is said to be better because its primary purpose is to control pollution, whereas the primary purpose of emission taxes is to raise revenue. I’m afraid that these propositions cloud the waters.
In order to understand the difference between different policies (or institutions), it’s often best to start with what’s the same (Coase). In the world of perfect competition, controlling quantity with price (Pigouvian taxation) is exactly equivalent to controlling price with quantity via transferable and auctioned permits. This remains true even if there is uncertainty about marginal damage costs but not about the marginal benefits of emissions (Weitzman, 1974). For this reason, the typical environmental econ textbook emphasizes the case of uncertainty about marginal benefits, holding the marginal damage cost function fixed. The result of this exercise is that taxes cause less excess-burden than tradable permits so long as the marginal damage cost function is relatively flat, compared to the marginal benefit function. This is probably true for global warming because this year’s emissions have a relatively small effect on the total stock of carbon and future effects are discounted. (I don’t know if this is why Nordhaus favors taxes or whether he gives some other reason.)
The equivalence perspective is also useful for understanding the implications of taxes vs. permits for revenue. In the world of certainty, there are none! Again, a specific tax on all emissions is equivalent to auctioning the permits. Same price, same quantity, same revenue. Suppose instead that the 85% of the permits are given away “free,” ala Waxman-Markey. Can we emulate that with a tax? Yes! For simplicity, suppose that each producer gets exactly 85% of its efficient pollution quantity for free. The same thing can be accomplished with a block-rate tax schedule with the first 85% of emissions untaxed. (The more cap-and-trade entitlements are manipulated by lobbies, the harder it will be to imitate the scheme by taxes, but the principle remains the same.) That is, cap and trade can be designed to match the revenue-raising implications of carbon taxes and vice versa. (Again, uncertainty about emission benefits throws this proposition off.)So much for blackboard economics. In the real world we have uncertainty about both costs and benefits. Clearly it is possible to design hybrid schemes that are superior to either taxes or permits, but I don’t think we have strong results about the optimal hybrid scheme.
