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.
Nice article, Jim. Thanks also for the link to the Sundqvist paper.
I think this issue would benefit from more extensive debate with someone on the pro-side. But here are a few off-the-cuff responses:
1) You say we’ll have to bribe the oil/coal companies to go along with it. Well, 2 of the 3 top Dem candidates propose cap and trade with 100% auctioning of permits. That’s not to say there wouldn’t be giveaways elsewhere, but a Democratic president/congress may be able to achieve things that a mixed government could not.
Also: if you tax everyone and give coal a 50% break, it seems to me you’ve still brought the economy closer to accurate prices. Of course that assumes we can set the proper price…
2) You say we can’t set the price. The Sundqvist paper is instructive. So, a lot of economists disagree about the right externality-price, the prices of coal/oil aren’t clearly higher than those of renewables, and anyways we’re leaving out that proper valuation is a moral/political question, not a question we already know the answer to.
I think this is a very good point. Economists can tend to be shady about why we should tax this externality in particular, when there are plenty of others. Using petroleum in cars has plenty of positive externalities for commerce, etc. It’s a bit disingenuous to zero in on a politically ripe target for externality pricing absent a comprehensive assessment of at least the positive and negative externalities of different forms of energy. Unstated moral assumptions are clearly seeping into the economics here, in an underhanded way.
As to the point about how proper valuation needs to come out of the political process, well, Bryan Caplan’s “The Myth of the Rational Voter” does not inspire much confidence here.
Despite all that, I think that a carbon tax survives scrutiny because it’s the cheapest way to achieve emissions reductions. Looking from Jim’s favored “real world political” perspective, I believe (but I admit the polls don’t support me right now) people are going to want to do something about global warming; the left (myself included) won’t quit yapping about it; so a carbon tax is the best way forward. Alternatives like CAFE, renewable energy standard, etc. are more costly. So, given a stated goal of emissions reductions, a carbon tax is the way to go. Jim may believe that the economic analysis is wrong and that tech subsidies achieve emissions reductions more cheaply, but I believe he would contradict existing economic analysis (http://www.rff.org/~fischer/papers/envirotechpol.pdf) to say so.
Also of note is that most people who want a carbon tax want tech subsidies as the “second-most-important” adjunct. The knowledge spillover externality is also important (http://www.rff.org/~newell/JaffeetalEcolEcon.pdf).
So in a nutshell: I might be willing to agree that it’s all political, but I still think a carbon tax is the best <i>political</i> compromise. At some point we have to stop haggling over Nordhaus papers and start deciding whether to pass bills given our current preferences. I argue that a compromise like a carbon tax will be necessary.
3) “We don’t need a carbon tax yet, unless we’re already so screwed that we need to wreck our economy to avoid disaster.” Good point, but a small carbon tax, I believe, is still the best hedge of risk, better than waiting. To decide this point once and for all I think we’d need to have an empirical estimate of the economic loss due to dead-weight and political rent-seeking. I’m not saying your point is not defensible but it is not decisive for people who place more importance on the environment. We each retreat to our preferences.
4) Carbon tax means more tax. You might be right; for me this is not a decisive argument. It’s a bit circular, though: insofar as your argument is effective that “revenue neutrality is a necessary part of a carbon tax”, well, that becomes part of the political bartering process, and increases the odds that revenue neutrality becomes a component. I think I just made myself dizzy.
— mk · Dec 5, 05:50 PM · #
I’m persuaded by Jim’s analysis, despite the fact that my strong inclination is to take some kind of action. I’ve been disappointed in some of the replies to Jim’s post re: the likely political outcomes. There is a naive faith in the ability of Democratic majorities to deliver philosopher-king policies, particularly since politics is an iterative game and those Democratic majorities will want to fend off the opposition. When a carbon tax can be portrayed as pitting one region against another, as it inevitably will, the political risks will be very high. The side deals will become correspondingly boondogglish, for lack of a better term.
Like MK, I’m not allergic to new taxes. But it’s also true that new revenue sources don’t go away easily. Some of Jim’s critics claim that taxes are cut or eliminated all the time, which reflects their American vantage point: while it’s true that the “death tax” has been “eliminated,” i.e., it will be eliminated in 2010 to come back in 2011. Or consider Britain, where a host of new revenue sources have been established during the Blair-Brown years. Will, say, a Cameron government simply get rid of them? Experience suggests otherwise. But this is a debate that requires attention to past track records, not an appeal to a vague sense about what the Bush years have meant in one fairly atypical polity.
— Reihan · Dec 5, 10:45 PM · #
mk:
Thanks for the thoughtful commentary. Some quick reactions:
1. This post was specifically meant to address the quetion of “Is a carbon tax actually a free good?”, rather than cap-and-trade or some other alternative. I think that cap-and-trade is the practical alternative on the table.
2. I think the political question of will we: (1) do nothing, (2) implement cap-and-trade, (3) institute more stringent CAFE standards, (4) invest in technology, or (5) some combination or other, etc.? is up for grabs. My view is that neither cap-and-trade (viewed as less elegant by the academics, but more palatable by the politicans) nor a carbon tax (the reverse) is the best policy, but that we should be investing in technology.
3. I agree that is the analysis that we would ideally have.
4. I agree that this is dizzying. I didn’t get into it in the post, but you can gt yourself into a wilderness of mirrors on the attributable effect of this on tax burden, but as I said, in the end, when you raise taxes, you raise taxes.
— Jim Manzi · Dec 6, 12:12 PM · #
As a neutral observer, it is distressingly uncommon to find intellectually honest conservatives, and so Jim Manzi’s post is a refreshing step in the right direction. It is clear that he is making an effort to understand the economics of possible carbon taxes. But when one reads outside of his field, there is always the risk of reading selectively and as a result coming to inadequately founded positions.
For carbon, the basic issue is that property rights to use the global commons as a place to sequester unwanted carbon are not assigned, and therefore we have a situation of an open access resource, with a zero scarcity price, and therefore a market failure and overuse.
So there is no question that government intervention is required, if for no more than to assign the property rights and create a market to allocate the scarcity efficiently. Coase’s basic contribution was to shift the focus to the role of property rights as undermining markets, but his suggestion that bargaining will spring up automatically, as when my neighbor and I have an issue with his noisy air conditioning compressor, is of limited use precisely because of the information and transactions costs for regional and global pollutants. So today’s textbooks do review the theorem, but then point out that it is of little practical use for the major pollution problems.
A few points:
1. First order (partial equilibrium) deadweight loss for carbon taxes is not a big issue because the demand for fossil fuels in general is very inelastic, an likely to remain so for a long time. Because of the near perfect inelasticity of the demand for fossil fuels, after land taxes, a carbon tax is about as efficient a tax instrument one can have. The recommendations for green taxes applies here: tax what we don’t want people to do, i.e., pollute, and reduce taxes on what we do want them to do, work. There is a literature on the general equilibrium effects of tax vs. permit instruments, but in general, these are second order matters. As one who constructs pollution markets, there is no question that the transactions costs for a carbon tax are lower than for permit markets. The tax administration system for collecting fuel taxes is already in place, and virtually all states collect severance taxes now on coal, natural gas and oil.
2. Finding the right price will be a matter of trial and error, just as it is for any new product introduced into the market place.
3. The political economy of the issue, either through carbon fees, or tradable carbon emission permits, will always require offsetting the adverse income distribution effects. True for taxes, and for permits.
4. A major deficiency of his argument is that he says nothing of irreversibilities. There is a large literature on this problem, known as option and quasi-option price, which he does not mention, and neither does Nordhaus, a fact that greatly diminishes the validity of his findings. This is a method by which to place a present value on knowledge to be learned from not making irreversible decisions now, which we are blithely doing. See this relatively recent article: K. Keller et al., “Uncertain climate thresholds and optimal economic growth”, Journal of Environmental Economics and Management 48 (2004) 723–741, and M. Ha-Duong, “Quasi-option value and climate policy choices”, Energy Economics 20 (1998) 599-620
5. Similarly, there is a large and growing literature the discount rates for long term environmental investments should be declining. This makes Nordhaus’ calculations excessively optimistic.
That said, a serious discussion, without ideological positions, is welcome, and I hope that Jim is able to cause some serious reflection in the conservative community.
— HCG · Dec 9, 03:15 AM · #
HCG:
Thanks for your extremely thoughtful and informed comments. A few quick reactions and/or questions, keyed to your numbers:
1. To the degree that fossil fuels demand is highly inelastic, doesn’t that negate the emissions reduction impact of the tax? (Recognizing that we are: (i) speaking of degrees, and (ii) that we mean long-term elasticity as driven by technological development over time.)
2. My header for the relevant section of the post probably didn’t communicate the point well. It’s unclear to me, since we can’t measure the external costs (including AGW plus everything else) of carbon and non-carbon-intensive fuels within an order of magnitude, how we can engage in trial-and-error learning. How will we know whether we have decreased or increased total external costs once we have shifted X units of production, say, from LNG to biomass?
3. I agree.
4. In the first post, referenced at the start of this one, I described the practical reality (in my view) that there are huge regrets on the other side as well. That is, once we institute a carbon tax, as a practical matter it will be extremely hard to reverse it. I agree that there are also large expected regrets to delay in implementing emissions abatement. I indicated in my post that I thought the global cost of delay to 2050 was about $1 trillion. Thanks for the cites on the Keller and Ha-Duong papers. In Keller’s recent paper “The regrets of procrastination in climate policy”, Environmental Research Letters (2007), he estimates regrets of delay of 43 years that look to be about $2 trillion at the IPCC best estimate climate sensitivity of 3C. I think (but don’t know without detailed review of the dataset) that this difference is driven by a different discount rate than that used by Nordhaus. I think that the balance of regrets – given that as per the first post I believe that the global political assumptions of a harmonized tax are so unrealistic – argue strongly against introducing large-scale emissions abatement any time soon.
5. I have read a lot of papers on this topic, but am far from a technical expert. I describe in my first post the (I’m sure well known to you) “wrinkle experiment” that I think makes a pretty devastating case that the discount rate used in Stern is not rational. Obviously, that still leaves a lot of room for debate. I think that when considering periods of 100+ years, our intuition around discount rates starts to break down, and it is always instructive to look at the stream of cash flows directly. As per the prior comments, I think that it’s hard to find a discount rate that justifies sacrificing a significant amount of consumption today in a world with average annual consumption of ~$7K in return for avoiding a ~3% reduction in consumption a 100+ years from now in a world with average consumption of ~$90K. (all these figures from memory)
Again, it’s always instructive to hear from an expert on the topic, and to engage on these questions in a fact-based manner. Thank you for taking the time to do this.
— Jim Manzi · Dec 9, 07:24 AM · #
A great discussion on carbon taxes! Even at $90/barrel, oil is not reducing demand in the developed world, yet I believe it is the price mechanism — whether a carbon tax or some other method — that should be used to create efficiencies in carbon use and reduce greenhouse gases.
Incidentally, Readers might like to know that they can get the latest green and socially responsible investing news at www.investingforthesoul.com
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Best wishes, Ron Robins
— Ron Robins · Dec 10, 05:31 PM · #