Common Tragedies

Thoughts on Environmental Economics

In theory there is no difference between theory and practice. But in practice…

Posted by Daniel Hall on October 30, 2007

Ian Parry and William Pizer have a new article in Cato’s Regulation magazine comparing carbon taxes and cap-and-trade as approaches to reduce greenhouse gas emissions. They suggest that taxes may be better than cap-and-trade in theory, and could be worse in practice.

They start with the big advantages of a tax system — revenue recycling and price stability:

…a $10 CO2 tax would raise about $60 billion in revenue per year…. One way of using this revenue would be to finance a reduction in individual federal income taxes of around 6 percent, which would (moderately) alleviate various tax distortions in the economy. …we would put the economic efficiency benefits from using revenues from a $10 CO2 tax to offset income taxes at around $20 billion a year. …the most recent research suggests that the overall costs of imposing a CO2 tax of around $5 to $15 per ton, with the revenues used to reduce income taxes, are small and perhaps even negative. …

Another potentially important advantage of the CO2 tax is that it fixes the price of CO2. In contrast, under a pure cap-and-trade system, CO2 permit prices can be volatile because the supply of permits is fixed but the demand for permits may vary considerably from year to year… . Volatility in permit prices may deter adoption of carbon-saving technologies… or major research and development programs… . This volatility may also dampen society’s appetite for progressively stricter emissions caps over time…

But then they discuss the worst possible outcomes of potential climate change regulation — rent-seeking, exemptions, and waste:

[There are] three mischievous outcomes. The least mischievous is allowance rent seeking; rather than collecting the rents and using them to cut taxes, with attendant efficiency gains, they are simply redistributed. The next-worst possibility would be exemptions, where some industries facing significant competition — or engaging in aggressive lobbying — would escape regulation. Here, the efficiency of an economy-wide program incentivizing the least expensive emissions reductions, wherever they exist, is threatened. Because taxes remove the opportunity for easy redistribution, they may increase the risk that politically favored industries will be exempt from the emissions control regime. Finally, the aforementioned “worst” outcome would be the collection of revenue that, rather than being used to cut other taxes or simply redistributed, is actually wasted on low-value pork barrel spending. Not only do we face the cost of emissions abatement, we also face the drag of additional wasteful government spending. Viewed this way, taxes threaten the worst two of three bad outcomes.

Further, cap-and-trade systems can be designed to mimic a tax system, by auctioning permits and including a mechanism to stabilize prices, such as a safety valve or banking and borrowing provisions. Therefore:

…the key distinction is not really between CO2 taxes and emissions trading systems per se. Rather, it is between policies that raise revenues — and use revenues wisely — and have limited price variability (i.e., CO2 taxes or auctioned permits with safety valves and emissions trading over time), versus nonrevenue-raising instruments with no provisions to limit price variability (i.e., traditional permit systems).

My thoughts? The very best outcome for taxes (revenue recycling) looks politically unlikely, and the possibility of widespread tax exemptions worries me. Cap-and-trade would also face political pressure for exemptions, but as noted above politicians may be able to buy off narrow interests through allowance allocation, leaving us with a system that will redistribute wealth but at least won’t cause economic distortions. Hope for a cap-and-trade system with broad coverage, an extensive auction, wise use of revenues, and a transparent mechanism to stabilize prices. Don’t let the best be the enemy of the good, particularly when the best could be the worst.

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One Response to “In theory there is no difference between theory and practice. But in practice…”

  1. [...] has a fairly detailed comparison of cap-and-trade and carbon tax systems in their latest issue. A couple of commentators have interpreted the article as supporting their preference for a cap-and-trade [...]

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