Cap and trade vs. carbon taxes

Brad DeLong sums up:

I would say that to first order cap-and-trade and carbon taxes are the same, that there are five first-order differences:

  • Cap-and-trade involves less redistribution because the losses of
    the losers are partially offset by their initial awards of tradeable
  • Cap-and-trade runs the risk that the cap will be set at the wrong
    place and so the price will go damagingly above its social optimum
  • Carbon taxes run the risk that the tax will be set too low and so
    the quantity emitted will go damagingly above its social optimum value.
  • Carbon taxes have the advantage that the government gets money that
    it can use for good–either to cut existing taxes that have large
    deadweight losses or to expand underfunded programs that have large
    social benefits.
  • Carbon taxes have the disadvantage that the government gets money
    that it can use for ill, and that the recipients and beneficiaries of
    that ill-used money will then dig in and defend their rent-seeking
    gains beyond death itself.

and that there are two third-order differences:

  • It’s easier to get not-too-bright Republicans to vote against
    something that is actually in their long-run interest if you can
    demagogue it by calling it a tax.
  • It’s easier to get not-too-bright Democrats to vote for something
    that actually is not in their long-run interest if you can demagogue it
    by claiming that it’s just a restriction on the behavior of corporations and not something that directly impacts people.

The fourth-order considerations would, of course, look at time consistency problems and irreversibility problems.


Makes more sense with these edits:
"five first-order differences" -> "five second-order differences"
"go damagingly above" -> "be damagingly different from" (2 places)

Is there any literature out there discussing the cost of uncertainty with regards to carbon permits?

Just looking at Europe, there's just going to be fantastic risk/volatility with the value of these things. There will be political risk, eg. when the going gets ugly, will the caps ACTUALLY be enforced? There will be general market risk, what will the supply & demand for these things look like 10 years out?

Since for global warming, the year to year CO2 emissions don't matter, just the long term aggregate, does cap & trade have the potential to create large deadweight loss effects by artificially creating MASSIVE uncertainty over the monetary cost of emitting CO2?

As a power company, sure you could go to Wall Street, hedge, and get a classic speculator to hold the CO2 permit risk, but if the risk is massive and difficult to diversify, I'd imagine the street would demand a mighty big cut for themselves.

Cap and trade will probably reward incumbents and punish entrants. This seems like a first order effect to me.

A tax will tilt the supply curve of carbon-expending products to the left (which is what you want it to do). Cap and trade will turn the supply curve into a hockey stick.

Calling the two policies the same is absurd. One is trying to modify quantity by pushing the price upward (guaranteed to work as intended), the other is choosing the quantity and hoping that you'll end up with a price that makes sense (potentially disastrous, also potentially useless).

A lesson from the California electricity crisis of a few years ago (I've seen somewhere someone said the cap and trade policies on sulphur played a role ??): Hockey stick shaped supply curve + inelastic demand = TRAIN WRECK (that situation also had price controls of course).

Two questions: 1) Why is everyone just assuming that a cap and trade will require the free distribution of permits, as opposed to the auctioning of permits? I can understand why issuing permits to current carbon users would be politically expeditious to reduce their lobbying against the policy, but surely it's a t least worth discussing the matter.

2) I usually think of cap and trade as being on emissions, while a carbon tax can, and probably would, will be on inputs. How would we deal with automobiles?

Don't forget that a dollar tax has to be adjusted periodically for inflation while a percent tax or a cap and trade does so automatically. But the biggest difference probably is not theoretical but practical. What is the ideal amount that the carbon tax should be? There's no real way to find that, but in a cap and trade system the price comes about naturally; its much easier to set a pollution limit than a price on that pollution.

You can set a pollution limit, but even if you could figure out the ideal limit (which you can't), it would still be a constantly moving target and the cap would not self adjust. What would you do about changes in population? What about changes (positive or negative) in the availability of substitutes for polluting technologies? If you have a tax you'll at least get socially desirable automatic adjustments to situations like these.

Related note: An admittedly unlikely hypothetical thought experiment - suppose I invent a technology that will cut emissions by all users in half.

If I live in Pollution-Tax-Land: all polluters pay me for the use of my invention to reduce their tax bills. I am rich.

If I live in Cap-And-Trade-Land: introduction of my invention causes the price of tradable permits to go to zero because total emissions go below the cap. I am not rich. On second thought, I might have something better to do than inventing world-saving techologies. After all I have to eat.

I think DeLong just keeps digging himself deeper. Samuelson's piece was fine--doesn't mean it was correct in the grand scheme, I just mean there was nothing demonstrably dumb in it--and then Avent misunderstood what Samuelson was claiming. So Avent flipped out, and DeLong jumped on board.

And now DeLong is giving kudos to Megan McArdle, who gets another basic point backwards.

I defend the above assertions here.

Is it not also true that cap and tax proposals differ in what happens when demand curve changes? Should one not also look at the possible consequences of the system if e.g. consumers start appreciating environment more, or energy more and this changes the demand curve? Why on earth should such analysis be done merely with static environment, which our world almost never is?

DeLong has edited first-order to second-order now. You might want to do the same.

Agree with Ed, this every government program looks like a program to protect large and established corporations.

Fixed it for you.

Those on the left tend to prefer cap-and-trade. Why?

Because, as with the tobacco, settlement, cap-and-trade won't be recognized as the stealth tax that it is. So it is likely to be larger than it would if it were a transparent tax with a known cost, and it can be framed as 'punishment' for corporate emitters rather than a tax on everybody. As a result, the revenues will seem like 'free new money' -- manna from heaven -- which politicians will feel able to spend liberally (in both senses of the word) on whatever strikes their fancy (rather than offsetting the cost with reductions in other taxes).

Furthermore, initially, the debate will be about the size of the cap and the pace of cap reductions rather than the cost of the permits -- since the caps will be known and the costs of credits to be bought on the open market will have to be estimated. If the cost of credits turns out to be too high, politicians will be able to claim, plausibly, that they couldn't have known this would happen (because estimates varied widely) and also claim credit for whatever later relief they provide.

And those on the right prefer a transparent carbon tax for all the opposite reasons -- people will understand they are paying it, and will be resistant. Therefore either the carbon tax will be smaller, or there will be reductions of other taxes included. Which, if the tax is revenue-neutral, will mean no manna for Congress. And if it is revenue positive, citizens, because they realize the money is their tax money, will be less likely to support spending it on all sorts of programs unrelated to energy.

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