Can The Optimum Carbon Tax Possibly Be Zero?

The Energy and Environment blog at TNR has a post up replying to Will Wilkinson’s post arguing that we don’t know how to set the price on a theoretical carbon tax. The gist of the reply is the sensible-sounding observation that “There’s essentially no disagreement at all that there’s some externality associated with carbon emissions, so the optimal carbon tax is certainly not zero.”

I believe that this is not so obvious, however, when you think it through, for at least three reasons.

1. The theoretical net benefits of a carbon tax (AGW cost reduction – reduction in output created by diverting behavior to activities that will produce less economic output) are not a free good. We have to “purchase” them with incremental compliance costs plus incremental deadweight loss that the political process might create. It is unknowable, but highly plausible, that in the expected case these would outweigh the theoretical benefits of the tax.

a. Unless we eliminate some other major class of taxation, there will likely be non-trivial pure compliance costs. As a starting point recognize that 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). Second, if the US imposes such a tax and some other countries do not, some production of GHG-sensitive goods will move offshore. In general these production facilities will consume more energy per unit output, and therefore more GHG emissions per unit output that the US production it was designed to displace. This will reduce the net benefits of the tax and/or require some kind of tracking and import duty system to reduce this “leakage”. All of this complexity is not insurmountable, and we already have some data collection and enforcement mechanisms in place at the state level, so pure compliance costs won’t be infinite, but they will be large with that much money changing hands. 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.

b. Carbon interests will not just roll-over, and these side-deals will likely create enormous deadweight loss. 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 National Review 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. 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. Think this is an excessively cynical read of the US political system? Think about this: academics and bloggers all prefer a carbon tax to cap-and-trade because it is so much more efficient, but every presidential candidate supports cap-and-trade because it makes it easier to hide the cost to consumers, and so is more politically palatable. So far, we can’t even get the political process into the more efficient category of the carbon tax instead of cap-and-trade, so it’s highly dubious that we could get it to an optimal carbon tax.

2. To Will’s point, we have no idea have 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. Think about this numericaly. The cost of a kilowatt-hour in that you would buy for your house is on the order of 10 cents, so incorporating the external costs would lead to a price increase of somewhere between 0.1% and 10,000%. Even using only the middle 50% of the studies (remembering that this is not a 90% or 95% confidence interval, we are arbitrarily eliminating fully half of the estimates), this would lead to something like a 1 cent to 20 cent, or 10% to 200%, increase in the price of coal.

There is a good reason for such massive uncertainty. Consider what it means to estimate the “external costs” of, say, petroleum. You have to unwind a chain of causation that is, in effect, infinite by evaluating the economics of the counterfactual world that does not dig up and burn oil. Let’s see. What vehicles would we now use for transportation? Would we have a smaller fleet of larger vehicles like trains, or would we have a larger fleet of smaller vehicles like battery-powered golf carts? Would this lead to different patterns of residential dispersion that would lead to both changes in transportation fleet, but also changes in family structure that in turn created changes in ethical and religious beliefs? Would the US armed forces now be smaller because we would have less need to defend the Persian Gulf supply chain, resulting in lower taxes and different domestic politics? Would this lead to further economic and social changes? Would this also result in different international perceptions of the US that would change international investment flows? Would it result in increased use of biofuels that would in turn change corn prices that would in turn lead to differing immigration patterns that would in turn lead to different political choices in the US that would in turn lead to higher levels of funding for K – 12 education that would in turn lead to a more effective US labor force that would in turn lead to greater economic productivity? You get the idea. It’s a Hayekian nightmare. Any “objective” analysis will inevitably be burdened by subjective assumptions that will dominate the resulting answer. There’s a reason we use markets to set prices.

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. But by what principle should we limit this idea of the government estimating the external costs of some activity and adding onto prices by law only to energy and only to AGW-related costs? As we’ve seen, there are plausible estimates for external costs that range from trivial price increases to, in effect, outlawing a commodity by price fiat. In practice, we would be handing the government the right to set prices for every good or service in the economy. 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. Here’s the logic by which some privilege AGW-related costs: climate change is a “global emergency”. (I’ll note that it’s interesting that the academic studies of AGW vs. total external costs do not seem, to put it mildly, to have achieved any consensus on this point.) But is this really true? Actually, 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.

Sorry for the length of this post – I’m sure somebody else could have figured out how to say this much more efficiently than I did.