Analysis of U.S. Greenhouse Gas Tax Proposals

Gilbert E. Metcalf, Sergey Paltsev, John Reilly, Henry Jacoby and Jennifer F. Holakdeals have a new NBER working paper out which deals with the issue of an "Analysis of U.S. Greenhouse Gas Tax Proposals", NBER Working Paper No. 13980, Issued in May 2008.

The abstract reads

The U.S. Congress is considering a set of bills designed to limit the nation's greenhouse gas (GHG) emissions. This paper complements the analysis by Paltsev et al. (2007) of cap-and-trade bills and applies the MIT Emissions Prediction and Policy Analysis (EPPA) model to carry out an analysis of the tax proposals. Several lessons emerge from this analysis. First, a low starting tax rate combined with a low rate of growth in the tax rate will not reduce emissions significantly. Second, the costs of GHG reductions are reduced with the inclusion of non-CO2 gases in the carbon tax scheme. Third, welfare costs of the policies can be affected by the rate of growth of the tax, even after controlling for cumulative emissions. Fourth, a carbon tax -- like any form of carbon pricing -- is regressive. However, general equilibrium considerations suggest that the short-run measured regressivity may be overstated. Additionally, the regressivity can be offset with a carefully designed rebate of some or all of the revenue. Finally, the carbon tax bills that have been proposed or submitted are for the most part comparable to many of the carbon cap-and-trade proposals that have been suggested. Thus the choice between a carbon tax and cap-and-trade system can be made on the basis of considerations other than their effectiveness at reducing emissions over some control period.

As Tim Harford notes

That sounds sensible. The difference between cap-and-trade and a carbon tax is much exaggerated.

Harford has blogged on this point before.

The Economist magazine argues in favour of a carbon tax here. The Economist argues

In the neat world of economic theory, carbon reduction makes sense until the marginal cost of cutting carbon emissions is equal to the marginal benefit of cutting carbon emissions. If policymakers knew the exact shape of these cost and benefit curves, it would matter little whether they reached this optimal level by targeting the quantity of emissions (through a cap) or setting the price (through a tax).

But in the real world, politicians are fumbling in the dark. And that fumbling favours a tax. If policymakers set a carbon tax too low, too much carbon will be emitted. But since the environmental effect of greenhouse gases builds up over time, a temporary excess will make little difference to the overall path of global warming. Before much damage is done to the environment, the carbon tax can be raised.

Misjudging the number of permits, in contrast, could send permit prices either skywards or through the floor, with immediate, and costly, economic consequences. Worse, a fixed allotment of permits makes no adjustment for the business cycle (firms produce and pollute less during a recession).

Cap-and-trade schemes cause unnecessary economic damage because the price of permits can be volatile.

But the magazine also points out that the cap-and-trade schemes can be be reformed so that they look more like carbon taxes. But if this is true then why, the Economists asks, are politicians so reluctant to impose carbon taxes in the first place? Their answer,

One reason is that their environmental benefits are harder to explain. It is intuitively easier to grasp how a carbon cap will slow global warming. Taxes are also more prone to ideological caricature, particularly in America, where many conservatives argue instinctively that all taxes are bad. Too many politicians pretend that carbon taxes will hurt consumers more than a cap-and-trade scheme, even though the cost of carbon permits will be passed on to consumers just as quickly as a tax.

But the biggest problem, at least politically, is that carbon taxes are transparent and simple, whereas cap-and-trade systems are complicated and conveniently opaque. Under a cap-and-trade scheme, governments can pay off politically powerful polluters (such as the coal industry) by giving them permits. Even more important, rich countries can pay poorer ones to cut their emissions without any cash changing hands between governments. Under a carbon tax such transfers must go through the government's budget. And that can be politically tricky. However sensible it sounds to an economist, American voters may be loth to see their tax dollars funding fat cheques for China.

So the magazine concludes, if we add in these political arguments then the choice between a carbon tax and cap-and-trade becomes less obvious.