Cap and trade vs. carbon tax

by on June 4, 2008 at 3:09 am in Economics | Permalink

Robert Samuelson writes:

Unless we find cost-effective ways of reducing the role of fossil fuels, a
cap-and-trade system will ultimately break down. It wouldn’t permit satisfactory
economic growth. But if we’re going to try to stimulate new technologies through
price, let’s do it honestly. A straightforward tax on carbon would favor
alternative fuels and conservation just as much as cap-and-trade but without the
rigid emission limits. A tax is more visible and understandable. If
environmentalists still prefer an allowance system, let’s call it by its proper
name: cap-and-tax.

Mark Thoma gets upset at this passage, here is Ryan Avent, Brad DeLong and Matt Yglesias, all upset.  Avent was the fount of the opposition:

Yowza. As any economist worth his or her salt will tell you, a cap and
trade plan with auctioned permits is essentially identical to a carbon
tax. That also happens to be exactly what Barack Obama is proposing.
So, another way for Samuelson to have written this column would have
been to title it, “Barack Obama has a good plan to reduce carbon
emissions."

But Samuelson is correct here and Avent is misleading.  When there is uncertainty about the location of the social optimum, and uncertainty about elasticities, a carbon tax and cap-and-trade are by no means equivalent.  If you see very high costs from setting the binding cap too low and choking off growth — as Samuelson mentions — you should prefer the carbon tax.  The price of carbon is more certain and you bear less risk from uncertainty about how fast solar power and other technologies will develop.  Alternatively, you might say that risk is transformed into price risk rather than "you can’t exceed this cap no matter what" risk.

Of course the postulated uncertainties are realistic in this context and you don’t have to invoke uncertainty about the science of global warming. 

If there is very high environmental risk to having emissions above a certain level, and we are unsure about the relevant elasticities (again, uncertainty about the pace of technological development can drive this), that militates in favor of cap and trade.  It is then easier to ensure that emissions do not exceed a particular level.

You can see that we are comparing the "growth threshold problem" to the "environment threshold problem."  Samuelson is apparently more worried about the former than the latter.  Maybe he shouldn’t be so sure he is focusing on the right problem, but on the economics he is on the mark in the criticized passage.

Addendum: Here is Mark Thoma with more on the topic, here is Megan McArdle on same.

Michael Greinecker June 4, 2008 at 3:59 am

The argument has already been made here.

john June 4, 2008 at 6:08 am

“It is then easier to ensure that emissions do not exceed a particular level.”

Easier than what? A Pigouvian tax that does not require the same bureaucratic framework to monitor and implement? (Not that a tax is preferable either…)

John Thacker June 4, 2008 at 8:00 am

A Pigouvian tax that does not require the same bureaucratic framework to monitor and implement?

To ensure that emissions do not exceed a certain level, regardless of the costs necessary to bring us to that level, john? Yes. The Pigouvian tax is the most efficient way to reduce all emissions up to a certain marginal cost in emissions. Cap-and-trade is the most efficient way to reduce emissions to a specific stated value.

Note that in reality, cap and trade as debated by the Senate includes a “safety valve” to allow the cap to go up if the cost of reduction is high. While this makes it even more theoretically similar to a tax, in practice it may make cap and trade entirely pointless aside from the corporate welfare and rent-seeking behavior. Experience in Europe indicates that when such safety valves are available, the tendency to cheat until the cap has no real effect is strong. (European countries do have strong emissions reductions effects from their fuel taxes, though.)

David Zetland June 4, 2008 at 8:37 am

For the crazy version of this argument, see Senator Inhofe’s WSJ op/ed here: http://tinyurl.com/57m2ck

Jonathan June 4, 2008 at 9:11 am

Marty Weitzman had the fundamnetal insight in the Stome Age (when i was in Grad school) and the application to GHG is here (among many others):
http://ideas.repec.org/p/rff/dpaper/dp-98-02.html

jb June 4, 2008 at 9:46 am

See, now you’ve proven yourself to be an economist not worth your salt. Why? Because Ryan Avent says so. After all, he’s an “Economist, Consultant and Writer” and you’re just a chaired, tenured professor at a private university.

Hmpph. Shows what you know.

Brad DeLong June 4, 2008 at 11:11 am

And your “capchas” are too hard…

Robert Olson June 4, 2008 at 1:04 pm

The idea that a tax favors growth while a cap favors the environment exists only in our political context. There is no economic reason that a tax should automatically set pollution abatement lower a cap-and-trade program. In fact, if the government was profit-maximizing, a tax should actually be higher and cause MORE abatement than a cap-and-trade program (assuming there was no auctioning off of permits)

Bob Murphy June 4, 2008 at 1:51 pm

Brad DeLong wrote:

Martin L. Weitzman (1974), ["Prices vs. Quantities",]…is brilliant, but it is second order–and it is not what Robert Samuelson is writing about. I don’t see a single word of argument in there about how the risk that the price will go too high is more worth guarding against than the risk that the quantity of emissions will go too high.

Give the guy a break, he was writing an op-ed for the Washington Post. And neither you nor Avent mentioned that subtlety, either; if it wasn’t worth getting into on your econ blog, why hold Samuelson to that standard in his op ed conclusion?

Samuelson’s statement was true. Earlier in the piece, he showed familiarity with the other reasons that mainstream economists favor a carbon tax over cap-and-trade (rent seeking, transparency). You’re right, I don’t know that he could explain the arithmetic behind the CBO illustration of how a tax can be more efficient, but I think he understands the big picture.

He said this at one point: [The above flaws] would undermine whatever abstract advantages the system has.

So here he seems to perfectly get the (correct) point that under idealized settings, cap and trade is the perfect solution, but in the real political world, a carbon tax is far preferable.

I can’t understand why everyone is flipping out when a columnist repeats arguments that tons of economists are making.

hwinva June 4, 2008 at 5:24 pm

what about the distributional effects of a carbon tax or c&t — between areas that use carbon to produce electricity and areas that use hydro? is this just an “endowment” issue that we easterners will have to get over?

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notblank May 12, 2009 at 11:49 am

“I’d say it’s the opposite. Economics is further along than meteorology.”

Where’s my seven day stock forecast, then?

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