Coase Club

In an earlier post I reviewed my opposition to imposing a carbon tax. My basic logic is that the benefits don’t justify the costs. Unsurprisingly, Reihan brings up by far the strongest response: that, in essence, we should impose a tax on carbon instead of other taxes – after all, we have to tax something, so why not tax something we want less of? It’s hard to accept my argument if there is no cost to a carbon tax.

This is often called a Pigovian tax in honor of economist Arthur Pigou, and it seems like it’s about as close to a free lunch as we are offered in this fallen world. Many very smart economists support this idea. But not all of them. Ronald Coase’s lecture upon receiving the Nobel Prize in economics is very instructive. When discussing one of the two papers for which he won the award, The Problem of Social Cost, he had this to say:

I was exposing the weaknesses of Pigou’s analysis of the divergence between private and social products, an analysis generally accepted by economists, and that was all. … Pigou’s conclusion and that of most economists using standard economic theory was, and perhaps still is, that some kind of government action (usually the imposition of taxes) was required to restrain those whose actions had harmful effects on others, often termed negative externalities. What I showed in that article, as I thought, was that in a regime of zero transaction costs, an assumption of standard economic theory, negotiations between the parties would lead to those arrangements being made which would maximise wealth and this irrespective of the initial assignment of rights. … I tend to regard the Coase Theorem as a stepping stone on the way to an analysis of an economy with positive transaction costs. The significance to me of the Coase Theorem is that it undermines the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances. Of course, it does not imply, when transaction costs are positive, that government actions (such as government operation, regulation or taxation, including subsidies) could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My conclusion; let us study the world of positive transaction costs.

I can’t see a practical way to get transaction costs on this issue anywhere close to zero – realistically it seems to me that we are in the world of positive transaction costs when it comes to anthropogenic global warming (AGW). What can we say about it?

I’ll begin the discussion by noting that, as with all tax policy, when you try to implement a seemingly simple concept, it starts to get complicated. First, a carbon tax would be highly regressive, so you’d have to institute some kind of offset, probably an income tax credit. This is especially tricky, since you have to make sure that the marginal deadweight loss (excluding the potential AGW-related benefits) of the carbon tax is no more than the marginal deadweight loss of the offset tax, or you will create a real incremental social cost. Second, if you only taxed carbon, you’d create all kinds of perverse incentives to convert some existing production to processes that create non-CO2 greenhouse gases, so you’d actually have to make this a multi-substance GHG tax (I’ll continue to refer to it as a “carbon tax” since this is the common terminology). Third, unless you make the dubious assumption that the major developing economies enact and enforce a harmonized international tax regime, a carbon tax would lead firms to conduct some GHG-producing activities offshore, typically in countries with less efficient production facilities, thereby increasing total GHG production for the offshored activities. I attended a climate change policy conference a couple of weeks ago in which a senior EPA economist gave a rough estimate that about 20% of GHG production subject to a tax in the US would leak in this manner. None of this complexity is insurmountable, but consider that the idea of “let’s tax each person a given percentage of annual income” sounds pretty simple too, but annual income tax compliance costs on the US are currently estimated to be as high as $100 billion. Assuming we do not actually do away with some other major class of taxation, imposing a carbon tax means imposing significant incremental compliance costs.

All of these complications apply even if we assume an idealized US political process, but the real fun begins when we consider how real, not imaginary, governments behave. It seems to me that there are least four huge practical problems with trying to implement a US carbon tax.

1. US carbon interests won’t just roll over. It doesn’t require complete cynicism to observe that political coalitions are not entirely composed of philosopher-kings debating the good of humanity. Trillions of dollars of assets and millions of jobs will be threatened by pushing a huge portion of a currently widely-distributed tax burden onto a subset of the economy. What do you think the reactions of the good people of Wyoming, North Dakota, and Alaska will be to the idea of paying for huge tax cuts for their beloved countrymen in New York, California and Florida? The senators for any 20 states can block most legislation. In my original NR article, I described how, in a presidential election, this dynamic would likely play out to punish harshly any candidate foolish enough to propose such a tax.

If history and human nature are useful guides, Plan A for politicians from these states will be to stonewall the tax. This is likely to be sufficiently effective that they will never need to go to Plan B. On the page of the Pigou Club website that proudly displays the list of well-known economists and writers who are members, there is this semi-pathetic plea: “We are always looking for more members. An elected official or two would be nice.” Sure would.

In the event that the pressure for a carbon tax becomes irresistible, Plan B won’t be to just roll over – they’ll demand a huge amount of money, and all of this fine-grained analysis of ”deadweight loss” and “regressivity” and so on would last about 10 seconds in a mark-up session. Who knows the details, but it would likely make the ethanol subsidy look like peanuts.

So here are the practical choices: no carbon tax or a carbon tax that comes with huge, economy-distorting side-deals required for passage. In the real world, a carbon tax would create large incremental costs, in the form of compliance costs plus likely massive inefficiency costs and economic drag.

2. We have no idea how to set the price. Burning fossil fuels adds CO2 to the atmosphere and thereby increases the risks from AGW, but these fuels create social utility by generating energy at lower direct costs than alternatives, but the US needs to bear a huge military burden to protect oil supply chains in unstable geographies, but a car-based economy allows more people to satisfy their desire to live in detached homes with yards, but roads are subsidized to do this and it crates excess congestion, and so on and so on ad infinitum.

There is an unending set of externalities created by fossil fuels, and there is no logical reason to privilege AGW-related costs over any others. If I die in an AGW-caused flood or I die from cancer caused by inhaling the fumes from somebody else’s car, I am in both cases equally dead.

But surely economists have worked through this, and come to some imperfect but tolerable estimate of fossil fuels externalities, right? A recent review of such analyses by European academics finds that the estimates for the external costs per kilowatt-hour of, for example, coal range from about .01 cents to $10. Glad they cleared that up. Even the middle 50% of studies have cost estimates that range by a factor of about 20. Depending on the analysis, AGW-related externalities might be anything from a dominant to a trivial component of external costs.

Now, a reasonable person might say: “So what, after all, we believe there are some external costs, so why wouldn’t some tax be a good idea?” The problem, as this same study indicates, is that the every form of energy production from fossil fuels (coal, oil and gas) to alternative fuels (nuclear, solar, biomass, etc.) has a huge range of estimated external costs. The cost estimate range for every energy source overlaps with the cost estimate range for every other energy source. How can we rationally choose which ones should be taxed at what level vs. the others for the purposes of pricing the externalities? Or are we to tax all energy production vs. other economic activities? Surely, this would provide an even higher-level challenge than comparing different methods of energy production, which is one we’ve failed. There is a world of difference between accepting the concept that pretty much any important activity has large external effects, and believing that a government has the ability to measure these externalities and tack them onto existing market prices in a rational manner.

We have to make policy decisions in the face of incomplete information all the time, but if we decide that it’s a good idea to use less oil for geopolitical or other reasons, we shouldn’t pretend it is some kind of fancy, analytical construct called “pricing an externality”. In practice, the actual level of a carbon tax would be set entirely politically, that is, based on the bargaining power of various interest groups, rather than through some abstract economic logic.

3. A carbon tax designed for the expected case can safely be avoided for decades, while a carbon tax high enough to ameliorate a low-odds disaster scenario would be insanely expensive. Suppose we did agree to focus only on climate externalities in setting a carbon tax. Based on the analysis of Nordhaus’s DICE modeling group at Yale, the optimal tax burden would be relatively low for the next several decades and then ramp up over time. In everyday terms, the gasoline tax, for example, would be about 9 cents per gallon through 2010, and would then ramp up to about 25 cents per gallon by 2050. To put this in perspective, the typical US state already has about a 40 – 50 cent per gallon gas tax, and a typical Western European country has gas taxes of several dollars per gallon. We are not going to transform our economy with such a tax; major changes really start in the latter half of the upcoming century. The low incremental taxes for the next several decades put into even starker contrast the relative practical risks of implementing a new global tax regime in return for such a small immediate changes in tax loadings.

What it would it cost us to wait? Consider the thought experiment of implementing no new carbon taxes until 2050, and then jumping onto the optimum policy ramp at that time. My back-of-envelope calculation is that the world would be about $1 trillion worse off in present value terms than if we began the optimal policy ramp today. Even if the US shouldered a pro rata share of this impact (which is unlikely because of our geographic position), this would cost something like $250 billion. Think of this as the option price to wait to 43 years.

In the world of multi-century software models, 2050 seems like it’s just around the corner. Here on planet Earth, 43 years is a long time. Based on 20th century experience, it’s about 11 US presidential election cycles, 1 French Republic and 0.8 global wars away. Because so much can happen, and we can learn so much, in 43 years, it’s a fairly cheap option to get more information.

That would change, of course, if our forecasts turn out to be wildly incorrect. As I have written about at length, this is a reasonable fear (remembering that modelers are not idiots, and they build probability distributions of outcomes into models – what we are discussing here are “outside of distribution” or “black swan” events that are inherently unquantifiable). But suppose some massive, unanticipated climatic change begins to occur within the next, say, 20 years – which would you rather have: the lowered emissions and associated technological change created by a 10 – 20 cent per gallon increase in fuel prices, or 20 years worth of directed research to build technological options?

One could argue that we should therefore have much higher carbon taxes immediately. To take one such benchmark, if we introduced a tax high enough to keep atmospheric carbon concentration to no more than 1.5X its current level (assuming we could get the whole world to go along), we would expect to spend about $17 trillion more than the benefits that we would achieve in the expected case. That’s a heck of an insurance premium for an event so low-probability that it is literally outside of a probability distribution. Of course, I can find scientists who say that level of atmospheric carbon dioxide is too dangerous. Al Gore has a more aggressive proposal that if implemented through an optimal carbon tax (again, assuming we can get the whole word to go along) would cost more like $23 trillion in excess of benefits in the expected case. Of course, this wouldn’t eliminate all uncertainty, and I can find scientists who say we need to reduce emissions even faster. Once we leave the world of odds and handicapping and enter the world of the Precautionary Principle, there is really no principled stopping point. We would be chasing an endlessly receding horizon of zero risk.

It seems to me that under the expected case, it is cheap (vs. the costs created by the political process required to create a carbon tax) to wait. Raising the tax high enough fast enough to realistically change the economy fast enough to impact a disaster scenario within the next several decades is enormously expensive, and it would at best blunt the impact. In such a scenario we would most want the technological geo-engineering options that would be the outcomes of the kind of technology-focused program that I have proposed. It’s hard to see the non-pathological case that justifies the tax being implemented for decades.

4. In spite of the rhetoric, a carbon tax will likely increase the total tax burden. While it is almost impossible to address this analytically, it seems very likely to me that we would not really reduce other taxes as an offset, or at best do so only very temporarily. (Reihan doesn’t make this argument, and is more intellectually honest and/or practical than many carbon tax advocates in saying that he thinks we need new sources of revenue). There will always be some new crisis to justify more government spending, and having put in place a whole new tax-collection mechanism will just make it easier. I think that to a first approximation, when you raise taxes, you raise taxes. So we would not just have the various compliance and inefficiency costs that we have been discussing, but in fact all of the lost efficiency of a higher tax burden as well.

The idealized carbon tax is an almost perfect example of what Coase famously called “blackboard economics”: abstract economic theory that proceeds by ignoring a detailed knowledge of the actual economic system. You can’t separate the “merits” of a carbon tax from the “politics” unless you want to compare the kind of carbon tax you could create in the imaginary world where you are absolute dictator to the alternative policies that have to be developed in the real, messy world of democratic politics. It is this practical recognition that explains why all those “dumb” politicians are blind to the incredible elegance of this academic creation.