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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 permits.
- 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 value.
- 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.
Posted by Tyler Cowen on June 4, 2008 at 06:18 PM in Economics | Permalink
Comments
Makes more sense with these edits:
"five first-order differences" -> "five second-order differences"
"go damagingly above" -> "be damagingly different from" (2 places)
Posted by: TAP at Jun 4, 2008 6:25:28 PM
Why can't this also be true?:
Posted by: anomdebus at Jun 4, 2008 6:43:32 PM
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.
Posted by: Matthew Gunn at Jun 4, 2008 6:46:37 PM
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.
It's not a bad summary, but I still say he's leaving out the rent-seeking gains involved in a cap-and-trade system, the recipients and beneficiaries of which will also defend their ill-gotten gains beyond death itself.
Posted by: John Thacker at Jun 4, 2008 7:03:56 PM
Cap and trade will probably reward incumbents and punish entrants. This seems like a first order effect to me.
Posted by: ed at Jun 4, 2008 7:21:53 PM
I agree with John Thacker and ed.
This would be an excellent summary, except that it leaves out the main disadvantage of cap-and-trade: politicians will distribute a massive allocation of free emission permits to the large and politically well-connected industries that currently emit the most carbon. This is exactly what happened in Europe, and it turns the system into one massive regulatory capture that works to permanently entrench the current players.
In fact, DeLong bizarrely lists this as an advantage, because it protects these "loosers". In my view, the loosers we should worry about are poor consumers who won't be able to afford the carbon-intensive good and services that they previously could, and neither cap-and-trade nor a carbon tax does anything for them.
But I am nonetheless aware of political reality: we will have a cap-and-trade system because it allows politicians to hand out these favors, and because the phrase "cap-and-trade" does not contain the word "tax".
Posted by: David Wright at Jun 4, 2008 7:47:15 PM
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).
Posted by: stubydoo at Jun 4, 2008 8:10:25 PM
A question I have had for some time now:
What is a first-order difference? Why is it different from a second, third, or fourth order difference?
Posted by: Robert Olson at Jun 4, 2008 8:48:20 PM
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?
Posted by: Scott Wood at Jun 4, 2008 9:16:19 PM
"Cap-and-trade involves less redistribution because the losses of the losers are partially offset by their initial awards of tradeable permits."
This depends on the cap and trade system. A system comparable to taxes would initially auction the permits. For example Germany started auctioning 8% of their annual permits.
Posted by: jk at Jun 4, 2008 9:17:00 PM
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.
Posted by: Isaac Opper at Jun 4, 2008 9:59:06 PM
its much easier to set a pollution limit than a price on that pollution.
ummm, wrong, wrong, wrong. How easy is it to set a pollution limit when you have no clue what price will emerge from that limit? How do you think politician's actions will be affected by not knowing whether any given limit is going to, say, shut down the U.S. economy?
This comment above is basically correct, I think:
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).
Posted by: mq at Jun 4, 2008 10:20:32 PM
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.
Posted by: stubydoo at Jun 4, 2008 10:44:54 PM
Agree with Ed, this looks like a program to protect large and established corporations.
Beyond that, this would be the ultimate econo-social engineering, a real orgasm for the more government economists.
Many things can happen, most of them bad.
Posted by: save_the_rustbelt at Jun 4, 2008 11:18:46 PM
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.
Posted by: Bob Murphy at Jun 4, 2008 11:25:10 PM
stubydo, no!
In tax land it depends what you charge for your "patent" and what installation/modification/operation costs are set against emission costs for particular industries and corporations as to how much you are rewarded how quickly.
In the cap-and-trade land it depends what you charge for your "patent" and the various corporations have to game what others are doing, what their particular associated costs are, and where they reckon permit costs will go over time. Certainly a more difficult and variable calculation.
Either way, for such a stunning invention, over time, in outright terms, I'm sure you'll be hugely rewarded but would not necessarily become rich if it cost you too much to develop the idea/technology and register your patent(s).
But that's the market at work. Either way.
Good luck, anyway.
Posted by: notthere at Jun 5, 2008 1:53:25 AM
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?
Posted by: Mikko at Jun 5, 2008 2:21:20 AM
Many think that King Canute tried to command the waves to stay. He was actually showing his sycophantic courtiers that he knew perfectly well when he was or was not wearing his robe.
First we need to get away from carbon alone. Water vapor is the main planet warmer but that is mostly the end result of the other warmers. Certainly methane should be added to carbon dioxide.
So let's have an emissions tax or cap-n-trade.
The problem with the tax is that you are asking a government to price a "resource" from one year to the next towards a target limitation on emmissions. I guess you could sketch out a target graph of emmission reduction over time and then appoint a pricing body who would attempt to keep the reductions on target. There would be the inevitable temptation for governments to favor industries and corporations with tax credits, holidays and the like and to pressure the pricing authority to relax pricing off the economy for political gain.
With cap-n-trade the advantage is that you can actually set your targets ahead of time and let the market work. Here's my idea. Probably not original.
You set your first emission target for, say, 3 years hence. You issue permits to that total emission level but they all have retirement dates stretching out to 2050 or 2060 matching your reduction curve with a final equivalent to the target emission level. You start auctioning them off in tranches right now so the market gradually buys them up for the start date, by which time companies either would or wouldn't have enough permits but a futures and spot market would have already been established and be trading.
By international agreement, each country gets its own total to which their permits would be limited (the EU would trade across borders) and their own retirement schedule, or expansion schedule! If some bottleneck occurs a permit "bank" would be able to supply short term liquidity; 1-5 year permits, just like the Fed adds liquidity now.
There would be all the usual pressure for preference for certain industries but it would have to be done some other way as it is now. But I bet you industries will be squealing at each other more than they do now.
Either way there's going to have to be a whole load of emission auditing and oversight.
Please note that all permits are sold. There are plenty of costs coming along from us using the atmosphere as a tip. How individiual governments use this in their current spending, etc. is, I guess, up to them. I'm thinking the U.N., World Bank or someone else needs some huge credits to draw down on to help developing nations adopt the best technology and for when the shit hits the fan.
Complicated? Less so than the bond market.
Are there going to be some dislocations. You bet. We are facing a crisis, even though many still don't seem to get it. Look what the US went through in the 70s and 80s; a huge restructuring.
In truth, we'll argue and haggle among ourselves and keep emitting, while all the world's great river deltas go below the oceans and we're stupidly spending huge money to defend Charleston, SC and NYC before they, too. subside.
When that happens you'll hear Canute laughing. Long and loud.
Posted by: notthere at Jun 5, 2008 3:12:26 AM
DeLong has edited first-order to second-order now. You might want to do the same.
Posted by: Johan Richter at Jun 5, 2008 8:05:05 AM
Johan_Richter: Considering how loosely and arbitrarily they all seem to be using the term [n]-th order, I don't think it's all that necessary to be precise here ...
Bob_Murphy: Are you ever planning to defend your bizarre cap-and-trade piece from my criticisms?
Posted by: Person at Jun 5, 2008 10:20:33 AM
Agree with Ed,thisevery government program looks like a program to protect large and established corporations.
Fixed it for you.
Posted by: Bob Montgomery at Jun 5, 2008 11:28:44 AM
Some questions:
1) Assuming that you set the cap too low (i.e., too restrictive) in a C&T system, what are the consequences of remedying the cap by suddenly increasing it? Will you crash the permit market? What are the recovery dynamics of a permit market crash?
2) Assuming that you set a carbon tax rate too low, what are the dynamics like when you remedy the situation by increasing the taxes?
3) I notice that nobody's mentioning offset trading in this discussion of C&T. Is that because everybody thinks that offsets have no impact on C&T dynamics, or because it makes everybody's head explode when they try to figure out the ramifications?
4) Has anybody enumerated the various types of fraud and/or loopholes that arise as a consequence of C&T? I know that there's a certain body of lessons learned from the Kyoto-based C&T systems, but I don't know if there's been any work done trying to imagine other Bad Things that could happen.
5) Can anybody tell me why you don't get non-emitting agents buying up carbon permits and holding them off the market because they think that society would be better off if it used less power? Related question: How do you damp out speculative bubbles from a C&T system?
6) Has anybody thought about the transparency/opacity requirements of a C&T market? Can energy end-users make informed buying decisions without knowing how much of their cost is related to permit purchases? Is it essential to the orderly operation of a permit market that public disclosure of permit holders be enforced?
Posted by: TheRadicalModerate at Jun 5, 2008 12:12:41 PM
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.
Posted by: Slocum at Jun 5, 2008 12:19:59 PM
"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. "
What I am missing?
Isn't the carbon tax right now ZERO DOLLARS?
How can it be set too low? Any rate would either be too high or closer to the optimal rate.
There obviously is a risk of setting the rate too high. However, if we were to tax carbon too low then we would only get minimal benefits. BUT it would be a benefit.
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