I’m not sure that this Wall Street Journal article gets the “carbon tax” vs. “cap and trade” debate quite right. It portrays the dispute as a split between politicians and economists:
Many academics, even conservatives, favor a tax on carbon emissions. Many lawmakers, including some liberals, fear a political backlash against new fees. They lean toward a cap-and-trade system, which would set a limit on carbon-dioxide emissions and require companies to obtain permits to release carbon dioxide into the air.
Obviously, there’s some truth to the economist/politician divide. And to its credit, the article gets one big issue right: to a large extent, “cap and trade” is a tax by another name. Both drive up the cost of emitting carbon, which leads all actors in the economy to cut back on emissions. (Even some proponents of cap-and-trade don’t seem to recognize how similar that system is to a tax.)
But to me, the fundamental divide isn’t politics vs. economics. It’s this:
Do we want a system where the emissions reductions are fairly certain, but the price tag for polluting is unpredictable (i.e., a cap)? Or would we rather have a system in which prices are a given, but the effects are difficult to gauge in advance (i.e., a tax)?
If you prefer price certainty, then a tax is for you. Many businesses would share that preference, since a fixed-rate tax—or perhaps even a tax that rises on a pre-set schedule—is predictable. And that makes it much easier to make long-term financial plans.
For example, if utilities know that it’s going to cost $15 a ton to emit carbon for the next 5 years, then they can plug that into their business spreadsheets, and plan an orderly (and potentially profitable) transition to reduce their fossil fuel use. But without predictability in prices, they may over- or under-invest in renewable energy, and get caught holding the bag if their guesses are wrong.
So taxes provide some certainty about the price of carbon—which is generally a good thing. But the problem is that, for any given level of tax, it’s just not clear how much economy-wide emissions will go down.
If the economy is booming, for example, then even a steep tax might not dampen emissions much. Or, in the alternative, if the economy is slow, then a tax may not even be necessary to reach annual emissions targets. And perhaps the tax will never quite be high enough to reduce CO2 emissions as much as climate scientists think is necessary.
So with taxes, the big unknown is whether any particular level of tax will be as effective as it really needs to be. (Carbon tax proponents also point out that it’s a lot more straightforward to levy a tax than to set up a complicated carbon auction and trading system…but that’s another matter.)
On the other hand, if you prefer certainty in the emissions reductions themselves, then you’ll favor a cap. Thus, both politicians and economists who are most interested in meeting specific emissions targets tend to prefer a cap.
But, quite obviously, under a cap it’s virtually impossible to know the price at which carbon allowances will trade. Europe’s system, for example, has experienced some wild price swings. In geek-speak: under a cap, the price of a ton of carbon will equal the cost of the most expensive ton of carbon avoided in order to meet the cap. But it’s impossible to know, in advance, what that cost might be—which is the whole point of a cap-and-trade system, since it harnesses market forces (i.e., the distributed efforts of lots of clever individuals) find the least-cost solutions—solutions that aren’t always obvious at the macro-level.
To me, the tax vs. cap dichotomy seems a bit Heisenberg-y, in that there’s roughly equal uncertainty in any system. With a tax, you know the price but not the emissions. But with a cap, you know the emissions but not the price. There’s always uncertainty—it’s just a question of where we choose to concentrate it.
And that, more than “politicians vs. economists,” is the real divide: between people and institutions that want to plan their finances, vs. those that prefer a firm guarantee that the economy overall really and truly meets its climate-protection targets.
Jonathan Shakes
I think you’re missing another big difference: who gets the revenue? With cap-and-trade, the current polluters get the revenue. With the overt tax, the government gets the revenue. The government could use that revenue to reduce taxes on other activities (it sure would make it easier to sell to the public if an income tax cut were attached to the carbon-tax law!), or invest the revenue towards research on global warming.
Eric de Place
Jonathan,Your point is important, but there are actually two ways of structuring cap and trade. In the first, carbon permits are allocated for free—and in this case you’re right. In the second, the carbon permits are auctioned off, and the auction revenue can be put to all the same uses as carbon tax revenue. You’ll see lots more of this subject here. In the meantime, you might find this primer interesting.
phil
I’m curious what you think of Pizer’s argument (PDF) that short-term certainty about quantity is not critical in a situation where what matters is the long-term stock of GHG? His simulations show that price controls are not only way more cost-effective, but on average deliver more emissions reductions. That’s because the cap-and-trade approach does not give emitters an incentive to reduce emissions below the cap, whereas under a carbon tax, less emissions is always better.
Clark Williams-Derry
Haven’t read the PDF, Phil, but from your summary Pizer’s argument makes some sense to me. I’d be very happy with a CO2 tax that sent economy-wide price signals for emissions—but only as long as the rate was enough to be effective!! And that’s where I think the problem lies—we don’t know how steep that is, really, either in the short or long term. In fact, I could see the tax being set too low at the outset, and it being politically impossible to keep raising it every few years. (See, e.g., the US federal gas tax, which hasn’t remained steady for 14 years.)Still, in theory, a tax has lots of advantages—simplicity, low overhead, economy-wide, hard to game, etc. But if it’s impossible to get the rate right, then I think it’s a mistake. In fact, you can think of a carbon cap as a complicated exercise in setting tax rates.
Morgan Ahouse
“vs. those who prefer a firm guarantee that the economy overall really and truly meets its climate-protection targets.” Just as a tax may fail to adequately induce sufficient GHG reductions, so to may a cap and trade system fail to set adequate climate-protection targets.It seems to me that there’s no way to get either a carbon tax rate or a carbon cap set at the right level. There are probably no two scientists, economists or politicians who could agree on either, not to mention how a group could come to such an agreement. For example, is the emissions cap 7% below 1990 levels , or 80% below today’s levels or somewhere else? If we believe that getting the rate/level right is requisite to policy action, then we’re probably in trouble. I think it’s more important to get the broader system moving in the right direction and do so as soon as possible, since climate seems to respond nonlinearly and irreversibly. Moreover, a carbon tax proposal, despite its bad taste, could be matched up with a balancing element, like displacing the climate-dumb B and O tax, to foster coalition building.So Clark, your point about the elasticity of CO2 output in response to a tax is well taken and reminds me that GHG production is a complicated problem requiring multiple approaches.