I knew sooner or later someone would write this paper

by on September 29, 2007 at 6:27 am in Economics | Permalink

Yes Pigou taxes can possibly have counterintuitive results:

Judged by the principle of intertemporal Pareto optimality, insecure property rights and the greenhouse effect both imply overly rapid extraction of fossil carbon resources.  A gradual expansion of demand-reducing public policies — such as increasing ad-valorem taxes on carbon consumption or increasing subsidies for replacement technologies — may exacerbate the problem as it gives resource owners the incentive to avoid future price reductions by anticipating their sales.  Useful policies instead involve sequestration, afforestation, stabilization of property rights and emissions trading.  Among the public finance measures, constant unit carbon taxes and source taxes on capital income for resource owners stand out.

Here is the full paper, here are non-gated versions.

The point is this: carbon taxes drive down the net post-tax price which fossil fuel suppliers receive; in fact the resulting transfer of wealth from the Saudis to the U.S. is a common argument for such taxes.  But the lower net supply price is not in every way a blessing.

One possibility is that at the new and lower (supply) price, other (non-Pigou-taxing) countries will buy more fossil fuels, picking up some of the slack and counteracting the carbon taxes at the global level.  This effect is strongest for low marginal cost oil.  If Americans buy less oil but all the oil will end up sold in any case, demand simply has been redistributed rather than lowered.  Instead the key is to get that oil to stay in the ground.

Second, at a lower supply price the intertemporal Hotelling resource extraction problem is tricky rather than straightforward, again especially for low marginal cost oil.  Lower (supply) prices today also mean lower (supply) prices in the future, so, after a tax is imposed, the time path of extraction can easily tilt toward the present rather than away from it.

Note that the higher the (posted) oil price goes, the lower are extraction costs relative to price and the more likely these counterintuitive results become a potential problem.  In 2006 average extraction costs were only 15% of the average spot price.  Obviously if extraction costs are high the lower net supply price to the producer does keep the stuff in the ground.

Further counterintuitive results can arise if market players expect a Pigouvian tax to rise over time.  A (politically impractical) alternative is to make the tax very high today and lower it over time.  We are more likely to do the opposite.

The bottom line is this: paying countries to blow up their oil fields may be more effective than taxing the resource.  (TC: don’t some people volunteer to do this work for free?)

Empirically, I still suspect that the "naive" first-order demand side effects predominate.  But if you want to know all the ins and outs of Pigou taxes, it’s worth spending some time thinking through these problems.  Taxing intertemporal resource stocks doesn’t always lead to simple, predictable results.

Don Marti September 29, 2007 at 9:36 am

John Robb talks about a “terrorism tax”, the extra costs to run a city because of the risks of terrorism. Countries’ oil industries also have to pay the terrorism tax.

The level of that tax is mostly set by the terrorists and their sponsors, not the governments where the oil extraction or use takes place. Could sponsoring attacks on the oil industry in low-cost countries be a cheap way to get the effects of a Pigovian tax?

A student of economics September 29, 2007 at 11:45 am

“average extraction costs were only 15% of the average spot price”

Hmmm, isn’t this blog called the “marginal revolution”? What matters is what happens on the margin on the average.

There is lots of expensive oil being drilled for now, e.g. deep sea, oil shale, tar sands, stripper wells, etc If we tax carbon, then demand falls and the price ON THE MARGIN for suppliers falls. That makes these marginal supplies uneconomical and they stay in the ground. Result, less global warming.

Furthermore, if taxes are phased in moderately quickly, e.g. within 10 years, then long term development of high cost fields will also be discouraged.

Think on the margin, Tyler :)

Laurent GUERBY September 29, 2007 at 12:10 pm

In France taxes represent 65,8% of the price of gasoline (about 20% goes to producer, and 15% to refining and selling – those 15% are taxed again).

A few years ago a “floating” tax was introduced to keep gasoline prices more or less constant when crude price was going up. This floating tax is currently inactive.

Not far from optimal, France the country of optimal economics policy (and did I mention health care ? :).

Maestro September 29, 2007 at 2:17 pm

Isn’t there also the problem that taxing people who pollute could have a similar effect as paying Yana to do chores had? I’m in favor of Pigouvian taxes, but this issue concerns me.

Floccina September 29, 2007 at 6:07 pm

2 points:

1. I have for years been thanking the Europeans for helping to make gasoline cheaper for me with their taxes.

2. Some gasoline and diesel fuel is now made from tar-sands. Fuel production from tar-sands is close to marginal and making tar-sands into gasoline and diesel fuel puts more co2 in the air than making fuels from light crudes. Same for coal to liquid.

Interestingly the people who say that Americans are buying too much petroleum from the middle east cite the percentage and then often suggest policies (like conservation) that would increase the percentage of our fuel that comes from the middle east (the cheapest petroleum to get and turn into fuel comes from the middle eat).

I think that any carbon tax should pay out to those remove co2 from the air. I think biochar is a promising way to do this cheaply.

A student of economics September 29, 2007 at 8:34 pm

“paying countries to blow up their oil fields may be more effective than taxing the resource. ”

If the oil fields are blown up, then the rents to other oil producers would go up.

If the oil is taxed, then the revenues go to the U.S. and other consuming nations governments with taxes, allowing them to fund programs and/or reduce other taxes.

For an equivalent increase in price, and drop in consumption, I think the have the consuming nations get the money is very much preferable.

aaron_m September 30, 2007 at 4:22 am

I thought these and other potential efficiency problems with domestic carbon taxes were well understood. That is why the IPCC, Nordhaus, and so on say we need global prices arrived through coordinated global instruments.

perianwyr October 1, 2007 at 8:23 am

I didn’t think the point of oil taxes was to keep us from drilling the stuff. Am I missing something? This is only true if our net consumption of petroleum is taken to be an unalterable constant. I do not think that is true.

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