The Climate Change Debate: Carbon Taxes vs. Cap-and-Trade

For anyone keeping up on climate change news, they will notice that Australia has been going nuts over the subject, staging rallies in support of action on climate change under the "Say Yes" Campaign. The campaign's current demand is for a carbon tax, a per-unit fee for each unit of carbon emitted. Recently, thinking on the subject of climate legislation has moved away from the cap-and-trade legislation championed by those nasty socialists over in Europe and in the White House and towards a carbon tax. Since there are compelling arguments for both, I felt it was necessary to outline the economic argument for each one.

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Carbon tax

A carbon tax is currently more fashionable, preferred by the likes of rowdy Australian hippies to egg heads at the London School of Economics. The most oft-cited benefits to a carbon tax is that it's simple. A polluter gets charged a fixed amount per metric ton of carbon equivalent. They know what to expect, and it gives them incentives to reduce their emissions through innovation. 

One argument in favor of taxes is actually pretty slick. The idea is that a tax could be charged on the emitter. The total amount of the tax could then be returned to the emitter as a lump-sum payment, thereby restoring their income to pre-tax levels. On the surface, this seems like a stupid plan; restoring an emitter's income to pre-tax levels shouldn't increase their incentives to reduce emissions. However, there is some merit to it.

This same idea was once floated with regard to gasoline consumption. The idea was to charge consumers a per-gallon tax for gasoline. At the end of the year, the full amount of the tax would be returned to them (presumably through their income taxes), thereby restoring their income to pre-tax levels. For the graphically-inclined, the situation is represented by the graph below. I represents the indifference curve for a representative consumer and B is the starting budget line. The optimal bundle for this consumer (represented by the point at which the budget line is tangent to the indifference curve) is x gallons of gas. A tax would effectively increase the price of gas, making the consumer able to afford less. This would rotate the budget line inward toward the origin, resulting in B'. Although not drawn, the consumer would end up on a lower indifference curve, making them unequivocally worse-off. However, assuming that the amount of the tax were refunded to the consumer, the budget line B' would shift out to budget line B", effectively keeping the consumer at the same level of preferences or utility. However, the optimal consumption bundle would result in the consumer purchasing x' gallons of gas, thanks to the Hicksian substitution effect. 

 

In summary, the consumer would be just as well off with the tax as they were pre-tax, but less gas would be consumed. This same basic concept could be applied to carbon emitters.

There is a problem with carbon taxes, though: how high should they be? This creates a further question: what's the optimal level of carbon emissions? There is an optimal level (not zero), by the way; we need carbon emissions for such things as transportation, industry, electricity, etc. But at what point does the cost of carbon emissions outweigh the benefits? These are questions that are difficult -- if not impossible -- to answer, and an efficient carbon tax is reliant on the answers to these questions.

Cap-and-trade

The biggest benefit to cap-and-trade is that the questions posed at the end of the previous section -- how high should the tax be -- is answered automatically through basic market interactions. Assuming that permits can be distributed to each emitter and a binding cap is set, producers will evaluate the costs associated with emitting carbon through analyzing the value of their permits. If they are able to reduce a ton of carbon emissions at a cost that is lower than the value of a carbon emission permit, they will sell that permit to a high-cost emitter, realizing a benefit associated with the difference between the value of the permit and the cost of emissions abatement. Through trades such as this and assuming transaction costs are minimized so that trades can flow seamlessly between emitters, this arrangement will result in the economically-optimal allocation of permits and, therefore, carbon emissions.

There are several problems with this arrangement. Enforcement of compliance is necessary and requires what would likely be a large bureaucracy. Further, the initial distribution of the permits poses a serious challenge. Certainly there has the potential to be a windfall to the emitters who receive the largest share of permits. Permits could also be auctioned out, and this idea has gained some popularity.

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There are pros and cons to each approach. Personally, I like the taxes idea better, since that approach has the potential to be the least disruptive. Either way, it's important that policymakers are able to convey the advantages and disadvantages of each approach to a public that is oftentimes overcome by reactionary politics so that the best decision can be made as we move forward with climate change legislation.