James Hansen heads the NASA Goddard Institute for Space Studies. If you have a question about radiative transfer in planetary atmospheres, he’s your go-to guy. But if you have a question about economics—say, about the merits of cap-and-trade programs—you might want to consult a different sort of specialist. Hansen’s recent New York Times piece provides ample confirmation of that.
The column oozes nonsense throughout, but it will be instructive to hone in on one exceptionally silly paragraph. Here is Hansen trying to explain why cap-and-trade is inferior to a carbon tax:
Consider the perverse effect cap and trade has on altruistic actions. Say you decide to buy a small, high-efficiency car. That reduces your emissions, but not your country’s. Instead, it allows somebody else to buy a bigger S.U.V.—because the total emissions are set by the cap.
First, this is true. But second, it has nothing to do with cap-and-trade. The same observation applies to a carbon tax. Carbon taxes work by driving up the price of gasoline and other pollutants so people will use less of them. Consider the perverse effect that has on altruistic actions. Say you decide to buy a small, high-efficiency car. You buy less gasoline, driving down its price, and encouraging someone else somewhere to buy a bigger S.U.V.
True, you have only a tiny tiny effect on the price of gas. But how big an effect do you need to trigger one more S.U.V. sale in a country of 300 million people?
Here, now, is the whole point: We don’t have to guess at the answer to that. A little bit of economics reveals that to an excellent first approximation, the carbon tax and the cap-and-trade program must have identical effects.
Here’s why: If we reduce our gasoline consumption by, say, 30%, then the price of gasoline must rise by just enough so that consumers are willing to cut their purchases by exactly 30%. If the price rises any less than that, consumers will want more gas than they can get, and they’ll bid the price up further. So the price consumers pay for gasoline is completely determined by the fall in consumption—and it doesn’t matter what triggers that fall. Cut gas consumption 30% via cap-and-trade and the price of gas will rise. Cut gas consumption 30% via a gas tax and the post-tax price of gas will rise by exactly the same amount. This one observation forces the programs to be equivalent in almost every relevant way.
Mr. Hansen prefers the carbon tax, because the revenue can be distributed to the public. (He calls this a fee-and-dividend system.) But by the same token, with cap-and-trade, the revenue from selling permits can be distributed to the public. And it’s not hard to prove (using arguments similar to the preceding paragraph) that the revenue from selling permits must exactly equal the revenue from raising taxes. So again the programs are entirely equivalent.
Mr. Hansen worries that with cap-and-trade, energy producers will demand free permits—essentially claiming the permit revenue for themselves. But energy producers that powerful could just as easily lay claim to tax revenue as to permit revenue. So again, the choice of policy makes no difference. He worries that politically powerful producers can get themselves grandfathered out of cap-and-trade. Yes, just as easily as they can get themselves grandfathered out of a carbon tax.
If you want to believe there’s a meaningful difference between a carbon tax and cap-and-trade, you’ve got to look elsewhere than the effects on pollution, incentives, consumer prices, profits, or government revenue. In other words, you’ve got to look at decidely secondary effects. Here’s a menu of choices:
- A carbon tax can be too small (allowing too much pollution) or too big (retarding too much economic activity). Similarly, a cap-and-trade program can be too small or too big. For somewhat technical reasons, I believe that it’s easier to calculate the “just right” carbon tax than to calculate the “just right” number of cap-and-trade permits. If I’m right, this is an argument for a carbon tax.
- A carbon tax is pay-as-you-go for producers. Cap-and-trade permits, depending on how the system is designed, can be a big upfront expense. This handicaps small companies with limited cash reserves and limited borrowing opportunities. This is an argument for a carbon tax.
- If you favor either of these programs in the first place, you presumably want it to last awhile. Cap-and-trade is politically self-perpetuating, because companies in possession of valuable permits will lobby to maintain the program that gives those permits their value. The carbon tax, by contrast, will come under constant assault from anti-tax lobbyists and therefore might be more difficult to maintain. This is an argument for cap-and-trade.
Me, I lean toward a carbon tax, just like James Hansen. But the differences are largely inconsequential, and almost entirely divorced from what Mr. Hansen thinks they are.
I fully agree about them being mathematically equivalent, and about differences in longer-term outlook.
But I’m not sure that he’s wrong about politics. Wasn’t it a US campaign promise last year that all of the permits would be sold, and now most of them are to be given away? I think there would be more of an uproar if equivalent cash amounts (from tax) were to be handed out to energy companies. Of course I can’t prove that…
I haven’t studied the details of proposed carbon taxes and cap and trade. One difference that could arise is if the carbon tax is a tax on the quantity of carbon in one unit of fossil fuel, and if the cap and trade measure is on carbon emissions, which is the case for SO2 cap and trade. If that is true, then there would be differences across fuel types and across differing combustion efficiencies at different sources. Does anyone know how people and/or legislation treat this issue? My sense is that there is not a clearly specified carbon tax proposal on the table. Many Republicans “favor” the tax over cap-and-trade, but seem to be taking that position mainly as a deflection of cap and trade. If the Dems were to do an about face and propose a carbon tax, I suspect that the GOP support for carbon taxes would dry up overnight.
Also, many of the advocates of a tax pitch it as a gas tax (for example Mankiw), which would differ greatly from a carbon tax, because it would leave natural gas and coal as an untaxed, carbon emitting substitute.
I just wanted to mention the Congressional Budget Office had a report in February 2008 titled “Policy Options for Reducing CO2 Emissions” (HTML and PDF format available here: http://www.cbo.gov/doc.cfm?index=8934. ) The report included several graphs which clarified some of the relevant points. (Not to ruin the ending, but they tended to prefer carbon taxes.)
I think the problems with cap & trade are much more significant than with a tax. Under either a tax or cap & trade, you have pick the right quantity of allowable emissions. That’s hard, and no one agrees on the right level of carbon emissions.
With a cap & trade, you also have to pick the right trajectory. If you expand/contract credits too quickly/slowly, the price of credits could fall to nothing (in which case the cap is doing nothing), or skyrocket (as they did in the sulfur dioxide system) and inhibit new businesses.
To add difficulty, the costs to reducing pollution are probably non-linear, but because of the huge stock of CO2, the benefits are probably linear, which lends it self better to price regulation than quantity regulation for volatility reasons.
Anyhow, I think cap & trade is fine for domestic goods when we know the right quantity. For carbon emissions, or international agreements, taxes are simpler, easier to impose, and have similar effects.
Dr. Landsburg,
Aren’t they only fully equivalent mathematically when the person setting the cap/tax faces no uncertainty? Didn’t Weitzman show they can be quite different in the presence of uncertainty? (And then there’s the political economy differences.)
Maybe this pdf is interesting
http://www.brookings.edu/~/media/Files/rc/testimonies/2009/1202_carbon_tax_gayer/1202_carbon_tax_gayer.pdf
It’s hard to compare because there are big variations possible in what a carbon tax actually is, and what cap and trade actually is. However, what do you think of this conjecture – if cap & trade happens to be done in a way that makes it true?
Cap & trade creates a business opportunity for those who can reduce emissions, because they can sell credits to those who have greater emissions. Under a carbon tax, those who pollute more pay more into the general fund, which can go to all sorts of things; under cap and trade, they buy credits directly from those who hold them but don’t need them due to having reduced their emissions. So the money is more targeted at reducing emissions, because those who reduce get a higher percentage of it (at the expense of the general fund seeing less of it).
Does that make sense? Can it work that way? Is it still equivalent?
I’d be interested in hearing why you think it’s easier to pinpoint the “right” amount of carbon tax vs. the “right” amount of capping. I tend to lean the opposite direction.
Jambarama, you make good points for the difficulty of setting the right quantity with cap & trade, but all of those difficulties are also present with a carbon tax. With both systems, you need to know the right quantity of allowable emissions. But with cap & trade, once you settle on that quantity, that’s the quantity you use for the cap. With a carbon tax, you have to know precisely what change is needed in prices to result in that desired quantity. If new technology is introduced, or there’s some other change in the market, your carbon tax estimates all become obsolete. But the quantity of the cap only becomes obsolete if the right quantity of allowable emissions changes– in which case, your carbon tax is also obsolete. Meanwhile, the problems of choosing the right trajectory are identical for both systems. A tax that increases too rapidly will have the same effect as carbon credits that contract too quickly.
Scott: To get the carbon tax right, you don’t need to know the right quantity of allowable emissions; you just need to know the amount of damage caused by the marginal unit of emissions. That amount of damage is the right amount of tax; get that right and the quantity will take care of itself.
The problem with cap and trade is that you *do* need to estimate the right amount of allowable emissions, and that can be difficult.
Really? Everyone is for either a carbon tax or a cap and trade system? You buy into man made global warming? Have you not seen any competing (and in some cases stronger) evidence to the contrary? I’m assuming these are only beneficial if man made global warming is REALLY happening. From the loads of evidence I’ve seen, they’re still no further in proving MMGW than they were any number of years ago. There is a reason.
http://scanlyze.wordpress.com/2007/10/12/gore-inconvenient-truth-film-contains-nine-factual-errors-uk-court-decision-finds/
MMGW is quite possibly one of the dirtiest political moves ever. I was listening to Bill Nye “the science guy” just today state how he *only* paid $31,000 to convert his Southern California (must be nice) home to solar panels. He wants *every* american to do the same. I’m seriously concerned that any such legislation for a carbon tax/trade scheme is going to pass.
Chris: There are only so many issues one can tackle in a single blog post, and only so many one can know something about. This post was about the relative merits of carbon taxes versus cap and trade, taking it as given that the goal is to reduce carbon emissions. To what extent that’s a worthwhile goal is a whole separate topic.
Steve,
In that case, let’s discuss the merit’s of throwing people out of plane’s without parachutes vs. letting them jump on their own. In the first case, you have to force someone to do something they don’t want yet in the second case you have to willingly let people commit suicide.
Ok, snide comments aside, we could discuss the merit’s of any “x vs y” thing until we turn blue in the face. My point was, why do that if it’s pointless?