Common Tragedies

Thoughts on Environmental Economics

I was gonna respond to Grist but then read Env Econ

Posted by Rich Sweeney on March 19, 2009

And saw that Tim already posted a great response. So I just stole his:

Relative prices, lump sum transfers and Carbon Cap and Trade

Dave Roberts at Grist asks:

How would rebating carbon revenue to taxpayers give anyone incentive to reduce emissions?

Since Dave is such a fan of economics (and me in particular), I thought I would take a shot at explaining this one (given my past sarcasm, I know that might sound condescending.  No condescension is implied.  This is an interesting and important question and something to which I think economists can add valuable insight).

The short answer to that question is ‘it depends.’  I know, I know, that sounds like a cop out, but really the truth here is that the effect of revenue redistribution on carbon emissions depends on the form of the rebate.

The proposal to which the question refers is the President’s proposal for carbon cap and trade with full auctioning of permit and rebate of auction revenues either in the form of a lump sum transfer to taxpayers or lower employment taxes.  So effectively, the program would increase the relative price of carbon intensive products and then give additional income to everyone.  But, by giving the income back to people who buy carbon intensive products won’t that counter the effect of the price increase?

Or, as Dave puts it:

It’s like if we put a $5 monthly tax on NetFlix use, and then sent every NetFlix customer a $5 check each month. Who would ever rent any fewer movies? It looks like you’re just moving money around to no end. Can someone explain what I’m missing?

To answer the questions:

Who would ever rent any fewer movies?  No one under this scenario.

Can someone explain what I’m missing?  Blockbuster.

Not to be too flip about it, but what’s missing in the NetFlix example are the other goods for which prices didn’t increase thereby making them relatively cheaper than NetFlix.

Back to carbon.

The carbon price (through cap and trade or tax or whatever) will increase the price of carbon intensive products relative to less carbon intensive products.  Without the tax rebate, the effect is unambiguous, consumption of carbon intensive products will decrease (and emissions will decrease).  But what happens if we add in the effect of the tax rebate?

This is where ‘it depends.’

For the tax rebate to not mess things up, the rebate can’t be proportional to the amount of tax paid.  In other words, the rebate has to be designed in such a way that the amount of additional income you get is independent of the amount of carbon intensive products you consume.  This is what economists refer to as a lump sum transfer.  The easiest example would be to take the auction revenue and divide it by the number of people in the U.S. and everyone gets $Total Revenue/Number of people (like the original $1,200 stimulus checks last summer).

Since the amount of money you get is not tied to the amount of carbon intensive products you consume, the rebate won’t affect the relative choice of carbon versus non-carbon intensive products.  Since carbon intensive products are relatively more expensive, they are less attractive than they were before and people will substitute away from them, independent of the rebate.

But, you ask astutely, since people have more income won’t the demand for all normal products increase–normal in the sense that they are desirable?

Yes.  We call this the income effect.  But, it is very unlikely (verging on absurdly impossible) that the income effect will come close to countering the full substitution effect.

Think of it this way.  When the price of carbon intensive products goes up, you are made worse off.  You lose something –satisfaction, happiness, utility whatever.  Suppose the government were able to design the rebate in such a way that you receive the exact amount of income necessary to make you just as happy as you were before the price of carbon intensive products increased.  What would you do?  Keep in mind that you now have enough money to make you just as happy as you were before, but carbon intensive products are relatively more expensive because of the cap and trade.

Unless you are really screwed up, you would adjust their basket of consumed goods so that it includes more of the relatively cheaper goods.  Even with the income effect, the change in relative prices will cause reduced emissions.

So why doesn’t the NetFlix example work?  Two reasons:  1) the tax rebate is tied to buying movies from NetFlix and 2) Substitutes whose prices aren’t changing were assumed away.  Put an untaxed Blockbuster in the picture and people will take the $5 NetFlix rebate and rent movies from Blockbuster.

It’s relative prices that matter.

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