Megan McArdle Moves the Ball Downfield on the Cap-and-Trade vs. Carbon-Tax Discussion

She interfaces with the knowledge base of the ancient Krell and writes:

Megan McArdle: Capped! Ryan Avent has been doing some great posting on cap and trade versus carbon taxes. With all information known, the two are theoretically identical. But in the real world they will differ; the question is how much.

One way to think about it is that we are choosing between two kinds of transparency: transparency to regulated companies, and transparency to voters. Politicians like cap and trade because the connection between the plan and higher energy prices will be less obvious to the voters. For that reason, a libertarian should generally prefer a direct tax.

On the other hand, cap and trade provides more certainty for companies, and a more direct relationship between their actions and profits. So the tax is not always a perfect slam dunk.

On balance I prefer taxes to cap and trade. However, politically, no one is going to enact a carbon tax with gasoline at $4.00 a gallon. Cap and trade is what we're going to get. In practice, that will mean that companies get subsidies to get them to go along (liberals who want cap and trade should concede on this issue to make it easier to pass), while prices rise somewhat. It's not clear to me how big a difference it will make in the long run.

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

I don't have a dog in this fight: I think second- and third-order pluses and minuses roughly offset each other. But the substantive case for action seems very clear--and the fact that oil has risen above $100 a barrel without killing the economy just makes it more painful to think of what a hideous waste of opportunity our failure to take Al Gore's advice back in 1993 and put on a carbon tax that IIRC was going to max out at $10/barrel...

Comments

[nemo]

Do you have to keep linking to Megan McArdle? It just encourages her. She's another Robert Samuelson / David Brooks / Ben Stein in the making, but with a female libertarian twist.

[DCBob]

Wrong or missing an important point, I think, on all first-order counts:

“Cap-and-trade involves less redistribution because the losses of the losers are partially offset by their initial awards of tradeable permits.” No, the same redistribution can occur be returning tax revenues to the losers (if you can accurately identify them to begin with – how do you know the permit recipients are the actual losers?)
“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.” It could as easily go below its social optimum. The point is it’s not very likely to be at it.
“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.” It could as easily be set too high. The important point is that a tax is more likely to be a particular price, which may or may not be the optimum, while a cap yields no such price certainty.
“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.” More importantly, NOT using the money to cut existing taxes means that mitigation costs will enhance the pre-existing distortions. The tax swap just keeps you from digging a deeper hole.
“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 how is that not true of allowances, either freely allocated or auctioned?

[Maynard]

Another difference: if there is variation in the cost of emissions reduction over time, a carbon tax is more (intertemporally) efficient than a straight-forward cap-and-trade system because it ensures that the marginal cost of abatement is equated over time. A cap-and-trade system can be modified so that it achieves the same level of efficiency by allowing borrowing and banking of permits.

And another: cap-and-trade is consistent with what the rest of the world is already doing, so it is arguably easier to implement. With a carbon tax in the U.S. and cap-and-trade in the rest of the world, there would undoubtedly be ways that transnational corporations could game the system to get around the controls.

And yet another: cap-and-trade would seem to work more seemlessly together with a system of offsets. A Chinese pig farmer implements a system to store methane gas emissions and under Kyoto converts the offsets to emissions permits that can be sold. What does he do with a carbon tax system, apply for a subsidy? That would be clunky.

[save_the_rustbelt]

This appears to be a great experiment in social and economic engineering with the American people as the lab rats.

A bad experience may give new life to the conservatives.

[Matt]

"Chinese pig farmer implements a system to store methane gas emissions and under Kyoto converts the offsets to emissions permits that can be sold."

How would an American pig farmer buy emission permits that he can resell?

Will the Fresno County, CA. pig farmer have a fair market when competing with the county government here in buying and selling permits?

[SamChevre]

A typo and a quibble:

The 5 effects are second-order, not first-order.

The first second-order effect is true if permits are given away, but not if they are auctioned off.

[bigTom]

I think the predictability of (carbon) prices is a big thing. With cap-and-trade, the price could be either dramatically too high or too low, depending upon whether the cap was set correctly. With tax, (which allows credits for any enterprise that actually goes carbon negative), the price trajectory can be known, during the project planning phase, and investment decisions can be made without additional risk due to miss-prediction of the future price of carbon.

[Matt]

OK, under CapnTrade, some semi independent agency sells, quarterly, emission permits. These, with efficient transaction costs, are spread throughout the wealth distribution according to the elasticity of energy use.

Where do the proceeds go? Granted to 38% of the economy, according to the current theory. That part is ludicrous.

Where should the proceeds go? To folks who can prove they are not users or very low users of energy. How much money is all this? Very little, if we judge by todays direct weather related personal damages.

If I am a bicycle commuter in San Fransisco, I can prove I am a low energy user, I can wear a GPS. But I can only prove about $500 per year in weather related damages.

But in San Francisco, I am in a temperate zone where global warming has milder affects. My damages go up if I am Pennsylvanian Amish. They are worse if I am an Alaskan Intuit.

You are pushing a regime that requires micro energy monitoring, one way or the other. If evolution granted us miracles, we would try a small test case, allow a small damage claim and see what happens.

[low-tech cyclist]

McMegan says: "Cap and trade is what we're going to get. In practice, that will mean that companies get subsidies to get them to go along (liberals who want cap and trade should concede on this issue to make it easier to pass)"

What am I missing here? If the government is selling someone a carbon allowance (or whatever they'll call the right to put a certain amount of carbon in the atmosphere), then turns around and hands the buyer a subsidy, wouldn't the subsidy just increase the price the buyer was willing to pay in the first place?

Unless you're going to subsidize some buyers but not others (which would be a minefield), the whole idea seems circular.

[Alex F]

Your 1st, 4th, and 5th differences seem to assume that a cap-and-trade plan would give away rather than sell permits. For what it's worth, Obama supports 100% auction of permits -- this would raise just as much revenue and have just as much redistribution as direct taxes.

[Fifi]

Brad, you're missing one important second order difference:

Cap-and-trade gives Wall Street yet another toy to play and mess it up for everybody else while a carbon tax reaffirms the authority of the state to intervene in the economy.

Anything that gives Wall Street a toy is a bad thing, DOA.

[Kevin Cox]

There is another solution that can be applied to both cap and trade and carbon permits. In both cases the price of polluting energy increases. The extra money collected need not go to the government it could go to back to the purchasers of polluting energy - with a proviso. The money they get back must be spent on building the infrastructure to produce renewable energy, or ways of saving energy, or ways of reducing greenhouse gases. With modern information systems this is easily implemented and can be done so that compliance will be near 100% - and it will cost very little to do.

[Robert Waldmann]

Second order does not mean small. A million squared is a trillion. and a million cubed is ... uhm a real big number ... a quintillion that's it.

Brad you once kindly linked to a post of mine entitled

The Third Meaning of "First Order"
http://rjwaldmann.blogspot.com/2005/04/third-meaning-of-first-order-formally.html
Now, however, you are clearly using "First order" with that third meaning. In this case you use "to first order" to mean "with perfect foresite" which is not a good approximation.

I vainly quote from my old post

Formally a function g(x) is a valid first order approximation of another function f(x) ...

However, economists, who like to play with math but don't always take it seriously, use "is true to first order" to mean "is a useful approximation to the truth". Similarly, economists use "second order" to mean economically insignificant.

[Not so recently], I noticed a third meaning of "first order" which is "according to the first neoclassical model of the phenomenon (that is the first model which featured rational optimization)." Note that this third usage is much further from the formal mathematical usage than the second is. No one could possibly believe that the first neoclassical model of something must be a good approximation.

The rules of theoretical debate among economists often require great deference to simplifying assumptions which no one has ever believed to be approximately correct. Roughly, the rule seems to be "according the first neoclassical model" must be accepted as meaning "true to first order" which much be interpreted as "a useful approximation."

I really don't know why.

[Robert Waldmann]

Oh and the Krell didn't end up to well but, I doubt that six Krell ever wasted there time parsing Robert Samuelson as you, Avent, Thoma, Yglesias, Cowen and McArdle* just did.

*just inducted, by you, into the ancient and hermetic order of the Krell)

By the way, what is the URL for Krellblog ?

Oh yes http://egregiousmoderation.blogspot.com/
You could make an alternative url
http://krellblog.blogspot.com/

[Douglas Knight]

I don't like this use of the word "redistribution."

It's redistribution with respect to the status quo, and that's practically important, but, morally speaking, externalities are theft. More consequentially, cap-and-trade has moral hazard. eg, companies in Europe inflated their pollution to increase their permits.

[moom]

If you give away carbon permits there is an efficiency loss due to the tax interaction effect. You need to get revenue from them to cut other distorting taxes to avoid this problem. A carbon tax gives you this as long as you don't end up using it on more spending. So a carbon tax is more efficient than free permits. But industry likes free permits as they create a barrier to the entry of competing firms. Seems we are headed to the less efficient solution.

David I. Stern