It’s all about design

I generally agree with Janet Milne that a carbon tax–or even better, a tax on all greenhouse gases–is preferable to a cap-and-trade system. However, if we follow good design principles, either will be effective. The importance of good design outweighs the choice of instruments: A well-designed cap-and-trade system and a well-designed tax look and operate similarly, while a badly designed tax or permit system is a bad idea.

For example, take the issue of where in the production process the regime is imposed: It could be upstream when the fuel is extracted or imported, downstream when carbon dioxide is emitted, or somewhere in between. If it’s substantially upstream, we can cover almost all fossil-fuel emissions by imposing the regime on fewer than 3,000 entities: the 149 petroleum refiners, 1,438 coal mines, and 530 natural gas processors in the United States, plus imports at a few locations. Downstream, there are almost 250 million automobiles and millions of heating units throughout the country. Upstream, we could capture a broad base of emissions cheaply. Downstream, we would capture a narrow base expensively. Either carbon taxes or cap-and-trade regimes can make the same choice in this regard, and a bad choice is likely to far outweigh any differences between the systems.

Similarly, taxes raise money, which is nice because other taxes can be lowered or our debt paid down. But if the permits were auctioned, a cap-and-trade regime would raise the same amount. Alternatively, if permits were to be distributed freely to favored industries, the tax system equivalent would be to exempt those industries from an equal amount of tax liability. Either way, it’s the policy choice–in the permits world, between auctioning and giving away permits, and in the tax context, taxing and grandfathering existing facilities–that’s paramount, not the choice between taxes and permits.

A final example concerns whether we cover other greenhouse gases under a cap-and-trade or tax regime. As Janet pointed out, emissions from fossil fuels are easy to price and cover because of the simple correlation between the input–the fuel–and the output–the carbon dioxide. With other greenhouse gases it’s not as simple to impose a cost. For instance, quantifying emissions from farming (where tillage and fertilizer use are factors) or forestry depends upon the local ecology and how exactly it’s being manipulated. Nevertheless, it seems clear that some additional emissions–i.e., potent methane from livestock operations or substitutes for ozone-depleting chemicals–should be targeted in any system. Again, both cap-and-trade and a tax would have to find ways to deal with this complexity, and one isn’t particularly better suited to it than the other.

Debates about a tax versus a cap-and-trade system are often about flexibility. Tax advocates claim that flexibility is a central virtue of a tax–the market decides which emissions are reduced and when. Cap-and-trade advocates claim inflexibility as a central virtue–by setting a cap, we’ll know the total emissions.

I tend to agree with the tax advocates on this issue, but again, perhaps too much is made of it. In both systems, we should expect to see adjustments to the system over time. If, for example, a tax isn’t reducing emissions quickly enough, we might expect to see the rate go up; therefore, the lack of an emissions target in a tax system may be less of an issue than it appears. Similarly, a cap-and-trade system can have all sorts of mechanisms to allow flexibility on the total amount–from banking and borrowing to safety valves and price floors. Cap-and-trade systems will not, in reality, provide a fixed target. The underlying policy choices about targets and flexibility are more important than whether they’re implemented through a tax system or a permit system.

The place where one system would be preferable over the other, and where I think a tax dominates, is when we consider implementing the system internationally. Greenhouse gas controls must be implemented internationally: No one nation can do much on its own to slow climate change. The question for cap-and-trade advocates is how is this going to work internationally? Subsidies such as Kyoto Protocol’s clean development mechanism, which allows polluters to offset emissions by investing in clean technology development in other parts of the world, have failed. The alternative is allocating permits to many different countries and trying to monitor compliance, but it seems infeasible that we would grant permits to countries that we would be unwilling to give similar cash aid. Taxes are simpler: We don’t have to figure out a way to distribute valuable property rights on an international scale.