David R. Henderson  

Robert Murphy: A New Result on Carbon Taxes

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Just about every public discussion of carbon tax swaps implicitly assumes that the distortions emanating from the tax code must decrease if the government begins taxing a negative externality (carbon emissions) and uses the revenue to reduce tax rates on productive activity. However, the analysis of the tax interaction effect shows that this assumption may be wrong.
This is from the just-released Econlib Feature Article for October, "Carbon Taxes and the Tax Interaction Effect."

In the piece, Robert Murphy lays out the results of work by A. Lans Bovenberg and Lawrence H. Goulder. Bovenberg is an economist in the Netherlands who was awarded the Spinoza Prize in 2003. Goulder is Shuzo Nishihara Professor of Environmental and Resource Economics in the Economics Department of Stanford University. Although their work appeared in the most-prestigious economics journal in the world, the American Economic Review, in 1996, it has received little attention.

Until now. Murphy does an excellent job of walking the reader through the steps in the argument. The bottom line is that even if global warming is a problem and even if the optimal tax on carbon in a simple framework is $50 per ton of carbon, that result does not hold up in the real world in which we have other distorting taxes. Taking account of how the carbon tax can interact with other distorting taxes, Murphy points out that the optimal tax will be lower than $50 per ton and could be as low as zero.


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COMMENTS (6 to date)
MikeP writes:

Isn't the case that carbon taxes are not efficiently exchangeable for more traditional taxes easier to make than this?

As I noted in a comment and the ensuing thread a few years ago:

I am glad we can agree that carbon taxes are far preferable to income, capital gains, or sales taxes.

This is not at all obvious. If you tax carbon while lowering taxes on labor or capital, you raise the price of carbon relative to labor and capital. Given that so very many uses of carbon fuels free up labor and capital to do higher valued work, it isn't clear that taxing carbon doesn't produce a greater deadweight burden on the economy.

There is a reason that modern economies move away from resource taxes and toward, if you will, "human" taxes. The latter cost the economy less.

Just to take another example, would you say that reducing income and capital taxes by half and obtaining that revenue by applying the equivalent total tax on water would make the economy no worse off?

MikeP writes:

Here's where the key error is in the quoted "summary of the conservative case for a carbon tax swap":

Conservatives do not have to agree that humans are causing climate change to recognize a sensible energy solution. All we need to assume is that burning less fossil fuels would be a good thing....

That is a poor assumption. People don't burn fossil fuels for kicks. People burn fossil fuels because it is allows them leverage to use human labor and capital for more valuable purposes.

Tax the carbon instead of taxing the labor or capital, and you are taxing the very inputs that enable the labor and capital to provide their value add.

Aussie writes:

Placing a tax on "carbon" is totally ridiculous. It impacts our lives more than is imaginable.

The worst of the impact is upon our utilities, especially electricity.

What seems to be missing in any analysis is that the supply and demand for utilities such as electricity is inelastic. It is very difficult to shift either the supply or the demand curve.

The other thing that is missing in analysis is the fact that utilities fall within the "oligopoly" competition. There is some competition but few suppliers and that means that the suppliers determine the price.

On top of that wind farms and solar panels are no substitute for other forms of electricity, gas etc.

None of these things gets taken into account when people start spouting on all of this green hocus pocus.

The fact is that taxing carbon is a very bad idea... and here in Australia where a deceitful government has been successful in introducing this behometh there is going to be a political earthquake. We are still waiting for the trickle down effects. The trickle is starting with our electricity bills, and it can only get worse as prices begin to rise out of necessity to offset the increase in utilities.

Electricity, gas and fuels are a necessary input in the means of production. Increase any of these inputs and the end product gets more expensive. Prices can be reduced if the cost of labour is somehow decreased - usually by redundancy. The only other way to offset the increase in a cost of production is to increase the price.

In other words, the price on carbon as a tax can really only lead to higher inflation.

Considering that in Europe the price of carbon has crashed to be something that is meaningless, then any tax that is something like $50 per tonne is outrageously high and can only be economically damaging.

The impact of introducing such a tax will be that more businesses will move offshore and there will be a decrease in investment. This is especially true in the mining industry, which here in Australia has been hit by a mining resources tax at the Federal level (is probably unconstitutional) as well as an iniquitous carbon tax.

Bob Murphy writes:

Aussie wrote:

What seems to be missing in any analysis is that the supply and demand for utilities such as electricity is inelastic. It is very difficult to shift either the supply or the demand curve.
...
On top of that wind farms and solar panels are no substitute for other forms of electricity, gas etc. None of these things gets taken into account when people start spouting on all of this green hocus pocus.

Aussie, I am a foe of carbon taxes too, but the standard models (from people like William Nordhaus and others) do try to take these things into account. They show substantial gross harms to the economy from a carbon tax, and just think that there is scope for a properly calibrated carbon tax to provide such environmental benefits (in the form of reduced future climate change damages) that it more than compensates for these gross harms (higher electricity prices, etc.).

Now you can argue, of course, that their models don't sufficiently account for all of these things, but I think it's a bit strong to suggest that the professional economists pushing for a carbon tax haven't considered that it will raise energy prices, etc.

Ryan V writes:

I don't get this. Taxes on externalities are only called "taxes" because they're collected by the government. But they're just prices that would exist if we had complete markets.

Consider the case of roads in two alternate universes. In the first universe, roads are all privately constructed and owned. According to some scheme the free market comes up with, tolls are charged for using those roads. For simplicitly, let's just say it's a simple price per distance travelled. Everything else is the same in the second universe, except that roads are all government constructed and owned. What's the efficient tax for the government to charge for using those roads? I think the answer is the same as whatever the free market price is in the first universe.

But the tax-interaction argument applies just as strongly here as it does to the case of a carbon tax. Why don't higher marginal tax rates on the road-using sector increase the dead weight loss?

The answer is that the deadweight loss is correctly calculated not using the supply curve derived from the private cost, but using the supply curve derived from the total public cost--which includes the externality. Once you do that, it's obvious that setting the tax at the complete-and-free-markets price is efficient, regardless of other distortionary taxes.

Am I missing something?

MikeP writes:

Ryan V,

What you're missing is that a great many people do not believe that the sole reason for carbon taxes is that they accurately incorporate externalities into the economy.

Rather, there is an implicit intuitive presumption among most that trading other taxes for carbon taxes dollar-for-dollar is a win-win. That sense is captured by Robert Murphy's quoting "tax bads, not goods." This argument is not valid, and that is what the original post is about.

It's much the same as arguing for more government spending on infrastructure in order to provide jobs. There may be a valid argument for government infrastructure spending. But the fact that it provides jobs is not a valid argument, as intuitively good as it sounds.

The argument for carbon taxes is a hard one to make. In particular, the last results I recall from Nordhaus showed that while the optimal tax was the social cost of carbon, the second best tax was not to tax carbon at all. That is, every proposed regime to tax carbon, from Kyoto to Stern, does more harm than good to the economy compared to doing nothing.

You don't get to short circuit that argument with the slogan "tax bads, not goods."

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