Search Results for: Pigouvian

Co-authored with Sieren Ernst, Environmental Markets Advisory.

“The Case For A Carbon Tax” (Island Press, 2011, 233 pp) brings to mind Hans Christian Andersen’s “ugly duckling” story. The word “tax” screams “cost” to most people, and so the beauty of a carbon pollution tax isn’t apparent on first glance. Prof. Hsu reveals the beauty as he shows why a gradually-rising carbon tax is the least costly and most effective policy for curbing the pollution driving global warming, and how enacting such a tax can usher in a new era of clean energy and efficiency.

Trained in engineering, law and economics, Shi-Ling Hsu, a law professor who is moving from the University of British Columbia to Florida State University, deftly marshals a multi-disciplinary “case” for a carbon tax. He opens by describing and comparing the four main climate policy tools: subsidies, regulations, cap-and-trade, and carbon taxes. Then he briskly articulates ten arguments for a carbon tax, emphasizing economic efficiency and the advantages of basing a coordinated international system on a simple, transparent tax.

Hsu is especially strong in rebuttal, answering the arguments against carbon taxes, including the oft-repeated assertion that a carbon tax is politically impossible. He dissects psychological “hang-ups” that have kept the public and elected officials from embracing carbon taxes. Hsu points to British Columbia’s enactment and implementation of North America’s first carbon pollution tax, arguing that it is broadly supported because its revenue is used to reduce taxes for individuals and businesses. As Hsu and Yoram Bauman wrote this week in their New York Times op-ed, “The Most Sensible Tax of All“:

On Sunday, the best climate policy in the world got even better: British Columbia’s carbon tax — a tax on the carbon content of all fossil fuels burned in the province — increased from $25 to $30 per metric ton of carbon dioxide, making it more expensive to pollute. This was good news not only for the environment but for nearly everyone who pays taxes in British Columbia, because the carbon tax is used to reduce taxes for individuals and businesses. Thanks to this tax swap, British Columbia has lowered its corporate income tax rate to 10 percent from 12 percent, a rate that is among the lowest in the Group of 8 wealthy nations. Personal income taxes for people earning less than $119,000 per year are now the lowest in Canada, and there are targeted rebates for low-income and rural households.

Hsu crisply articulates the theory of Pigouvian taxes — the idea of taxing pollution rather than productive activity. But he sidesteps the thorny question of how high to set a carbon tax and how rapidly to increase it. And he does not mention the potential efficiency advantages of using carbon tax revenues to reduce other taxes such as taxes on work and thereby use climate policy to improve overall economic well-being. (Economists call that a “double dividend.”) He notes that while British Columbia’s carbon tax is revenue-neutral, the regressive effects of carbon taxes can be addressed by a wide variety of other mechanisms, leaving substantial revenue for cash-strapped governments, as recent reports and a new book by the International Monetary Fund have stressed.

Hsu delves into the limitations of EPA regulations, which he shows cannot create the broad incentives for innovation and planning needed to drive carbon eminssions way down:

A [carbon] tax, by imposing a cost on every single ton of pollutant, constantly engages the polluter with the task of reducing her pollution tax bill. By contrast, a command and control scheme that mandates a one shot, irrevocable installation of pollution control equipment allows for the polluter to stop thinking about pollution reduction. Why, if compliance is achieved, should the polluter look for other ways to reduce?

There are further problems, too: EPA can too easily be persuaded or intimidated by industry into granting exemptions and relaxing standards. Hsu also glosses over the enormous effort that would be required to write and enforce permits for each of the thousands of point sources of CO2. One has to wonder where and how the already-stretched EPA (and state environmental agencies) would find funding for such a massive undertaking.

Hsu neatly unveils the hidden high cost of taxpayer-funded subsidies of renewables and supposed low-carbon fuels. Subsidies, along with regulations and cap-and-trade with offsets, are attractive to the public and Congress despite serious limitations on their effectiveness, because their costs are largely hidden. Not only is Congress notoriously ineffective at picking technology winners, but subsidies create “lock-in” to incumbent technologies and businesses, foreclosing opportunities to spur innovation. In contrast, as Hsu shows, a carbon pollution tax’s laser focus on CO2 pollution creates incentives for all low-carbon alternatives, leaving specific technology decisions to engineers rather than politicians.

Cap-and-trade with offsets seems to be Hsu’s choice for second-best policy; it allows flexibility and could result in a “price on carbon” pollution, albeit one that is indirect and subject to price volatility. Happily, Hsu debunks the notion of “emissions certainty” that was used to sell cap-and-trade, by pointing out that for a “stock” pollutant such as CO2 that persists in the atmosphere for a century, the objective must be cumulative rather than annual reductions. Even year-to-year “emissions certainty” is vitiated in the European Emissions Trading System by provisions allowing borrowing and banking of allowances as well as by voluminous offsets. Carbon prices there have remained so low that recent analyses have concluded that industrial facilities will have little incentive to reduce their emissions through at least 2020.

Hsu points out the hidden costs that cap-and-trade would impose on consumers, profiting the financial sector and purveyors of offsets. His most egregious example: Chinese refrigerant manufacturers who garnered far more revenue from offsets awarded for destroying their greenhouse gas byproducts than from the sale of their underlying products. As documented by UN and GAO reports, the carbon market paid about 100 times more for the installation of emissions reducing equipment (an HCFC 23 incinerator) than the price of the equipment. The Chinese refrigerant manufacturer and the investors in the offset project reaped those windfalls, contradicting claims about the efficiency of cap-and-trade.

As Hsu illustrates, evaluating and verifying offset projects is staggeringly difficult. Applications for hundreds of different project types are submitted to a single U.N. panel with little capacity to evaluate “additionality” — to determine whether projects would have occurred in the absence of offset funding. Stanford University law professor and offset expert Michael Wara estimates that 30-50% of offset projects in the U.N. systems should not have been awarded credit, a fraction so large as to overwhelm any claim of “emissions certainty” under a cap with offsets.

Hsu concludes that linking cap-and-trade internationally would offer constant opportunities for mischief and arbitrage. In contrast, under a tax every country would have an incentive to scrupulously monitor emissions in order to collect the revenue. Moreover, the transparency of a carbon tax offers potential for international linkage via World Trade Organization sanctioned Border Tax Adjustments. WTO rules were built around a consumption tax — the European Union’s Value Added Tax; Hsu suggests that a carbon tax should similarly be supportable under WTO rules. But he seems to understate the capacity of Border Tax Adjustments to protect domestic energy-intensive industry while offering a growing monetary incentive to trading partners to enact their own carbon taxes.

Finally, Hsu’s discussion of the psychology of carbon taxes adds a dimension that we haven’t seen elsewhere. As behavioral economists like Daniel Kahneman have shown, we humans tend to underestimate the benefits of avoiding future harms while overestimating the cost to avoid them. And when a harm isn’t clearly identified with a specific person or persons, we have difficulty feeling concern. One child trapped in a well evokes national interest and empathy, but because we can’t see or name the millions who might drown or starve because of climate instability, we refuse to bear the near-term price of avoiding catastrophe. And we are easily misled into thinking that policies whose price is hidden, such as subsidies, regulations or cap-and-trade with offsets, are preferable to a carbon tax. Hsu proposes that polls disclose the cost of all policy alternatives in order to fairly gauge public opinion.

Hsu’s book offers a readable and authoritative, comprehensive and concise “case” for the most broadly effective, least-bureaucratic and least-costly approach to the climate crisis: a gradually-rising carbon pollution tax. We highly recommend “The Case For A Carbon Tax” to both general audiences and to those steeped in climate policy who may be seeking further insight on the nuances.

Photo: Flickr — jbparker

A carbon tax offers a unique and powerful combination of fiscal, economic-efficiency and environmental benefits, argued Adele Morris, the Brookings Institution’s Policy Director for Climate and Energy Economics, at an Oct. 18 forum convened by the Brookings Institution, the Urban Institute and the Tax Policy Center. Morris acknowledged the political obstacles. One of course is the failure of anti-tax politicians to distinguish beneficial “Pigouvian” taxes on pollution from conventional taxes that burden and discourage productive activity. But another has been “tepid” support for a carbon tax from the environmental community.

We heard that as a challenge: Why has the environmental community (with a few notable exceptions) parked itself on the sidelines of this crucial policy debate?

Adele shared her presentation text, which we reproduce below:

Time to ’86 the Tax Code? Prospects for Tax Reform After 25 Years

AN URBAN INSTITUTE – BROOKINGS INSTITUTION – TAX POLICY CENTER EVENT 10/18/11

The potential role for a carbon tax in a broader tax reform package is timely and economically important. This paper addresses two aspects of the issue: the economics and the politics. It makes good economic sense to embed a carbon tax in a broader tax reform package. If you’re going to “go big” on deficit reduction, it makes sense to include a carbon tax, and likewise if you’re going to do serious climate policy, it makes sense to raise revenue for deficit reduction or to offset other taxes. Despite the strong economic case, the political challenges to a carbon tax are many, and they aren’t just from anti-tax Republicans who don’t believe in the science of climate change. Some of the headwind to a carbon tax derives from tepid enthusiasm from Democrats and the environmental community.

Embedding a Carbon Tax in Broader Tax Reform

First and foremost, the reason to do a carbon tax is to reduce the risks posed by climate change. If you don’t believe the science that indicates that humans are responsible for rising temperatures then naturally there is nothing else compelling beyond this point. But if we stipulate the risks of climate change, then a policy that prices those damages (as best as we can estimate them) into fossil fuels is an economic no-brainer.

Adele Morris, Climate & Energy Policy Director, Brookings Institution

The kind of carbon tax policy I support is the canonical carbon tax recommended by many economists. It would fall on the carbon content of fossil fuels broadly across the economy. It would start modestly, at something like $15 to $25 per ton of CO₂, and ramp up at a modest real rate over inflation, something like 4 percent per year. It would allow tax credits for carbon in fuels that are not subsequently emitted, for example because it is sequestered underground or embodied in a product, such as plastics.

While it’s true that tax reform is hard enough without larding it up with a grab bag of other policy priorities, especially something as contentious as climate policy, there are several good economic reasons to combine these two efforts. First, a carbon tax can raise significant revenue. Depending on the tax rate, it can raise more or less revenue, but estimates suggest that a price on carbon about $33 per ton of CO₂ in 2020 would raise about $180 billion per year. A tax of about the size I described earlier would start out at revenue of about $100 billion per year, and it would rise from there. However, the revenue profile isn’t as steep as you might think because people respond exactly as you want them to — by emitting less carbon. That means that although the tax rate goes up, the revenue tapers off and eventually falls over the long run as the falling emissions dominate the higher tax rate. So a carbon tax is a medium- to long-run revenue instrument, but as emissions fall to low levels in the very long run the tax eventually raises little revenue, which is exactly what you want if the goal is to stabilize greenhouse gas concentrations in the atmosphere.

A second reason to embed a carbon tax in broader tax reform is that a carbon tax can be regressive. If you don’t make the carbon tax part of a progressive tax reform, then you have to fix the regressivity within the climate policy or not fix it at all. If you address the regressivity within the carbon tax system, you can end up with less efficient climate policy – for example with rebates to households to offset higher energy bills. This blunts the incentive to conserve energy, which means you have to have a higher carbon price to get the same environmental benefits, which is obviously more costly.

Third, a carbon tax used for deficit reduction could possibly avoid some of the protracted rent-seeking we saw over the cap-and-trade bill, where relatively little of the debate over cap-and-trade was over the cap — most of the squabble was over who got the free allowances. Everyone who thought they were about to lose their share of the pie had incentive to block the measure and get another bite at the pie. Maybe if all the carbon tax revenue goes to deficit reduction or to fund the reduction of other taxes, then there’d be less to squabble over and we could make some progress.

Fourth, a carbon tax policy that doesn’t apply the revenue for deficit reduction or to offset other distortionary taxes would be a lot more costly to the economy than one that does. The economic literature is clear on this. If you just give away allowances or carbon tax revenue, you’re not getting the economic benefit of reducing distortions from the existing tax system which in turn makes the climate policy a lot more costly than it could be.

A final reason to embed the carbon tax into other tax reform is that it might make it harder to unwind later. There’s always going to be a constituency to repeal the carbon tax, and it will get louder as the tax and retail energy prices go up. If there’s a countervailing constituency that is the clear beneficiary of the other taxes reduced, then we have a counterweight. That’s what they did in British Columbia, which is a model we should consider.

More on the Politics

AEI’s Kevin Hassett recently observed that one reason we not have discussed climate policy this long without actually putting a price on carbon is that economists haven’t done a good job convincing Republicans that Pigouvian taxes are okay, meaning that taxing something you want less of is good economic policy. I agree with his assessment.

I also think economists haven’t done a good job convincing the environmental community that Pigouvian taxes are good environmental policy. After decades of opposition, the good performance of the Acid Rain program led environmentalists to support the idea of cap-and-trade to control air pollutants. And we saw their strong support of the cap-and-trade legislation as it moved through the House but died in the Senate in 2010. However, even as the environmental community embraced cap-and-trade, which put a specific limit on emissions, they didn’t entirely trust it to do the job. Recall that only one title of the monster bill was cap-and-trade. The environmental community embraced, and still does, a wide variety of ancillary policies, some of which would have been redundant to the cap. These include appliance standards, fuel economy standards, renewable energy mandates and subsidies, and a host of other measures that would have shifted around where emissions reductions occurred and raised costs, but not necessarily decreased emissions below the cap.

So if there was lingering distrust of cap-and-trade, there’s probably even less confidence in a carbon tax to do the job. Very few NGOs supported a carbon tax over cap-and-trade, mostly because they viewed the cap-and-trade as more certain environmentally. Perhaps downward sloping demand is just not that convincing, and now, when we’re in the context of discussing a carbon tax instead of cap-and-trade, the unease over letting go of the ancillary policy apparatus is likely to be higher.

The political reality is that Democrats will likely have to give up something to get a carbon tax. It might include proposed or existing clean air act regulations that could become redundant with a carbon tax, spending on clean energy or green jobs initiatives, or transfers to what Republicans view as sketchy UN bureaucracies for climate finance in developing countries. (I would note that the politics of those ancillary policies aren’t just about concern about the environmental effectiveness of a carbon tax; there are important Democratic constituencies for these clean energy measures, such as renewable energy firms and labor unions.) But be that as it may, I think the way forward, if Democrats are serious about putting a price on carbon, is for leaders to put together a carbon tax proposal and to sell it in part by describing what they would be willing to give up to get it.

It might have to wait until we’ve tried everything else, and it hasn’t worked. We can pursue appliance standards and renewable subsidies and the like. Then when we’re not meeting our environmental goals, we’ll converge on the economic equivalent of concluding the earth revolves around the sun and put a price on carbon.

The U.S. Department of Energy’s official estimate of the “Social Cost of Carbon” (SCC) is $21/ton of CO2, which amounts t0 $0.21/gallon of gasoline.  That’s the weighting factor (set by DOE rule) used to decide how much importance to give to the future damage from global warming in a panoply of decisions both inside and outside government.  The SCC can be viewed as an estimate of the “true” cost of fossil fuels — the cost of doing nothing about global warming.  In economic theory it’s the “optimal” Pigouvian carbon price or tax — it would tell us how much effort to make to reduce our CO2 emissions to minimize economic harm from global warming.  But if the SCC estimate is too small, we won’t do enough to avert disaster; if it’s too large we’ll over-react.  Setting the SCC is a bit like deciding how much to spend on fire insurance– except that in this instance, we know that if we do nothing, there’s a “fire” coming, we just don’t have a good handle on how bad it will be or when it will get really bad.  According to “Revising the Social Cost of Carbon,” by economists Frank Ackerman and Elizabeth Stanton (E3 Network), the government’s SCC estimate is far too low because of three crucial assumptions:

1) Climate Sensitivity. How warm will Earth’s climate get if we double CO2 levels from the historic 270 ppm to 540 ppm?  The working consensus among climate scientists is that CS is about 3 degrees Celsius (5 degrees Fahrenheit).  But four years ago, the IPCC concluded that there’s at least a 5% chance that CS is 7 degrees C.  For a sense of that magnitude, the difference between our climate and that of the last ice age (when North America was covered by glaciers) was about 8 degrees C.  Recent data and weather events suggest that CS will need to be revised upward– scientists have  almost certainly overlooked some important feedback mechanisms that will make the Earth get hotter as CO2 levels rise.

2) Severity of Damage from global warming. How much harm will a given amount of warming cause and how soon? Ackerman and Stanton critique the DOE estimates which are based in part on work by economist William Nordhaus which assumes that half of world economic activity would continue even when Earth’s temperature had risen 19 degrees C.  In contrast, economist Martin Weitzman estimates that 6 degrees C would wipe out half of world economic activity.  Credible estimates suggest that a 12 degrees C rise would result in large parts of the world experiencing temperatures at least once a year too high for humans to survive, suggesting that Nordhaus’ (and DOE’s) estimate is far too low.

3) Discount Rate. Discounting reduces the importance of the future by making it seem farther off.  A high discount rate represents an assumption that future well-being is less important than a low discount rate which weighs the future more heavily in our present-day decisions.  If we assume that the future will be prosperous, maybe it’s not so bad to lose half of whatever we value in life to the ravages of global warming.  But if the future looks like a long stretch of hard times, losing half might really be painful, especially if we lose half of our food production.  DOE uses a discount rate of 3%; Ackerman and Stanton point to the Stern review which used 1.5%.  In some ways, the discount rate is a value judgment, somewhat like the question of how much to save for your child’s education when she’s only 2 years old.  But like the decision to start saving early, the discount rate affects results later very strongly, especially when the potential for larger future damages is also factored in.

Ackerman and Stanton argue that low damage assumptions and over-discounting mean that the official $21 figure is far too low.  Using a range of more realistic assumptions, they calculate SCC values ranging from $56 to $893.  But they point out that when the SCC — essentially the present value of the future damage if we do nothing about climate — becomes large enough, standard cost-benefit analysis stops making sense.   In that situation, any effective action we can take will cost less than the discounted present value of the damage.  Translated into pricing policy, that means that if a carbon tax is meant to internalize the social cost of carbon, it needs to aim high.  There may be little advantage in setting the carbon tax very high initially, but it needs to rise and be expected to rise briskly enough to induce as much reduction in CO2 emissions as fast as our economy can deliver.

In short, the message of “Revising the Social Cost of Carbon” sounds like parental advice:  Start modestly, don’t delay, and aim high.   Ironically, it’s Generation Hot who will need to deliver that message to its elders.