David R. Henderson  

Friday Night Video: McKitrick on Carbon Taxes

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If you have paid much attention to the debate about carbon taxes, you know that there is a "Pigou Club," of which Harvard economist Greg Mankiw is a founding member, and that these members advocate a tax on carbon. Here's my reading of their argument:
(1) Burning carbon-based fuels creates greenhouse gases.
(2) These greenhouse gases warm the planet past the amount that's optimal.
(3) A tax on carbon is (a) a tax on a negative externality and, therefore, (b) is a good idea.
(4) As a bonus, the government can make the tax on carbon revenue-neutral by reducing one or more of the many other taxes--on income, labor, capital, etc., thus reducing distortions elsewhere.

If one believes (1) and (2), it seemed that there was a case for 3(b) and 4. It seemed straightforward: tax a negative externality and you reduce distortions and then you can use the revenue to reduce other distortions.

Ross McKitrick's talk, along with an earlier Econlib article by Bob Murphy, has convinced me that that may be wrong. The tax interaction effect undercuts the conclusion and it could undercut it substantially. The bottom line is that the optimal carbon tax, assuming (1) and (2) are correct, is below the one that one would otherwise estimate as the optimal carbon tax, and could be well below.

Bob Murphy gives some highlights of the talk here.

The Pigou Club doesn't have just economists. It has politicians and pundits too. So I don't necessarily expect the latter to respond. But, as far as I know, good economists who are members of the Pigou Club--three who come to mind are Tyler Cowen, Greg Mankiw, and William Nordhaus--have not responded to this critique. Has anyone seen a response by any of these three?

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COMMENTS (22 to date)
Silas Barta writes:

After the discussion in Bob Murphy's blog comment section, I tried to give the intuition about why a green tax shift could be inefficient due to the tax interaction effects he describes in the Econlib article.

To give a summary of my blog post, it's all about how the harms of a tax are disproportionate to their rate. Each additional increase in a tax is more harmful than the previous -- hence the efficiency reasons to "lower the rate(s), broaden the base".

So if you have taxes on income (from labor and capital) at the same time as taxes on carbon, the latter will "stack" onto the former, causing a lot more harm than if they were imposed on top of 0% income taxes.

Also, since carbon-related income is a narrower "base" than income in general, shifting taxes onto it will increase the behavior-changing effects of taxation, and with it, the inefficiencies.

(Note: this doesn't guarantee that a green tax shfit will be welfare-worsening, but gives the intuition about why it could be.)

David R. Henderson writes:

Thanks, Silas. I think that’s right.

Peter H writes:

I didn't find his presentation very convincing. Partly because his claim about the social cost depended on a black box model. I am specifically referring to around the 6-7 minute mark when he says that the cost of reducing the marginal ton of carbon via a carbon tax is $25/ton but the social cost is only $5/ton.

Suffice to say that a black box model at a forum that is actively lobbying against a carbon tax gets no weight from me.

Also, two points he makes seem to contradict each other. At ~10 min he shows a formula where he says that the factor by which we have to reduce the tax is the relative elasticities of labour w/r/t taxes and emissions w/r/t taxes. But he says at around 15 min that the elasticity of emissions w/r/t taxes is very low, and earlier he also says that labour elasticity to taxes is also low. This means by his formula, you would get a tax around the marginal damages of the emissions, contrary to the conclusion he draws.

More fundamentally, I think he is wrong that elasticity of carbon emissions is low. It is low in the short term, but high over the medium to long term. The marginal cost of fuel plays a very big factor in the total cost of ownership for a lot of capital equipment and consumer durables. For example, between 1990 and today, US real GDP went from 6 trillion to almost 17 trillion. Carbon emissions went from 5 billion metric tons/yr to 5.8 billion metric tons/yr over the same period. That implies that demand for carbon emissions are extremely elastic with respect to total economic output, since output can more than double while barely requiring more emissions on a long time frame.



Pacemaker writes:

As an undergrad, I'm trying to understand this using the intuition from the Corlett Hague rule, so correct me if I'm wrong.

Carbon taxes have a smaller base, so the tax rate has to be higher than the reductions elsewhere to raise the amount of revenue.

Since carbon consumption is complementary to other factors of production, a tax on carbon will distort the use of these factors. Given the higher tax rate on carbon--and indirectly, the complementary factors--this new distortion has to be weighed against the loss in distortion from the comparatively small reductions in the existing tax rates on factors.

One implication is that the optimal carbon tax is lower than the "social cost" of carbon. Another is that we shouldn't be so easily convinced by the "double dividend" argument for carbon taxes. The least palatable point--to me, given my priors--is that the optimal carbon tax could be zero.

David Friedman writes:

Have any of them dealt with what I regard as the most serious weakness in their position--the lack of good reasons to believe that the externality is negative? Everyone assumes it is and there is lots of hand waving, some of it probably wrong (typhoons and droughts), some of it almost certainly right (sea level rise). But there are also lots of positive externalities, especially since temperature increase will be greater in cold times and places than in hot, for well understood reasons. The increase in habitable area due to expansion towards the poles should be a couple of orders of magnitude bigger than the decrease due to sea level rise.

We can expect significant negative externalities, significant positive externalities, and the size of both is quite uncertain, so why do people take it for granted that the net is negative?

Pajser writes:

Humanity have much to lose (extinction) and little to win (some wealth) with lot of carbon emission. That's why I care about negative externalities more. Some libertarians claim that pollution is aggression and not mere externality. It seems consistent to me, but in practice, libertarians accept more pollution than anyone else.

Handle writes:

David Friedman is correct.

And furthermore, even stipulating that they would be negative and significant, CO2 externalities are global, not local. It does no good to anyone in regards to reducing whatever social costs there may be if taxation merely causes CO2-intensive productive to be outsourced oversees. Such a policy would be worse than worthless - it wouldn't reduce CO2 production, but it would needlessly sacrifice certain modes of production.

Even worse, the shipping of CO2-intensive products back to a West which has forgone their production itself creates extra CO2 emission which would not have been produced but for the policy. Imposing CO2-tariffs at the border would undermine free trade, could invite a tit-for-tat trade conflict, and would present an accounting and compliance enforcement nightmare.

So, carbon taxes = less production and more pollution. Maybe the Pigou club needs some more economists.

Bob Murphy writes:

Thanks for the post, David. I too would love to hear Tyler or Greg Mankiw address this, because the tax interaction effect (the way it is estimated in the literature) is not a quirky little bit of trivia. It is a very big deal even if carbon tax receipts were used 100% to offset other income taxes. So if--as some of the conservative supporters of a carbon tax are willing to concede--in practice only a fraction of the revenue would be used in a "tax swap," then even in theory the thing might hurt conventional economic growth. So the rhetoric of some people "from the right" on carbon taxes really is misleading as it currently stands. I've seen some people (not Tyler or Mankiw) go so far as to say that even if you don't believe in the warnings about climate change, you should support a tax swap deal because income taxes are so distortionary. That is likely not true, at least according to the people who publish in this technical area.

For those who have studied economics at least at the college level, the best summary of this issue I can find online is this 2013 Goulder paper. (McKitrick's textbook discussion is the absolute best, but I don't think it's online.)

Yancey Ward writes:
So, carbon taxes = less production and more pollution. Maybe the Pigou club needs some more economists.

It probably needs better economists, but might actually be better off with fewer altogether.

Yancey Ward writes:

And I thought Silas explained it beautifully, though I thought he was a little too hard on Murphy.

Peter H writes:

David Friedman,

I question whether the increase in temperature will result in a corresponding increase in habitability. Almost all of the land we're discussing is in Canada and Russia, and both Canada and Russia have settlements and even cities going quite far north. Edmonton, AB for example is quite far north but is a major city. Anchorage, AK likewise, though it has some coastal effects that keep it warmer than it would be inland.

But the shortage isn't of habitable land, it's of arable land. I'm not familiar with Russian geography, but I am somewhat familiar with Canadian geography. And most of Canada is not arable at almost any temperature because of the Canadian shield and the rocky mountains. The land is not farmable because it's composed of giant rocks, not soil. Raising the temperature of Canada won't add much arable land there. You'll get a bit in northern AB/SK, but not nearly as much as you'd think.


Darin Johnson writes:

Taxes on fossil fuels (at least gasoline) are already pretty high. Even if I stipulate that the net externality is negative, are you should that increasing the tax is optimal? Maybe we're already using too little.

Michael W writes:

I'm with Peter H. Any black box model that doesn't have as a variable the value I (or anyone else) may assign to my enjoyment of the natural world as it is and to the intrinsic value of the environment is a purely academic exercise of little value in policy prescriptions.
I and many others (I suspect) are quite willing to part with some portion of our current and future wealth if, in fact, that were required (and I've yet to see proof that is the case) in order to minimize carbon emissions and to slow or reverse climate change.
The costs discussed seem very minimal in my mind, in any event.

Silas Barta writes:

@Michael_W && @Peter_H:

I think my explanation above made clear how the Tax Interaction Effect argument does indeed have a term for the social cost of CO2 emissions. It's just a matter of whether the net harm from CO2 is greater than the harm from the higher cumulative taxes that result from carbon taxes stacking onto those levied on labor and capital.

Again, it doesn't prove that it would be a net loss, but it shows how a tax shift from goods onto bads can indeed be welfare-worsening, even and especially if we accept the magnitude of the purported harms.

@David_R._Henderson && @Yancey_Ward:

I just wish I didn't have to translate the black box model into an understandable mechanism!

Jason Scheppers writes:

I may not fully understand the tax interaction effect, but may be your commentators could give me some feedback on my more simplistic reading.

First, despite my agreement with David Friedman that there is a significant chance that the externality is positive or neutral, let us place a $100 per ton price on the carbon emissions. To give an example of the effectiveness in reducing carbon let us take driving. A $100/ton would equate to a $0.05 charge per mile driven if each mile a car emits 0.005 ton per mile. If driving on average costs $0.35 per mile and has a price elasticity of 0.5 you would expect a reduction of 7% of driving and 93% of the emission remain.

Second, if the price is correct you have charged the full price to internalize the externality but there is no transaction to convey the compensation you have collected to future aggrieved parties. If CO2 causes damages to them they are still in trouble.

Third, there will be new carbon emissions in the things that the government purchase with the taxes or if returned to the taxpayers what they spend the money on. It is likely that over half of the emissions that were reduced will now be re-introduced by the expenditure of the Carbon Tax revenues.

I think that this is separate from the double dividend discussed in the video. I would think that the lack of a balanced transaction is a far greater problem than the taxing issues. I suggest that my argument is parallel to why ethanol programs are wholly inefficient.

Harold Cockerill writes:

Pajser writes "Humanity have much to lose (extinction) and little to win (some wealth) with lot of carbon emission."

I think the surer path to extinction is through the imposition of poverty. Terrible government policies in the 20s and 30s created the conditions in which huge numbers of people saw war as a viable alternative to the mess they were living in. Now growth has stalled in most of the advanced economies and millions live on hand outs from bankrupt governments. I see few governments pushing policies that will lead us out of this mess.

Given current technology a world war would be vastly more destructive than WWII. We've created a mess and piling on more cost for business through taxes and regulation is not the way to escape it. Too many people see creating wealth as evil but it's the only way to escape poverty. CO2 isn't the big evil, poverty is.

Tom West writes:

We can expect significant negative externalities, significant positive externalities, and the size of both is quite uncertain, so why do people take it for granted that the net is negative?

The net is not all that important, if the distribution significantly changes.

Let's be realistic. The USA & Canada will survive and maybe benefit from global warming. However, poor nations may suffer tremendous destruction from the loss of densely populated arable land.

If North America was to agree to allow a few hundred million displaced citizens to immigrate, then we could discuss 'net' externalities. Until then, can we admit it's mostly "it's not going to hurt me, so why should I pay?"

And realistically, that's why nothing major is going to get done on global warming.

(Unless of course, the third world agreed to nuke all the Western nations if global warming turned out to be as calamitous as feared - it would be darkly humorous to see how quickly the risk of global warming would suddenly be taken *very* seriously when it's *our* lives on the line.)

Pajser writes:

But, if there is a mess in the most developed countries, it cannot be due to poverty — these are the wealthiest countries that existed.

Indur Goklany writes:

There are lots of positive externalities from burning fossil fuels; only economists (and others) haven’t bothered to look. And if thou don’t seek, don’t be surprised if thou don’t find. Consider, for example, that burning fossil fuels:

1. Increases agricultural (and timber) productivity which means less habitat loss, which is generally acknowledged to be the greatest threat to species and ecosystems.

2. Equalizes disparities between genders.

3. Via a variety of avenues, has helped increase human capital (via efficient lighting, freeing up time through the use of household appliances, etc., which have increased the amount of time available to each human to use as they choose).

4. Help reduce hunger and poverty.

For an explanation of how fossil fuels contribute to these – and other – positive externalities, see Humanity Unbound: How Fossil Fuels Saved Humanity from Nature and Nature from Humanity, Policy Analysis, No. 715, Cato Institute, Washington, DC (2012).

Andrew_FL writes:

@Tom West-

Let's be realistic. The USA & Canada will survive and maybe benefit from global warming. However, poor nations may suffer tremendous destruction from the loss of densely populated arable land.

Oft claimed, seldom justified. May is a wonderful word, it allows one to cite possibilities and ignore how unlikely they are.

Here's the thing: really large warming pretty much requires there be a lot of emitting going on by currently "poor" countries. In fact future warming is mostly going to be due to those poorer countries themselves-our contribution is relatively negligible. Of course, you need to dig into the emissions scenarios to find this out. If being wealthy allows us in the US to escape any negative consequences of warming, then presumably the fact that those poor countries aren't going to be poor forever (and it's that very fact that leads to lots of future warming!) allows them to negate those negative effects, too, and reap the benefits.

ThomasH writes:

Surely the corporate income tax or payroll taxes should be the target for a carbon tax rebate as they have higher distortions than the personal income tax.

Nick writes:

@Indur Goklany

(3) and (4) aren't positive externalities, they're just benefits. I don't know what (2) means so I don't know if it's an externality.

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