The title to this post is inspired by Tim's email from the stats department at tOSU but it fits Mankiw's baffling August 9th attempt at making Siamese twins out of climate policy and tax cuts (A missed opportunity on climate change).
Here is the twinning of a carbon tax and tax cuts:
The textbook solution for dealing with negative externalities is to use the tax system to align private incentives with social costs and benefits. Suppose the government imposed a tax on carbon-based products and used the proceeds to cut other taxes.
Here is Mankiw's twinning of cap-and-trade auction revenues and income tax cuts:
The auction price of an emission right is effectively a tax on carbon. The revenue raised by the auction gives the government the resources to cut other taxes that distort behavior, like income or payroll taxes.
The twinning is dead wrong. Here is how Mankiw the textbook writer puts it (pp 213-214, fourth edition of the Micro split):
... the government can internalize the externality by taxing activities that have negative externalities ...
... Thus, while corrective taxes raise revenue for the government, they also enhance economic efficiency.
A carbon tax or cap-and-trade increases efficiency. Both can raise revenue for the government. The government can do a number of things with the additional revenue but none of these things are required to make correcting negative externalities efficient.
In fairness to Mankiw he makes his efficiency point here:
How much does [zero auction revenue] matter? For the purpose of efficiently allocating the carbon rights, it doesn’t. Even if these rights are handed out on political rather than economic grounds, the “trade” part of “cap and trade” will take care of the rest. Those companies with the most need to emit carbon will buy carbon allowances on newly formed exchanges. Those without such pressing needs will sell whatever allowances they are given and enjoy the profits that resulted from Congress’s largess.
Thank you for that clear explanation (as good as your excellent textbook). But,
The problem arises in how the climate policy interacts with the overall tax system. As the president pointed out, a cap-and-trade system is like a carbon tax. The price of carbon allowances will eventually be passed on to consumers in the form of higher prices for carbon-intensive products. But if most of those allowances are handed out rather than auctioned, the government won’t have the resources to cut other taxes and offset that price increase. The result is an increase in the effective tax rates facing most Americans, leading to lower real take-home wages, reduced work incentives and depressed economic activity.
The macroeconomic problem is that some taxes are too high, distorting economic activity. The macro problem should be decoupled from climate policy as soon as possible. Please?
Here is Mankiw's conclusion:
As for me, I hope the president refuses to sign a bill that fails to auction most of the allowances. Some might say a veto would make the best the enemy of the good. But sometimes good is not good enough.
In other words, Mankiw hopes that the president vetos a bill that generates more benefits and costs in the hopes that someday we get a bill that generates even more benefits than costs. Me? I think climate policy with economic incentives built in is "good enough." This would be an important movement in the right direction for environmental policy.