Common Tragedies

Thoughts on Environmental Economics

Equity, efficiency, and (long run) equivalence

Posted by Daniel Hall on June 5, 2008

You knew, dear readers, that the econoblogosphere has been arguing vociferously the last few days about carbon taxes versus cap and trade and to what degree they are equivalent, didn’t you? It seems Robert Samuelson started the entire thing with a grumpy tirade about cap and trade on the editorial pages of the Washington Post. Ryan Avent criticized it, and then things blew up. Here is Tyler Cowen, Mark Thoma, and Brad DeLong with more, another response from Ryan, and there are many further links at these posts if you want more. The short story is that only Tyler comes to Samuelson’s defense; everyone else agrees that while there are differences they are not the ones Samuelson “identifies” since he actually spends his time whinging about regulation of any kind at all. (Brad DeLong makes this point most clearly.)

I have been on the sidelines the entire time, partially because I have been very busy with my actual life, partially because I already covered this, and partially because I am consciously trying to avoid this malady. But I could not let this statement from Arnold Kling pass without comment:

In theory, you can make cap-and-trade equivalent to a tax. What I worry about is that under cap-and-trade Congress is very unlikely to have a pure auction of permits. Instead, permits will be given to favored industries. The equivalent under a carbon tax would be to set different tax rates for different industries, with favored industries getting anywhere from a partial exemption to a full exemption to a negative carbon tax, or a carbon subsidy.

Wrong.

Giving allowances away for free in a cap-and-trade system and giving (full or partial) exemptions in a carbon tax system are not the same thing. But why not? They seem so similar, don’t they? Some particular industry or firm gets favorable treatment — either free permits or lower tax rates — and this makes them more profitable, right? Why aren’t they equivalent? Briefly, because one system (cap-and-trade with free allowances) equalizes the marginal cost of emissions, while the other (carbon taxes with exemptions) does not.

Once you establish a cap-and-trade system, every regulated entity within that system will have an identical incentive to reduce emissions. The incentive will be the market price for allowances. And this incentive will be the same for all firms regardless of how allowances are initially distributed. Even if firms get allowances for free, they will still face an opportunity cost for emissions.

If you establish a carbon tax system with different tax rates for different sectors, however, firms will face varying incentives to reduce emissions. This will end up making some firms or sectors work much harder to reduce emissions (those with the higher tax rates) and others work less hard. This will have (at least) two unfortunate effects: one is that society will get less bang for its buck now — fewer emissions reductions for the money it spends than it could have done if marginal tax rates were equal. The second problem is that over time the existence of differing marginal tax rates will tend to push economic activities into sectors with low tax rates and away from those with high tax rates. Both these effects mean that the system is less efficient than it would have been if marginal carbon tax rates were equal across the entire economy.

Economics students will recognize this as the classic distinction between equity and efficiency. How allowances get handed out matters a lot for the distributional (equity) effects of the policy, but doesn’t affect the efficiency. Exemptions and carve-outs in a tax system, however, make the program less efficient. (The actual carbon tax policy equivalent to free allowances would be lump sum rebates of tax revenues, while leaving marginal tax rates equivalent.)

In my mind this difference is important, and constitutes a public choice argument for cap and trade. In order to get any climate policy passed you are realistically going to have to make a lot of political side deals. With cap and trade the natural side deal is to give away allowances. This may not be fair, and it may be ugly, but it at least leaves us with a system that is efficient, and this is very important when thinking about policies that will likely be in places for several decades. With taxes, however, the natural side deal is exemptions. And once full or partial exemptions get established in a carbon tax code I doubt they will go away. That might not look too problematic today but the inefficiency will just get larger and larger over time and by 2020 or 2040 we will be very unhappy we have a system that has inefficiently squeezed economic activity into certain sectors. Better to give up some equity now in exchange for a system that is built for the long haul.

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3 Responses to “Equity, efficiency, and (long run) equivalence”

  1. [...] few more notable pieces on the subject from Felix Salmon and Daniel Hall. Have I mentioned lately just how many remarkable people there are writing about economic issues [...]

  2. moom said

    Unfortunately, because of the “tax interaction effect” giving away permits for free results in magnifying the efficiency distortions of the existing distortionary effects of taxes on labor, capital etc. Auctioning the permits generates the revenue to cut those taxes and reduce the effect. Of course auctioning the permits and then using the revenue for government spending as Liebermann seems to want to is no better efficiency wise than giving them away and maybe worse.

  3. Daniel Hall said

    Moom, you are correct that there are some efficiency losses with free allocation — indeed, see a subsequent post from Rich on this exact topic.

    But I would argue in the real world as it is likely to turn out this is a much, much smaller inefficiency than tax exemptions, which is the relevant comparison case. The comparison in your comment is to a first-best world with full revenue recycling through lower taxes on capital and labor. This is an unbelievably optimistic interpretation of what is likely to happen. In the real world most of the proposals that include free allocation phase it out over time, gradually eliminating the (relatively small) inefficiency; on the other hand, tax exemptions will grow over time as they rearrange economic activity, thus increasing the (much larger) inefficiencies.

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