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.
Thanks for the nice post, and clarity of thought on a difficult issue. One question: On balance, do environmental economists agree with the Nordhaus model, about the costs vs. benefits of mitigation? Or are the quoted numbers contentious in the env. economics community?
— mk · May 1, 04:59 AM · #
Thanks for the very interesting post.
I think the political considerations you point out are the real killer. Just look at corn-based ethanol -universally derided yet the centerpiece of our alternative energy plans. It would take huge amounts of political capital to do this in anything close to the right way.
The other problems you point out seem less serious – that is, if we’re discussing what we should do rather than what congress will pass, then they are all solvable. To mention just a few –
The export problem seems serious in only a few industries – aluminum, cement, I don’t know what else. A lot of energy use can’t be exported – transportation or lighting for example – and in most of the rest of the economy any reasonable energy tax (combined with corresponding reductions in some other tax) wouldn’t be a major problem.
Of course you’re right that there’s no way to know the optimal level of taxation, or for that matter what the appropriate environmental targets are, but it is clear that large oil imports and large emissions of greenhouse gases both have potentially serious externalities. It would make sense to move some tax away from things we want to encourage – like jobs – and put them on carbon instead. Why not cut the payroll tax and put some fairly straightforward taxes on coal, oil and natural gas to make up the difference? We have to tax something, and at least part of the tax might as well be on things we want to discourage – tobacco, coal, etc. If the political will was there it wouldn’t be that complicated – although those could be famous last words.
The uncertainties are so large in this area that people’s positions seem to have as much to do with personality as analysis. Some folks are risk averse, see the carbon dioxide level going where it’s never gone before, and panic. Some think of all the cool ways we can fix the problem – sequestration, maybe even giant space mirrors! – and don’t worry as much.
— Peter · May 1, 06:19 AM · #
I would much rather live in the world in which we decided to take modest measures, then realized in 2050 that those modest measures were a waste of time, then a world in which we decided to “wait” and find out that we should have done more today. In either case we have the option to change course in 2050 or any point before that as more data emerges, so we might as well take the course with the highest expected payoff as data collection continues.
It might make sense to take a course with a lower expected payoff if the other course was somehow riskier, but in this case the “wait and see” has larger risks than the “act and see” approach.
— Consumatopia · May 1, 10:32 AM · #
We know that the answer to the sundry environmental problems is one that will be very difficult to find. but so is flying to the moon and we have done that. Prehaps we should copy the model we used to solve that challange and apply it to this one. Why not develope a large gov’t funded organization consisting of engineers and scientists capeable of tackling one problem at a time. we would get alot solved and just look at the products NASA has produced that are sold on the market today(WD-40 comes to my mind)
— zach baron · May 1, 02:17 PM · #
mk:
They are the subject of great contention. Nordhaus’s general findings represent a reasonable mainstream view. Notable examples of economists who think the present value of costs is much higher include Niicholas Stern (author of the Stern Review), who argues for a much lower discount rate and Martin Weitzman, who argues for a different discounting function and a different method for include the expected costs from extreme events. Nordhaus has addressed (conclusively, in my view) Stern’s arguments about discount rates. I’ve addressed the Weitzman article in a very long post here at TAS – you can judge for yourself how successfully.
— Jim Manzi · May 1, 06:49 PM · #
Point 1: You have a curious way of expecting the whole world of science and the fossile-driven economy to be turned upside-down in four decades in the end of the article, while you are assuming perpetual stupidity in the Senate in the first part. Most environmentalists are into the business of arguing what would be best for the environment, not arguing what would be possible given current political conditions.
The point related to offshoring is technically correct, but hardly a convincing argument against a carbon tax. If the US supports an international carbon tax, the world is ready. After all, the world has spent ten years tring to get US aboard Kyoto. And if the world is not ready, they must be coerced. I’ve heard the US are pretty good at it.
2. Pricing is clearly an issue, but any tax on carbon fuels will reduce net energy consumption, which is good for the environment. Costs are quite simple to observe, and there is no need to set a tax rate that is supposed to last forever. If the tax strangles the economy, it will be reassessed. After all: we will know everything in the future (or so you assume).
3. Is this a crisis? Well, I don’t know your source of information, but the IPCC does not exactly recommend “waiting a few decades” with carbon cuts.
The IPCC is generally cited on their mean estimates, which are fairly terrifying. Those are 95% CIs, though, and they are two-sided. The correct way of dealing with such a situation is to tax as necessary if the mean was true, and then add some risk aversion (because the likely consequences of “too little tax” are worse than “too much”). Remember that the black swans are on both sides of the confidence interval.
— Indregard · May 3, 12:03 AM · #
Indegrard:
My reactions, indexed to your point numbers:
1:
You have a curious way of expecting the whole world of science and the fossile-driven economy to be turned upside-down in four decades in the end of the article, while you are assuming perpetual stupidity in the Senate in the first part.
Right now the projected costs of AGW just aren’t that big (vs. the costs of rapid, aggressive emissions abatement). If, in 40 years, we have a much, much higher estimate for expected costs, it’s reasonable to expect that behavior would be different.
Most environmentalists are into the business of arguing what would be best for the environment, not arguing what would be possible given current political conditions.
I do my best to be practical.
The point related to offshoring is technically correct, but hardly a convincing argument against a carbon tax.
I agree, which is why I described it as “not insurmountable”.
If the US supports an international carbon tax, the world is ready. After all, the world has spent ten years tring to get US aboard Kyoto.
Whihc agreement “includes” China and India in a way that requires no emissions abatement from them.
And if the world is not ready, they must be coerced. I’ve heard the US are pretty good at it.
Come see the violence inherent in the system.
2. Costs are quite simple to observe
As per my post, I guess they are a lot easier for you to measure them than they are for me.
3. The IPCC is generally cited on their mean estimates, which are fairly terrifying.
IPCC 4AR mean estimate for warming by 2100 under scenario A1B: 2.8C
IPCC 4AR estimate of economic impact of 4C warming: 1 – 5% reduction in global GDP.
Expensive? Yes. Terrifying? Not to me.
— Jim Manzi · May 3, 07:34 PM · #
Top stuff. It was a long way round of saying ‘do nothing’, but as with most perceived problems, ‘do nothing’ should be the starting point and just watch and see what happens first.
— Mark Wadsworth · May 5, 08:54 AM · #
Perhaps, in lieu of a carbon tax, for now we should focus only on solutions that we ALREADY know pay for themselves in the long run, even when discounting the environmental advantage. For example, solar panels, wind mills (so long as there is a stable bird population), hydroelectric, and even nuclear power have minimal environmental costs and even PAY for themselves in the long term, from a purely economic perspective. Biofuels and some other solutions have many economic and environmental external costs.
The problem is that most people do not think about economic advantages in the long term. Thus, I think payment plans are the best way to go. If we tell people who buy solar panels, that they will have to pay no more than they would have for coal per month, then the government would break even after about 20 years, and would even gain money if the plan requires that the person renounces their right to ever “own” the solar panel. This plan would not yet work for cars because there is no good replacement for auto fuel as there is for coal in sunny regions. But that could be a tremendous start, especially because the only real “costs” are ugly roofs and delayed economic gratification. Once all those “no long term economic cost” solutions are implemented, maybe THEN we can focus on carbon taxes. But it won’t be for some time until we’ve exhausted all the low-cost solutions, and I suspect that by then we’ll have more knowledge both about the true risks of GHG emissions, as well as their true “costs.”
— adina · May 6, 06:33 AM · #
Well, as a Swede, if you say U.S. democratic institutions are inherently flawed in such a way that a federal carbon tax don’t stand a chance, I’m inclined to take your word for it. However, I don’t feel that your arguments for waiting are that well thought out.
1. The spread of external cost estimates can be narrowed considerably not only by taking the middle estimates, but using later, more prominent (more cited) work.
2. The exact level of the tax that is initially agreed upon might not be what scientist deems optimal, sure, but it will almost certainly be lower and obviously that will be better than nothing.
3. The enourmous cost you associate with the tax – why should we regard those as more precise than the estimates of externalities? Since externalities are avoided, the likely outcome is that the economic effects of the tax are, in fact, positive. Especially since payroll taxes, with their associated costs, can be lowered using the carbon tax revenues.
4. Sure, the U.S. lowering of external costs would benefit the entire world, so you wouldn’t reap all the benefits yourself. OTOH, it would be morally right and set a good example, and you do represent 25% of the world GDP. We Europeans, representing another 25% while being poorer on average, are way ahead of you here. If you get on board, probably China, India and Japan will too. For most countries, such a tax shift isn’t that big a deal.
5. Why preferentially choose external carbon costs, of all things, to internalise, you ask. Well, do you really need a reason to do a particular optimization, other than the fact that it is an optimization? AND, this one is a good candidate because of the media attention, and if it works, perhaps we have experience and momentum enough to do something about overfishing, too?
— Jesper · May 7, 07:53 PM · #
Jesper, Thanks for your comments. Here are some quick reactions.
1. As per the example I gave, I think that the source of the incredible range of estimates is not that we have been advancing the precision of our measurement instrument over time, so that we can take the later / better studies and get a narrower range, but that the estimation process itself is inherently subjective. I think that imagining we can get an expert measurement of the external costs of carbon emissions is scientism.
2. There are already large taxes on many of the most important forms of carbon. For example, about 50 cents per gallon in the US and several dollars per gallon in most Eiropean countries on gas – how do you know that this is “certainly lower” than the Platonic optimum?
3. I don’t know how enormous it would be.
4. I think that even if the whole world moved to a common regulatory framework, then the benefits to the whole world would be less than the costs. I think that if you want to use this as a foreign aid program, it is incredibly inefficient. I don’t think that the argument that the US and Europe “owe” this to developed world because of historical emissions holds water (see my post at TAS “Emmissions Equity”) if you want to see my reasoning. I also think that the worst thing to do in terms of negotiating leverage with China, India, et al is to preemptively give up he leverage of the “I will, if you will” card.
5. Once again, I don’t think that that legally-forced reductions in CO2 emissions is a good idea in absolute terms.
— Jim Manzi · May 8, 06:10 PM · #