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Carbon tax vs. labor tax
I used to think that a revenue-neutral carbon tax would, in addition to its effects on climate, have superior allocative properties over a tax on labor or capital income. "Why not tax pollution rather than productive activity?" or something like that.
It turns out I was (mostly) wrong. I read this passage yesterday and said to myself "Duh!" A tax on carbon, by raising the prices of goods and services, also lowers the real wage and discourages labor supply (holding constant its effect on climate), just as an income tax does:
However, this does not necessarily mean that revenue-neutral CO2 taxes, or auctioned allowance systems, produce a “double dividend” by reducing the costs of the broader tax system in addition to slowing climate change. There is a counteracting, “tax-interaction” effect (e.g., Goulder 1995). Specifically, the (policy-induced) increase in energy prices drives up the general price level, which reduces real factor returns, and thereby (slightly) reduces factor supply and efficiency. Most analytical and numerical analyses find that the tax-interaction effect exceeds the revenue-recycling effect, implying no double dividend, and that abatement costs are actually higher due to the presence of preexisting tax distortions. A rough rule of thumb from these models is that the costs of revenue-neutral emissions taxes are about 15 percent greater than the direct cost due to interactions with prior tax distortions, implying the optimal tax is 15 percent lower than the Pigouvian tax (e.g., Bovenberg and Goulder 2002). However, the cost increase is far more substantial for policies that do not exploit the revenue-recycling effect (i.e., cap-and-trade with free allowance allocation or CO2 taxes with revenues not used to increase economic
efficiency). According to cost mark-up formulas derived in Goulder et al. (1999), the increase exceeds 100 percent when the emissions reduction is below 30 percent.
I'm not sure this should be a major factor in one's assessment of a carbon tax, but I hear this analytic error quite often, so I thought it was worth a post. (I should add I don't understand their qualifying point about revenue-recycling at the end of the excerpt and as I read it I don't think it is correct; an income effect which offsets a substitution effect does not eliminate the distortion from the latter.) The source paper, which is interesting on the economics of climate change more generally, is here.
Posted by Tyler Cowen on June 5, 2009 at 06:31 AM in Economics | Permalink
Comments
I didn't understand this either (to be honest, I really doubt if the authors did.) That said, I feel that this result is so incredibly counter-intuitive that it is worth an explanation that is a lot clearer.
If raising carbon taxes, and reducing labor taxes by the same amount would "discourage labor supply", doesn't it follow that raising labor taxes and using the extra revenue to pay for carbon emissions would encourage labor supply? Because surely we are not right now on that magical spot on the Laffer curve where any change in either direction would be for the worse?
I call BS.
Posted by: Joe Torben at Jun 5, 2009 7:12:10 AM
These kind of general equilibrium effects are always very tricky, indeed. An optimal carbon tax does discourage labor to the extent that it would be used to produce inefficient goods (where the production cost plus externality exceeds the consumption value). To go beyond that level to fund desired public goods and services will create deadweight loss in labor markets (among others) as you highlight above. As anyone who has taught college economics knows, it is a very rare student who can grasp the subtle aspects of general equilibrium effects, and this example is as sneaky as it gets.
Posted by: liberalarts at Jun 5, 2009 7:17:25 AM
I'm no economist, but my guess as to their point about "revenue recycling" is that if you make your carbon tax/cap-and-trade revenue neutral, *but* you allow a big chunk to go untaxed/give away free credits to existing emitters, then the marginal effective tax on labor is larger because less revenue comes back to reduce income tax.
As the first couple of commenters point out, this all seems to depend quite a bit on how easy it is to increase the carbon efficiency of economic activity -- or for that matter, how much in the way of substitution of low-carbon-input goods for high-carbon-input goods can be made by consumers.
Posted by: Alex R at Jun 5, 2009 7:40:00 AM
If I understand the argument at all, it's a monetarist one. If so, then shouldn't the effect be counterable through appropriate monetary policy?
Posted by: Cyrus at Jun 5, 2009 7:48:41 AM
Joe, yes, that's what they say, but compared to a situation of perfect pigouvian taxation, not compared to the current situation. So in the situation of perfect pigouvian taxation it would be good to lower CO2 taxes a little ("pay for more CO2", as you put it), and increase labor taxes by the same amount, to end up in a situation with more CO2 than optimal, but also a more efficient labour market.
But that doesn't mean that in the current situation paying for more CO2 would have good effects. They estimate (God knows how) the magic spot at 15% below perfect Pigouvian taxes, so a lot higher than current CO2 taxes.
Posted by: Zamfir at Jun 5, 2009 7:48:41 AM
I think that the key to understanding the key reason as to why the double dividend hypothesis is overstated is that you can't make labor income untaxed and shift the burden to carbon if the income of labor is used to purchase goods and services that are made with carbon inputs (which is essentially everything.
Posted by: liberalarts at Jun 5, 2009 7:54:25 AM
you can't make labor income untaxed and shift the burden to carbon if the income of labor is used to purchase goods and services that are made with carbon inputs (which is essentially everything.
Yes, but so what? This is not a "tax interaction effect", it's a "raise the price of energy" effect. Any CO_2 mitigation strategies will lead to an increase in the price of energy - be it direct regulation, carbon taxes or cap-and-trade - but this cost is hopefully offset by the benefit of mitigating climate change. But carbon taxes and auctioneed permits have the advantage of capturing the ensuing scarcity rent in a transparent way, which helps offset some of the costs of the tax system.
Posted by: anon at Jun 5, 2009 8:17:30 AM
"Yes, but so what?"
The point is not that it is undesirable, rather an externality canceling tax (pigouvian) can't be made in a vacuum. The very act of internalizing the carbon externality creates deadweight loss in the labor markets, which are already distorted. If all desired government revenues --beyond those raised by an optimal pigouvian tax on carbon-- came from nondistortionary lump-sum taxes, then a carbon tax set at the marginal carbon externality would be the most efficient choice. But, since government revenue comes from distortionary taxes on labor and capital, a revenue neutral carbon tax for labor tax swap would still leave positive taxes on labor. The distortion there means that it becomes efficiency improving to back down the pigouvian tax from its textbook level, because the efficiency loss from that is more than recovered in reduced labor market distortions. At least according to their model parameters, that is.
Posted by: liberalarts at Jun 5, 2009 8:43:36 AM
But would it be correct to say that currently we have an incredibly inefficient hodgepodge of systems for regulating energy and pollution, and there would be gains if we replaced that with a simpler standard system? (like a nation-wide tax or cap&trade)
Posted by: Marc Brodeur at Jun 5, 2009 9:46:45 AM
Why would a pollution tax raise the GENERAL price level? It should raise the price of pollution-intensive sectors. No one suggests that cigarette taxes raise the GENERAL price level as well.
Posted by: dm at Jun 5, 2009 10:07:02 AM
I've heard this beforem and something I genuinely don't understand is why a reduction in labour supply due to a (tax related) change in the price of goods that reflects the cost of their externalities is a labour market distortion. Why is this not an optimal response to a change in prices to their 'right' level?
Maybe we wouldn't see an overall increase in Labour supply but why is this what we would expect or want to see?
Posted by: Sam at Jun 5, 2009 10:27:45 AM
The issue is that some of the "blue dividend" (the benefits of tax revenue) is offset by the new tax exacerbating the distortions of pre-existing taxes. There is still a "blue" dividend, but it's smaller than one might think initially. This in no way changes the fact that a Pigouvian tax increases economic efficiency. It's still better than taxes on labor or capital, but rather than being miles better, it's only kilometers better.
Posted by: libert at Jun 5, 2009 10:46:39 AM
Sam, if I understand it correctly, the point is that when it comes to the trade off between leisure and work-for-consumption, people are already (because of taxes) below the pigouvian optimum with respect to CO2. So a CO2 tax plus lump sum payment would decrease marginal real income after tax, moving the amount of leisure even further away from the optimum.
So using the CO2 income to lower labor taxes would only correct this back, it would not in itself be an improvement over the situation without CO2 tax.
The same reasoning applies to most taxes.
Posted by: Zamfir at Jun 5, 2009 10:48:59 AM
2&3. It seems to be several full time time jobs to keep up with Krugman's blarney, and he seems to only be The Left's best B.S.er. At what point do people decide that the best defense is a good offense and go FoxNEWS.
1. Economists in general deserve credit for regularly achieving papers of 30+ pages chock full of dense, confusing material such as this. Reviewers should be given 3 days, and if they don't understand a damn thing on first reading then that's a no-go.
Posted by: Andrew at Jun 5, 2009 12:22:55 PM
Oopsie, wrong thread.
Posted by: Andrew at Jun 5, 2009 12:47:05 PM
For me, dm and libert are right on point. A carbon tax off-set by a reduction in income (or preferably payroll) taxes would on the margin increase employment and decrease carbon emissions. Perhaps these effects would be offset somewhat by "tax interactions" (it seems natural to suppose they would be), but I find if difficult to believe that they would be swamped.
And since most of use would rather have more employment and less CO2, I'm not sure I see how this is an argument against such a taxation scheme.
Posted by: mravery at Jun 5, 2009 12:49:16 PM
Tyler,
I also am not sold on this, so if you really "see" it, a follow-up post with some nice examples would be great.
In particular, is this different from the fact that an income tax discourages savings, whereas a consumption tax does not? In other words, I used to think that both taxes equally discouraged saving, since after all the whole point of saving is to consume (in the future).
But if you do a general equilibrium analysis, you see that's not true; the income tax changes the present vs. future tradeoff, in a way that the consumption tax doesn't.
But you're saying that a consumption tax vs. income tax doesn't affect the leisure/income tradeoff?
Posted by: Bob Murphy at Jun 5, 2009 1:06:37 PM
As Coase pointed out, externalities are of reciprocal nature. They are not only caused by the externality-emitting person, but also by the person who puts herself in the situation of being able to be harmed by the externality. Thus, to optimally internalize an externality, a double-sided-pigou-tax would be needed.
Does that mean that to minimize the damage from climate change we should impose a worldwide tax on lifestyles which are more harmed by climate change than other livestyles, e.g. living near the ocean or in arid countries? Of course, for this to be effective one would have to abolish restrictions on the possibility to avoid the externalities, e.g. immigration laws, to allow people to leave the countries hit hardest by climate change.
As a positive side-effect, this two-sided tax might create a double-double-dividend...
Posted by: bbb at Jun 5, 2009 2:15:39 PM
Dr. Cowen,
How do you read the revenue-recycling comment? Or what do you mean by "an income effect which offsets a substitution effect does not eliminate the distortion from the latter"? If I'm reading your comment right, I disagree. Income taxes distort the labor-leisure decision, but if you use income taxes to finance lump-sum transfers, you distort the labor-leisure decision even more -- that is, the income effect of income taxes does, in a sense, reduce some of the distortion of the income tax's substitution effect. As I read them, all the authors are saying is that using a carbon tax revenues for lump sum transfers might very well mean you have don't even get a single dividend much less a double dividend. What's wrong with that?
Posted by: ryan yin at Jun 5, 2009 5:12:25 PM
The issue of "revenue recycling" is about whether the money is used to reduce other distortionary taxes, or if it is handed out as a lump sum (to consumers or firms). You have much higher efficiency if you reduce other taxes.
Posted by: Alex F at Jun 5, 2009 5:14:30 PM
I don't understand the details of this article, but on the surface it sounds like it also applies to replacing income taxes with consumption/sales/value-added taxes? If carbon taxes raise the price level and so hurt the labor supply, surely sales taxes do the same thing?
Posted by: Jeffrey Yasskin at Jun 6, 2009 12:08:18 PM
"A tax on carbon, by raising the prices of goods and services, also lowers the real wage and discourages labor supply (holding constant its effect on climate), just as an income tax does"....
So, a reduction in income taxes, like in 2001, 2003, 2006, and 2008 worked to increase the labor supply which is why there are so much labor sitting around idle. Unfortunately, those tax cuts seemed to drastically cut the demand for labor. If we compare the demand for labor during the crushingly high income and capital tax Clinton years, labor demand increased employment by an average of 200,000 a month, while the low tax increase labor supply Bush years produced labor demand that only increased employment by an average of 1000 a month.
The question I have is, what good is having increased labor supply if there is no demand for the labor and the labor not only sits idle but also reduces the general welfare of the employed labor.
The cost of employing the labor to produce energy producing capital as a substitute for the carbon capital burning activity that is favored by tax policy and government's land rent pricing makes employing the labor more expensive than letting it sit idle consuming resources from the employed labor supply.
Of course, this is reducing the general welfare for not only the employed labor, but also for the idle labor, and this has made the cost of much of the capital accumulated over the past three decade when the policy was reversed from energy sustainability to producing energy consuming, carbon capital burning, capital assets: big houses, gas guzzlers, long supply lines. All those capital assets from the engines of consumption and the enterprises that produced the energy consuming capital have fallen drastically in value.
I think that limiting the rate of burning carbon capital and instead favoring the accumulating of productive energy capital will produce more demand for labor. So, if the idea of income tax cuts was to increase the supply of labor, what we need is a tax on burning carbon capital that will increase the demand for labor.
Unless, someone is willing to employ creative destruction on the idle labor capital supply: euthanasia and sale of body parts would increase the general welfare by reducing the drag on the employed labor of the idle labor, plus increase the supply of body parts needed by the productive but sick labor. But that requires abandoning the criticism of the Chinese government and adopting their very wise creative destruction of the least productive labor in the Chinese economy.
Posted by: mulp at Jun 6, 2009 3:37:12 PM
Bob Murphy writes: "In particular, is this different from the fact that an income tax discourages savings..."
I presume you mean a low income tax discourages savings while a high income tax promotes savings, right?
The savings rate during the low income tax Bush years reached zero, while the savings rate during the crushingly high tax Carter years were at their peak, with the savings rate falling as income taxes were cut in between.
Posted by: mulp at Jun 6, 2009 5:22:52 PM
I would imagine that any form of taxation that takes an equal amount of money out of the economy will have about an equal effect on skewing of efficiencies. If the public sector is vacuumin x% of the cash from the economy via taxation, no matter how it happens, it's going to trickle down to the ends of the road and hurt the little guy. No matter how you diminish profit, you've diminished profit, and therefore you've diminished the ability for employers to pay employees, lower product prices, and invest and reinvest in the business. Call it whatever you want, by any method you wish, it's still just the government taking your money.
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