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The case for carbon tax

Hydrocarbon Engineering,

According to the Institute for Energy Research (IER), the ‘carbon fee’ legislation introduced by Senators Whitehouse and Schatz epitomizes the dual reality in the debates over climate change policy. The commentary on the bill would lead the innocent reader to believe that this is textbook economics in response to ‘market failure’.

In reality, the proposed US carbon tax is unjustified on its own terms; the very same textbook economics can be used to show that the proposed tax is not suitable for the problem.

The ‘social cost of carbon’

The White House press release explains the proposed legislation as follows:

‘Whitehouse’s American Opportunity Carbon Fee Act, which is cosponsored by Senator Brian Schatz (D-HI), would correct a market failure that currently allows polluters to push the costs of their pollution onto everyone else.

‘The American Opportunity Carbon Fee Act would require polluters to pay a fee for every ton of carbon pollution they emit. The fee would start at US$42/t in 2015 and increased annually by an inflation adjusted 2%. The price of the fee follows the Obama Administration’s central estimate of the ‘social cost of carbon’, the value of the harms caused by carbon pollution including falling agricultural productivity, human health hazards, and property damages from flooding’.

The above description makes the proposed carbon tax sound scientific and calibrated. But even on its own terms, if the US government enacts a carbon tax equal to the ‘social cost of carbon’ estimate, that is far too high and causes an inefficient amount of economic damage, according to the IER.

In theory, the social cost of carbon (SCC) is the present value summing up all of the future net climate change damage that an additional ton of CO2 emissions will yield, centuries into the future. There are various computer models that the Obama Administration selected to estimate this value, and (with various parameter choices) the number they’ve settled on is US$ 42/t for 2015.

Making government policy

If one was to use textbook economics and have the government set a tax equal to the SCC, this really only makes sense if one imagines:

  • A worldwide government setting a uniform carbon tax of US$42 on all emitters of CO2.
  • That this worldwide government initially had no other taxes or penalties on emissions, or subsidies/mandates for non-carbon intensive fuels.
  • This worldwide government initially had no other distortionary taxes on labour or capital.
  • The revenue from the new carbon tax were returned as cash payments to citizens for them to spend as they pleased.

Under these further assumptions then the standard economics textbook treatment of ‘negative externalities’ like pollution would imply that this worldwide government should enact a new carbon tax equal to the SCC, or US$42/t in this case.

Yet, in the real world, not a single one of these assumptions applies, highlights the IER. First of all, the US government does not have the power to compel other governments around the world to join in the carbon tax scheme. Climate scientist Chip Knappenberger recently estimated that the IPCC’s own models and parameter choices indicate that if the US suddenly ceased all carbon dioxide emissions, while other countries continued on their baseline emissions paths, then in the year 2100 the global temperature would be a huge 0.2°C cooler than otherwise. Thus, even a draconian carbon tax imposed unilaterally by the US government would be virtually insignificant if it merely displaced emissions into other jurisdictions.

Furthermore, even if one sets aside the problem of ‘leakage’, there is still the matter that the US and state governments already impose significant penalties on CO2 emissions, and give subsidies and mandates encouraging ‘alternative’ technology and fuels. For example, federal and state gasoline taxes were not set up as carbon taxes, but to the gasoline consumer they have a similar effect. Currently, federal and state carbon taxes average approximately 42 cents/gal., which is higher than what the ‘optimal’ tax on a gallon of gas (approximately 37 cents) would be, if the social cost of carbon were indeed US$ 42/t.

To carry this point further, Senators Whitehouse and Schatz should also put in their bill the elimination of the ethanol mandate, the EPA’s power plant regulations, all CAFÉ standards on fuel economy, all energy efficiency mandates, and they should remove all regulatory hurdles for the Keystone Pipeline – after all, once their proposed carbon tax has cured the ‘market failure’, one should let individual businesses and households choose their optimal behaviour guided by the market. That’s what the textbook analysis says, upon which they rest their legislation. Are they willing to do all of that, or do they not actually believe in the textbook treatment of negative externalities after all? These considerations show that the Whitehouse and Schatz plan is not really about adjusting the ‘costs of pollution’ but instead is about giving the federal government more control over the economy, and energy sector in particular.

The crucial ‘tax interaction effect’

Returning to the list of assumptions, the third element was that a worldwide carbon tax of US$42/t only made sense if one starts out with a blank slate. But if instead there are already distortionary taxes on labour and capital, then in general IEA would expect the new carbon tax to hurt the economy even more. Correcting for this real world complication will most likely significantly lower the ‘optimal’ carbon tax; it will not be the US$42/t that the computers calculate for the ‘social cost of carbon’.

Will all revenue be returned to the citizens?

The last piece in that standard textbook case is that the government should take all of the revenue raised from a tax on a negative externality and return it to the public in a way that does not itself invite inefficient behaviour. For example, it would obviously distort things if the government handed out carbon tax revenue according to how much money a firm has lost in the previous quarter; this policy would subsidise unprofitable companies.

In the press release, meeting this requirement so that the professional economists can give their legislation a blessing:

‘All revenue generated by the carbon pollution fee – which could exceed US$ trillion over ten years – would be credited to an American Opportunity Fund to be returned to the American people. Possible uses include:

  • Economic assistance to low income families and those residing in areas with high energy costs.
  • Tax cuts.
  • Social security benefit increases.
  • Tuition assistance and student debt relief.
  • Infrastructure investments.
  • Dividends to individuals and families.
  • Transition assistance to workers and businesses in energy intensive and fossil fuel industries.
  • Climate mitigation or adaptation.
  • Reducing the national debt.’

There are several examples from this list that are clearly examples of more government spending. If the carbon tax money spent on building a new road or bridge is considered ‘returned to the American people’, then nothing the federal government does could possibly violate that promise.

IER conclusions

The proponents of an aggressive US government carbon tax have tried to paint the matter as ‘settled science’ and have castigated any critics as ignorant. Yet even if one takes the standard economic case for taxing ‘negative externalities’ at face value, and even if one agreed for the sake of argument with the computer models’ estimates of the ‘social cost of carbon’, it would not follow that the US government should impose a carbon tax. Once one corrects for the various complications outlined above, a quite reasonable guess for the ‘optimal carbon tax’ is US$0/t, the IER concludes. 

Adapted from IER analysis by Emma McAleavey

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