Further thoughts on a carbon tax

by on February 24, 2008 at 5:11 am in Economics | Permalink

Responding to an earlier post of mine, the very smart Ian Dew-Becker emailed me the following text:

I saw you had a post up about some work I did with Bob Gordon, and I
found your comments very interesting.  I have a couple questions that I
hope might help clarify your thoughts on the subject.

First, you
seem to argue that we would expect a CEO to be paid her marginal
product.  As you point out, there is ample evidence that a CEO adds far
more to the value of a company than she is generally paid.  I’m
curious, though, what you mean when you say we would expect the CEO to be paid her marginal
product.  Models in this literature often assume that
each firm must hire one CEO.  The concept of a marginal product breaks
down at this point.  The firm can’t hire a second CEO.  There is no
marginal value.  It’s possible that we can look at marginal products in
terms of the skill a CEO brings to the firm, but in that case, we would
be mixing up marginal and average products if we were to simply look at
the total contribution a CEO makes to firm output.

I think you’re correct to point out the institutional factors
holding down CEO pay pre-1970.  That said though, why didn’t we see CEO
pay rising much faster than market cap during the 80’s in order for it
to catch up to where it should be?  There is a period where the
pay-market cap elasticity may have been higher than 1, but it’s only for a few
years in the 90’s.  Looking at the full 1976-2005 sample, the
relationship is nearly unitary (.935, according to Frydman and Saks).  So I guess I’m surprised there is no
catch up in pay.

I think you’re right to be skeptical of the Bebchuk-Grinstein
results.  To me, the most interesting result
from Gabaix and Landier, no matter what one thinks about their model as a
whole, is that the cross-section and time series may show very
different patterns.
So one wouldn’t necessarily expect the cross-sectional results from Bebchuk and Grinstein to predict the time-series.

One
of my biggest concerns with Gabaix and Landier’s model is that it does
not display decreasing returns to scale.  An analogous
example is Berk and Green’s model of mutual funds.  They assume that if
a manager all of a sudden
sees the size of his fund double, he will see lower average returns.  I
think this is reasonable.  When there are not diminishing returns, it
is difficult to make models function.  Gabaix and Landier are forced to
do it by assuming firms never merge.  That concerns me in this
setting.  Dixit-Stiglitz competition is often a reasonable
assumption because the models using it do not actually care about firm
size
or mergers.  In the case of CEO pay, however, firm size is clearly
critical.

The question about the marginal product of a CEO is a tricky one.  I can imagine the following definitions which either express marginal product or some modified version thereof:

1. How much better the highly-paid guy is than a less-well-paid substitute would be.

2. How much better the highly-paid guy is than the next best person (in stochastic terms, that is) the firm would get for that same sum.

3. How much a bit of extra pay causes the CEO to improve effort and thus performance.

4. The complex econometric definition offered by Jensen and Murphy, read pp.33-38 here.

5. Some number between the CEO’s value of leisure and how well the firm would do with no CEO at all.

None of these quite make sense in pure theory, and it is even harder to say which is the most important variable for practice.

1 jsalvati February 24, 2008 at 6:37 am

If the first scenario the new form of energy is actually cheaper than currently existing energy sources; that’s a rather silly assumption. In any case, a world where cheap energy lets billions of people improve their life dramatically would be a much better place than one where they can’t; probably even if we do have to worry about GHG emissions.

2 Mike February 24, 2008 at 8:20 am

Absent some astonishing technological miracle, the world will burn every drop of oil it can raise from the ground for the foreseeable future.

This is a fundamental that’s simply not going away. The rest of it is just polite talk.

3 Dan Cole February 24, 2008 at 8:52 am

Once the government introduces a carbon tax, it can alter the tax rate as necessary to counter increasing carbon emissions. Total transaction costs can be minimized by taxing carbon content of inputs rather than emissions.

4 Bob February 24, 2008 at 9:45 am

Should not imports also bear carbon taxes, import duties or tarrifs (Im not an economist and dont know which is the proper term)? Would not countries such as China and India reduce carbon emissions to reduce the burden of duties upon their exports to the US? If imports were free of such duties, the US would simply offshore carbon generating industries.

5 Ari Tai February 24, 2008 at 10:09 am

To date we’ve seen no advances that fundamentally change Steven Den Beste’s analysis:

http://denbeste.nu/cd_log_entries/2004/06/AnewManhattanProject.shtml

And if the wisdom of crowds is to be believed, the current (non government boondoggle) investments in new energy sources implies a long term price of a barrel of oil below 20 of today’s dollars. What do the VC’s know that we don’t? They are certainly not making the multi-billion dollar technology-sector-like wagers that “Peak Oil† is true.

An aside. I’ll wager a fine dinner that when the cost of an alternative to oilfield derived energy sources is competitive, it’ll be used to create a synthetic fuel that has the energy density, handling, and safety characteristics of today’s gasoline, kerosene and diesel. Meaning if nature hadn’t invented oil, by now we would have.

Unfortunately Électricité de France is as opaque and as softly-corrupt as any state-run business (or near-state run, like the Bell company in its prime), else we might have a better sense of what a well engineered nuclear solution would cost. My guess is their sixty plus plants were built at a cost of not more than $100M-US each at the time (irrespective of the numbers they quote in their financial reports). Which they staff with operators from the equivalent of a service academy. Call it a quarter-cent per KWH fully burdened. Note that they charge more than ten cents a kwh today, and export half. Granted, they have 20-30x the employees they need to run their < 100 facilities, including many state employees "retired" to EDF jobs, etc. Not dissimilar to the old AT&T. If we can get another two orders of magnitude reduction in our costs per KWH (from a best-case 5 cents down to .05 cents), we'll be able to make petrochemicals out of air and water at a cost competitive w/ oil pumped at $10 a barrel (but still not competitive at what would be a competitive price in a non-cartelized, non-OPEC controlled market of $1 a barrel – given that oilfield is a “manufacturing† business that has otherwise seen 50-100x productivity gains over the last two to three decades). Sensible nuclear regulation and appropriate locating of mega-plants would get the first order of magnitude (could be done today). The second is likely fusion or new physics - perhaps we (more likely the Europeans at Cern, Switzerland) will find the Higgs bosun and then learn how to control it (could make WMDs as we know them look like firecrackers). Maybe in 25-40 years. The third order of magnitude (to compete with $1 per barrel oil) I can’t conceive, so let’s put it out 100 years. The cost of energy is inversely proportional to the quality of life (historically and there’s no sign that this won’t be true in the future). The more energy costs, the more humans sweat (and the more time is diverted from productive activities).

6 Ari Tai February 24, 2008 at 10:16 am

Den Beste analysis of various energy alternative cited above as a link.

7 D February 24, 2008 at 11:04 am

I agree with Dane Cole, but he assumes that we know the damage function. Since there is so much dispute about what it exactly looks like, and we are definitely not sure what it will look like for specific regions this is problematic.

Nevertheless, we seem to know certain thresholds and that we need to reduce emissions massively to not cross them. That alone should be enough to introduce the tax as the most efficient tool and adopt it over the time if cheap low-carbon technology actually increases consumption. In that way, the incentive at the margin for everless carbon using technologies will remain.

I don’t see why “it is impossible for reduced use of carbon to have such large price effects that it leads to increased use of carbon.” If a new product only has marginally lower carbon use than its predecessors, but its price is much lower and the quality the same, than eventhough use of carbon is reduced the higher demand will increase the total use of carbon. Think about the car market where decisive innovation rarely seems to occur, but everything is about the marginal decreases in gasoline use. If because of some other reason the price drastically drops, we will have increased use of carbon

8 Anonymous February 24, 2008 at 11:48 am

“Maybe factories and homes can go solar but cars can’t.”

Cars can go solar, they just need a big battery.

9 JDM February 24, 2008 at 12:39 pm

Lots more people are going to be using more energy regardless of the cost of low carbon energy. We’re building huge coal plants all around the world.
There’s an almost limitless supply of coal. Burning massive amounts of coal will produce an environmental nightmare. The only question is whether there we’re going to have alternatives. If we don’t internalize the costs of burning coal through a carbon tax, we’re much less likely to develop low carbon alternatives.

10 Keith February 24, 2008 at 12:54 pm

Following up on JDM’s comments on coal, to what extent should we consider an export tax on our coal in order to reduce carbon emissions around the world?

If our coal burns more cleanly than other coal sources, this may be counterproductive.

But surely we could place an export tax on our bituminous coal relative to our anthracite, or something like that.

Are there other coal-exporting developed countries in the world that would sign on to a coal export tax?

11 david February 24, 2008 at 1:24 pm

I just read Nordhaus’ critiques of the Stern Review in Science and the JEL, and what I find remarkable is that 100 years from now, the planet is going to be 2C warmer if we cut back to 1990 levels, and 2.5-3C warmer if we don’t. So regarding the “Viola” part, I think the probability that the world is able to cut back anywhere near 1990 levels is right about 0.

12 A student of economics February 24, 2008 at 1:42 pm

Tyler, I don’t understand your reasoning. You worry that “Even if the new technology is three times as carbon-efficient, if the world as a whole uses three times more energy, carbon emissions do not go down.” However, if there’s no carbon tax, then the next “new technology” can be expected to be just as cheap (if not cheaper) while being less carbon efficient. If 3x as many people use it, then carbon emissions go up. Are you assuming that there will be more cost-reducing technology advances with a carbon tax than without one? I don’t follow that.

Your example of gas efficient cars is even more confusing. Are you arguing that the cost of cars (including fuel lifecycle costs) will be lower if we constrain ourselves to the set of technologies that minimize gas usage rather than allow an unconstrained choice of technologies?

13 Michael Bishop February 24, 2008 at 1:57 pm

Why can’t we just compel other countries to impose a similar carbon tax?

Couldn’t we just impose tariffs on imports calibrated to the estimated greenhouse pollution content of each product category from each country. Exporters that can demonstrate that their product (including pollution by suppliers and employees) generates significantly less pollution than the estimate for that product category would face a lower tariff. This would create a local incentive to find ways to be less polluting.

Since countries with a well administered carbon tax regimes would be exempt from the tariff, China and India would find it in their interest to establish carbon taxes covering the entire economy.

14 jorod February 24, 2008 at 3:00 pm

Co2, carbon, whatever. It is a red herring. It is something that will never be changed. It’s just a political issue with no answer that politicians and crack pots get a lot of mileage out of. Wise up. Pollution control is the real issue, not carbon nonsense.

15 Giacomo February 24, 2008 at 3:09 pm

Unlike Keith, I miss elasticity, which I think clarifies what scenario we should be rooting for.

Obviously we hope that U.S. policy stimulates technological progress that reduces the carbon emissions associated with some good or service by a proportion C% and reduces its price by a proportion P% such that C/P is greater than the elasticity of worldwide demand for said good or service.

Tyler first worries that C/P will be lower than demand elasticity, but he admits that this worry goes away if C is very large, as in solar power generation. Crucially, it equally goes away if P is very low, and I fully expect this to be the case.

Isn’t it the reason why government intervention is needed to begin with? If P were large, the technology would be profitable, and the market would suffice to stimulate its invention. Instead, P is so small that innovation only happens when the government artificially turns C into something the inventor can profit from. In this scenario U.S. taxpayers and consumers end up making a gift to the whole of mankind, but since we are rich and benevolent that is not something to worry about.

Taylor advances a second argument, i.e., that aggregate demand elasticity could be very high itself, because a lot of people in developing countries are on the verge of adopting carbon-using technology. Although I do not have a fully-fledged model in mind, I am skeptical of this worry because it is based on the income effect of improved technology, not the substitution effect. Hence, two considerations mitigate it.

First, poor people are getting richer anyway, surely in China and India and hopefully in Africa too. Thus the carbon- and price-reducing technology at most accelerates their entry into carbon-using sectors of the economy. It seems reasonable that it could be better for the environment to have them start driving a low-emission car today rather than a high-emission car tomorrow.

Second, if the worry is that improved technology will make people too rich, there are many policy interventions that can solve this problem. Indeed, most Marginal Revolutionaries probably agree that governments are surprisingly good at inventing wealth-reducing policies.

On the other hand, I agree there is a very real possibility that emission-reducing technology never becomes as cheap as the polluting alternative. But how worried should we be about that?

It doesn’t sound too naive to suppose that we could have some system of carbon taxes and quotas adopted by all developed countries. It would certainly be a sub-optimal system, but it would probably be feasible if the U.S. agreed.

Even if poor countries keep polluting, at least something would have been done for the environment. I am not too concerned about the outsourcing of carbon-emitting activities to poor countries. Having a look at the EIA data, U.S. CO2 emissions are about 6 billion metric tons, of which only 1.7 come from the industrial sector. Outsourcing does not seem feasible for the transport, residential, commercial, and power generation sectors. So it would seem that over 70% of current emissions by developing countries would be affected.

Finally, as many have remarked already, carbon taxes could be extended to carbon tariffs. That would probably reduce carbon emissions in poor countries too, and it would also reduce aggregate income. To the extent that carbon emissions are a normal good, which Tyler seems to agree with, income itself is bad for the environment, so the protectionist environmentalists’ agenda is at least internally consistent.

16 Randall Parker February 24, 2008 at 4:49 pm

Solar, nuclear, and wind do not have to become cheaper than oil or natural gas were 10 years ago. They only have to become cheaper than the fossil fuels will be 10 to 20 years from now.

The energy and capital cost of extracting fossil fuels is rising because the remaining deposits are much harder to reach. Getting oil out of Jack 2 or Tupi deep water fields is a hugely expensive undertaking. Barring some big technological advances in extraction technologies we can expect falling non-fossil fuels prices to meet rising fossil fuels prices. As that happens (and it has already begun) a lot of substitution will occur.

I do not think oil and coal extraction costs have as much potential to fall as do photovoltaics and nuclear power costs.

17 Floccina February 24, 2008 at 7:26 pm

One solution might be that any carbon tax be combined with a payout to those who in net remove carbon from the air. This way carbon neutrality can be reached even while we are still burning carbon. I think that biochar/terra preta/agrichar has potential to remove carbon from the air at a low cost.

18 Tim February 24, 2008 at 8:09 pm

It seems to me that the limiting factor is going to be when we actually start to run out of oil. Indeed, making cars more efficient and cheaper will mean we can afford to use more of them rather than using the same amount more efficiently. There will be more utility creation per unit of energy consumed, which is good, but not less total energy consumed.

A certain amount of global warming is therefore inevitable in my view.

Even though GW gets more attention, I see resource depletion as the larger problem.

19 Floccina February 24, 2008 at 9:22 pm

Electricity can made from coal in a net carbon negative process.

20 poetryman69 February 25, 2008 at 7:04 am

Energy Independence Now!

No more Oil Wars!

Stop funding the terrorists!

Drill in Anwar.

Build more nuclear power plants

Use More coal.

Use more natural gas

Turn trash into energy

Double the efficiency of windmills and solar cells.

If France can do nuclear power so can we.

If Brazil can do biomass/ethanol power so can we.

If Australia can do LNG power so can we.

Domestically produced energy will end recession and spur the economy.

21 odograph February 25, 2008 at 9:42 am

“Just to be clear. Is there anyone who doesn’t agree that the goal of reducing global carbon emissions is, with our current technology, fundamentally in conflict with the goal of raising billions of people out of grinding poverty?”

There are already “bicycles for Africa” and “solar for Africa” campaigns.

It strikes me that if you can’t endorse them, if you say essentially “it’s gotta be oil” that you run into a money problem.

Would any amount of charity make the genuinely “grindingly” poor successful bidders in the world market for oil?

Chevy Tahoes (or even micro-cars) for everyone?

I don’t think there is, actually, money or oil for that.

22 francesca February 25, 2008 at 11:57 am

Someone earlier mentioned that carbon border taxes may violate WTO rules. Such taxes could easily disrupt international trade and lead to numerous challenges and trade disputes for several reasons.

First, WTO rules prohibit tariffs that would have discriminatory effects on countries. Under WTO rules, a country can enact measures to protect human, animal, or plant health and to protect natural resources as long as they are not “applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade.†

Second, the WTO also has rules — that have been disputed — relating to “like” products. Countries are not allowed to discriminate against a product because of its production/process, if the end product is similar to others allowed. Disputes and their resolution in this area have been inconclusive.

If future disputes negate these rules, expect an onslaught of protectionist measures that would severely undermine the world trading system.

Some have argued that these potential problems could be alleviated by a “harmonized” carbon tax — can one imagine the bureaucratic and economic disaster that would be?

23 John Dewey February 25, 2008 at 2:31 pm

JasonL: “I really wonder if it is just setting money on fire in the face of a problem we can’t budge. I can see a clearer picture along the path of ‘let’s learn about living in a warmer climate’.”

Makes a lot of sense to me. Now, I’m not convinced of the CO2-water vapor feedback as predicted by climatologists’ models.

“In short, the CO2 feedback proponents appear to always count positive feedback effects, but neglect negative feedback effects. They claim the earth will become dryer as the temperature rises, as if all of that water will stay put in extreme heat. If this were so, the feedback loop would break as the water vapor required for feedback would no longer be there. If, on the other hand, more water found its way into the atmosphere, cloud cover could become intense enough to block solar radiation, cooling the planet balancing the system.

Climate change is NOT well understood – Duh!

But even if climatologists’ computer models are correct – even if modeling ability has improved greatly since the 1970’s days of global freezing – maybe we just cannot do anything about it.

24 Suzanne Jones February 26, 2008 at 11:43 am

I believe that we do need to find alternative fuels, eco friendly cars, etc., but I believe that there are bigger issues in the USA that need to be addressed for first, such as health care, education, and employment.

The issue with driving big SUV’s though is never going to go away. Consumer’s in America want the newest biggest and best. Rather than trying to convince people to drive more eco-friendly cars, why not find a way to make the big vehicles more eco-friendly?

25 John Dewey February 26, 2008 at 3:52 pm

Carl Milsted: “Use a carbon tax to replace FICA”

Interesting suggestion, but consider it from the politicians perspective.

First, if U.S. voters truly wanted a carbon tax, Congress would have already implemented one. There’s no large scale movement to raise gasoline prices.

Elected officials are not likely to increase a tax that’s as obvious as the gasoline tax. FICA taxes are removed from workers incomes before they receive it. That makes FICA practically a hidden tax – which is exactly the type politicians love.

Carl Milsted: “Solo commuters from the suburbs could drive one-seaters that get over 100 miles per gallon. At that level of efficiency, biofuels could do the job.”

Those commuters could drive vehicles today that get 40 to 50 miles per gallon – and reduce sharply their fuel costs and their vehicle emissions. But they aren’t buying very many such vehicles. Do you think they will anytime soon?

26 Carl Milsted February 27, 2008 at 9:40 am

We don’t have a carbon tax now because most proposals are for a carbon tax in addition to current taxes. Many conservatives are still in denial on global warming

Also, the recent CBO study was for a carbon tax less than a tenth of what I propose. Those who expect positive feedback loops to kick in find such a plan to be wimpy and want to keep all the subsidies, regulations, cap and trades, etc. on top of such a tax.

What I propose (and Al Gore, I think) is something of value to skeptical conservatives: a foot in the door towards privatizing the biggest entitlement program of them all in return for some serious action on global warming.

Weight the carbon tax a bit against Arab Oil and you do far more to fight global terrorism than our current efforts in Iraq. Saudi Arabian money is the biggest culprit. I hear that some conservatives want to do something about global terror…

27 Carl Milsted February 27, 2008 at 1:04 pm

We area major buyer of Arab oil. If we have a carbon tax that hits Arab oil higher than other carbon sources, we in effect have a Pigovian tax on jihad and a user fee on the military expenses for keeping the Persian Gulf open.

If the U.S. jacks up a high tariff on imported oil, then the world price drops, and the Saudis have less spare cash to pay for radical madrassas around the world.

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