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Carbon Taxes vs. Cap and Trade

In yesterday’s post I argued that the easiest path to deficit reduction is to impose new taxes on activities that cause harm to others—Pigouvian taxes on negative externalities, in the economist’s parlance. Probably no negative externality has commanded more attention in recent years than the emission of CO2 and other greenhouse gases.

One of the central weapons in President Obama’s proposed attack on global warming is a carbon cap and trade system. Under cap and trade, the government first sets a limit on how much total carbon can be released into the atmosphere each year (the “cap”). Companies can still employ production processes or sell products that release carbon into the atmosphere, but only if they first purchase a permit for each unit of carbon released (the “trade”). For example, if the cap were set at 5 trillion tons per year, the government would auction off that many tons of annual carbon permits to the highest bidders.

When economists first proposed a similar system of pollution permits for attacking the problem of acid rain during the late 1960s, critics complained that it would “let rich firms pollute to their hearts’ content.” Such statement betrayed a comically naive understanding of the forces that guide corporate behavior.

Firms don’t pollute because they take pleasure in fouling the air and water but because clean production processes cost more than dirty ones. Requiring firms to buy pollution permits gives them an incentive to adopt cleaner processes. To avoid buying expensive permits, firms that have access to relatively cheap, clean alternative production methods will be quick to adopt them. A firm will buy pollution permits and continue polluting only if it lacks such alternatives.

Auctioning pollution rights makes sense because it concentrates the burden of pollution reduction in the hands of those who can accomplish it at the lowest cost. It minimizes the total cost of achieving any given air quality target—an outcome that is clearly in the interest of all citizens, rich and poor alike. The more people learn about the auction method, the less likely they are to oppose it. For instance, although environmental groups once bitterly opposed pollution permit auctions, they now endorse them enthusiastically.

Firms that lack cheap ways of eliminating carbon emissions from their operations would have to charge higher prices to cover the cost to the required permits. The cap and trade system is thus functionally similar to a tax on carbon.

Indeed, in stable world with perfect information, cap and trade would be exactly equivalent to a carbon tax. Of course, we don’t live in such a world. This has led many critics to favor a carbon tax over cap and trade. These critics argue that by setting a fixed tax and sticking with it, government could create the stable incentives that make firms willing to undertake costly investment projects.

But committing to a fixed carbon tax entails risks of its own. Although we have estimates of the amount by which carbon emissions must be reduced to achieve climate stability, we have no idea how high a carbon tax would have to be to achieve those reductions. If the tax were set too low—the more likely outcome politically—it would soon be necessary to raise it, which would invalidate many of the investments that had been made on the basis of the original tax. To avoid such costs, cap and trade advocates favor starting with what we know best—the emissions target—and then letting the “market” (as embodied in the permit auction) reveal the effective tax required to get there.

In short, there are sensible economic reasons for taking either side in the cap and trade vs. carbon tax debate. But the smart money seems to be lining up behind cap and trade for essentially political reasons. A carbon tax is an explicit tax, and Americans are notoriously tax phobic. In contrast, cap and trade levies an implicit tax on carbon. In purely economic terms, it’s a distinction without a difference. But if someone offers you an even-money bet on which system congress will adopt, pick cap and trade.

In any event, the good news is that after years of denying the problem even existed, our political system seems ready to take serious steps to address global warming.