We shouldn’t assume that carbon taxes are less feasible than cap-and-trade

We’re developing a good list of criteria for assessing the pros and cons–environmental effectiveness, the relative risks of bad design, costs, simplicity, political feasibility, and implications for an international regime. David Weisbach raises a good point about the need to look at what might work internationally, which I hope we can discuss more. For now, though, I’d like to focus on environmental effectiveness and political feasibility, where carbon taxes may be getting short shrift.

Environmental effectiveness is a sine qua non. Nathaniel Keohane, Gernot Wagner, and Ken Richards all question whether it’s possible to identify the tax rate necessary to reduce emissions by the desired amount. That challenge should be an economist’s dream. It will require making assumptions about behavior, technology, and economic conditions, but I suspect that a well-chosen team could provide a credible answer.

I also wonder whether a blunt instrument might be as effective as a scalpel. We’re dealing with a multi-decade time span and commitment, and it’s difficult to predict how technologies and purchasing patterns will evolve. A tax that sends a loud price signal could have real effects, just as the market-driven price increases in gasoline have triggered real changes. Stated differently, perhaps precision in the tax rate may not be as important as we think in producing fundamental, structural changes in our economy and lifestyle over the next two generations. A tax also allows us to go below the cap.

As we’ve agreed, effectiveness will depend on design. Ken speculates that legislators would give exemptions from carbon taxes just as they give away allowances in a trading regime; I have no doubt that lobbying would be intense. But a carbon tax worth supporting has a built-in brake. If one gives too many exemptions–or “grandfathering,” to use David’s term–there’s not much left to tax. Too many activities escape the price signal that was intended to reduce emissions. And once the carbon tax proposal has lost its raison d’être, it’s not worth enacting.

In order to be effective, the price signal of a carbon tax or trading system also needs to be reliable over time. Ken suggests that a tax might not be as stable as a cap-and-trade system, deterring carbon-reducing investments. But as David wrote earlier, both are susceptible to legislative change. The cap-and-trade proposal debated by the Senate in June called for periodic studies and legislative recommendations. In addition, cap-and-trade proposals often contain “off-ramps” that allow for flexibility. I’m not convinced that a cap-and-trade system would be built with less stable parts than a carbon tax.

In terms of political feasibility, the assessment may depend on how far one looks beneath the surface. Tax is a politically toxic word, but the Senate debate over the cap-and-trade bill this summer is sprinkled with arguments that the proposed cap-and-trade regime is the same thing as a tax. With a more prolonged debate, will trading programs really look that much more politically feasible?

The relative political feasibility of a cap-and-trade program turns in part on how the allowances are allocated. Giving them away will win more support from companies subject to the trading caps; they won’t have to buy them at auction. But allocating all or many of the allowances at no cost may put a trading program in a politically weaker position for two reasons:

• Giving away allowances means that the government won’t get the revenue it could otherwise use to directly fund climate initiatives, provide relief for people who will be hit with increased costs, or invest in tax reforms that could stimulate the economy. These benefits could help build political support for a climate change package. A structurally sound carbon tax (or auctioned permits) will produce these revenues.
• Giving away the allowances has a counterintuitive effect that may be politically dangerous. Based on experience with the European carbon-trading program and economists’ studies, the value of the free allowances is likely to translate into increased company profits; we can’t assume that the savings will be passed along to consumers. The market will establish a value for carbon, and products then reflect that value even though companies don’t have to pay for the allowances. Consequently, the recipients of the free allowances get two benefits from the government–the free allowances and increased profit. If this shareholder benefit gains visibility during political debate, assessments of political feasibility might change, particularly at a time when the country is investing heavily in bailing out private enterprise. And as a matter of policy, is this the right result? The question of who bears the costs and benefits might be added to Ken’s list.

Auctioned allowances and carbon taxes avoid these two problems. When we compare the political feasibility of allowances and taxes, the two options may not be as far apart as one might think.