Don’t forget about the role of politics

David Weisbach is absolutely correct: The specific design of either a tax or cap-and-trade program is far more important than the issue of which approach Congress adopts. Either approach, properly developed, can help reduce greenhouse gas emissions. And conversely, either approach, poorly designed, can lead to real trouble.

At one level, there is less difference between the two approaches than it might seem. Janet Milne cites the fact that a carbon tax can be imposed early in the production or distribution cycle of fossil fuels. But as David points out, the same is true of a cap-and-trade program, where an active market could develop among the upstream firms that introduce carbon into the economy. Similarly, contrary to what Janet infers, both systems will require “accurate monitoring and verification,” which is a good reason to target the system upstream where there are better records of carbon flows and fewer parties than downstream.

Janet also says that a simple tax on carbon would be more transparent than a cap-and-trade program, but that’s only true if you assume Congress wouldn’t load a carbon-tax scheme with all of the exceptions and favorable treatments it has included in so many other programs, including both tax systems and environmental programs.

Gernot Wagner and Nathaniel Keohane point out that from a political perspective the genius of a cap-and-trade program is the ability to dole out allowances to regulated firms, presumably to achieve support for the program. But similar favorable treatment could be built into a tax program; firms could be granted tax exemptions for a portion of their emissions without affecting their marginal costs.

This isn’t to say that the approaches are the same. At its core, the tax approach protects us from runaway economic costs. That’s important if you believe that the costs of emissions reduction could become steep. In contrast, the cap-and-trade approach gives us more certain protection from environmental damage, which is important if you think that environmental risks are daunting and costs of abatement won’t rise rapidly.

But there are also political and institutional factors that would suggest that, at least in the case of the United States, a cap-and-trade approach might be superior to a tax approach. One is raised by Gernot and Nathaniel: In the presence of uncertainty about the costs of emissions reduction, and particularly in a growing economy, we’ll have a difficult time maintaining a tax aimed at any particular emissions level.

Janet suggests that a market in allowances may exhibit price volatility, making it difficult to plan investments. Certainly that has been the case in the European Trading System and in recent years, in the sulfur-dioxide emissions allowance market. But this volatility isn’t so different than that observed in many commodity markets, and businesses manage to cope. The more severe risk isn’t market uncertainty, but political uncertainty. Congress has shown an inclination to allow quantity controls to remain in place over long periods of time. It hasn’t demonstrated a similar discipline with respect to its treatment of the tax code. This difference in the regulatory stability of the two approaches is particularly important when the government is trying to induce capital investments in a low-carbon economy.

Institutionally, Congress might do better to adopt a cap-and-trade approach simply because other countries and regions are doing the same thing. To allow the integration of the U.S. system with the rest of the world, and to take advantage of the potential gains in trade, it will be necessary to have a similar system.

Finally, although it offends me as a policy analyst to admit this, perhaps the best reason to adopt a cap-and-trade program is because it isn’t called a tax. While a well-designed cap-and-trade program would have many of the same revenue-raising features as a carbon tax, the fact is that the U.S. public may not be willing to swallow a pill with the tax label on it.