David R. Henderson  

The Pigou Club Reconsidered

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Last Friday, I highlighted Ross McKitrick's exposition of the argument that taking account of the "tax interaction effect" (TIE) leads to the conclusion that the optimal Pigovian tax on carbon is less, and possibly substantially less, than the one that you would estimate without taking this interaction effect into account.

I also wrote:

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?

In exploring further, I did find some pieces by Greg Mankiw that give a further case for the tax. His latest is "Smart Taxes: An Open Invitation to Join the Pigou Club," Eastern Economic Journal (2009), 35, 14-23. In that article, he doesn't address the TIE.

Mankiw also claims that "a majority" of economists favor higher taxes on fossil fuels. He's probably right: He gives some evidence for this from a 2006 article by Robert Whaples, "Do Economists Agree on Anything? Yes!," The Economists' Voice, 3(9). But he goes too far in interpreting other evidence on economists' views. He quotes a Wall Street Journal article by Phil Izzo in which Izzo reports on a survey of economists. The survey found 54 percent of economists polled saying that the most economically sound way to encourage development of alternatives to fossil fuels is" to impose higher taxes on fossil fuels.

This latter does not mean that 54 percent of those economists favor imposing higher taxes. I trust the reader to figure out why. One hint: If you asked me to give the best way to encourage development of alternative fuels, I would probably answer "higher taxes on fossil fuels." But I don't believe in higher taxes on fossil fuels.

Is there somewhere else where Greg Mankiw considers possible objections to a Pigovian tax on carbon? Yes, there is. It's here. He gives four possible reasons for people to object. The closest he comes to considering the TIE is his reason #3. Mankiw writes:

3. You recognize the externalities, think the government should try to correct them, but think the current low taxes we put on gasoline are sufficient. In this case, you have weighed and rejected the evidence, such as that of Parry and Small, that higher Pigovian would be optimal. (Parry and Small calculate an optimal tax of $1.01 for the United States in today's dollars. After my proposed phase-in of a $1 hike, the U.S. tax would be $1.40. Assuming 10 years of 3 percent inflation, the tax in real terms would approach almost exactly what Parry and Small recommend. By the way, the published version of Parry and Small was in the American Economic Review, September 2005.)

Parry and Small do reference the literature on the TIE. So one could say that Greg Mankiw has answered the McKitrick point indirectly, by referencing Parry and Small.

Comments and Sharing

COMMENTS (20 to date)
Pajser writes:

"One hint: If you asked me to give the best way to encourage development of alternative fuels, I would probably answer "higher taxes on fossil fuels." But I don't believe in higher taxes on fossil fuels. "

Hm ... let me guess... you're Xerxes? No, no, wait a minute ... wrong word is encouragement. You don't believe in encouragement.

Ziad K Abdelnour writes:

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Andrew_FL writes:

Pardon me, but 54% is not terribly impressive. If nearly half of economists disagree, then if you care about "consensus," you haven't got it.

(I'm not saying they are right to disagree. As you point out, one can agree it is the best method and disagree that the goal should be pursued by the state in the first place.)

When the physical science is put forward, they allege near unanimous agreement, though. And this is put forward by advocates as a reason why one should believe that there is a climate problem. So by that very same logic, one should believe the economists' proposition if there were near unanimous agreement...but there isn't.

At any rate, the thing I think the "Pigou Club" just fails to comprehend is that designer policies of an economist's optimal dream are not in the cards. Of the actual options, that could actually happen in the real world, we have: essentially don't do anything, or doing something draconian and more harmful than good. Whether it is better in computer model land to do a perfect policy than nothing is irrelevant, the only question that matters is whether it is better to do a real policy or nothing. The answer so far is no.

Bob Murphy writes:

Thanks for your continued attention to this topic, David. I was pretty astounded when I delved into this literature and saw that "the standard case" for a carbon tax was much weaker than I had been led to believe. In particular, I actually learned of the "tax interaction effect" from an MIT paper arguing that a carbon tax swap would lead to greater conventional economic growth, and the MIT paper cited the pioneering Bovenberg and Goulder paper even though their paper said the exact opposite (sic!).

I don't expect Mankiw et al. to change their positions, but I really believe that his summary of the issues for the public is misleading.

Brian writes:

If my microeconomic intuition -- that taxing harmful externalities will enhance net welfare, and to a greater degree than some regulatory regime -- turns out to be wrong, then I wonder what else I might be wrong about? After considering tax interaction effects, should we not be so hard on speeders? Maybe even encourage them? And what about theft, of various sorts? Keeping Coase (rather than Pigou) in mind, I sometimes think about uncompensated environmental externalities as a form of theft. I wonder if theft, generally, might turn out to be beneficial in some CGE model beyond my ability to comprehend.

I'm no expert on CGE models, but I am not confident that it is possible to build a realistic model that credibly keeps track of welfare changes, including environmental externalities.

One specific problem in the CGE models here is the revenue neutrality condition. I understand why it is there: it avoids the political problem of trying to reach a consensus on the size of government, and avoids the economic problem of trying to put a value on whatever the government is doing. But it also can work mischief, and it leaves us unsure, when we see a welfare change, whether to attribute it to the carbon tax, the income tax, or the neutrality constraint.

So my sympathies lie with the Pigovians, but I'm skeptical of BOTH the claims for a double dividend AND the arguments for a TIE.

(To be clear, I don't support a carbon tax, because that requires accepting what I regard as some rather bogus climate science and even more bogus political science -- but this post is about the economics, not those other things.)

Andrew_FL writes:


taxing harmful externalities will enhance net welfare, and to a greater degree than some regulatory regime

This could only true assuming that the taxation is done at an appropriate level, and not above that level. If the tax is well above some "optimal" level, it's actually worse than nothing.

And that's my main problem with it. The State is not going to set an optimal rate, it's going to set the rate it wants, and raise the rate whenever they need more money. Replacing other taxes with the carbon tax only makes it more certain that the policy purpose of the tax will come to be to collect revenue, not to control an externality. Making it the funding source for a welfare program even moreso.

I suppose this is what you mean by bogus political science, though?

Silas Barta writes:

It's also interesting that a green tax shift[1] goes against Mankiw's very own tax policy advice to "lower the rates, broaden the base", since carbon-touching activities are a narrower base than income in general -- although, for reasons given by Bob_Murphy, that may be a point in its favor!

[1] revenue-neutral shift of taxes off of labor and capital and onto CO2 emission

Bob Murphy writes:


I totally understand why you are skeptical, but you're misunderstanding the precise claim that McKitrick et al. are making. Try this blog post to see what I mean.

Walter E. Williams writes:

I'm wondering why there should be an artificial search (taxed motivated) for fossil fuel substitutes in the first place. Don't make up something like to prevent global warming and/or pollution because nature has done more of that than the activities of mankind ever has or ever will.

MikeP writes:

A simple test for the Pigou Club:

If you think that taxing fossil fuel consumption and rebating the same tax on labor and capital is a win-win, then you must also think that taxing water consumption and rebating the same tax on labor and capital is at least a win, and hence good policy.

Feel free to replace "water" with any and all resources that societies used to tax before they realized how phenomenally inefficient it is to tax economic inputs that are used to add value to labor and capital.

Apart from whether a CO2 tax is economically efficient in the long run due to pricing environmental damage, the argument that carbon taxes in lieu of labor and capital taxes are good for the economy is utterly bogus. People don't generate CO2 for the hell of it. They generate CO2 as a by-product of useful production and consumption. If you tax CO2, you tax people's ability to produce and consume.

Brian writes:

ALERT: For all those who are interested, OMB today opened a comment period on the Social Cost of Carbon.

For more information visit GW's Regulatory Studies Center.

Blogging is good, but it is also good to get your thoughts on the official record (for future rulemaking, litgation, etc.)

Brian writes:

@Bob Murphy

I appreciate the detailed explanation on your blog, but I don't find it persuasive. My first objection is just rhetorical; I don't like the phrase: "harm to the economy." In the context of discussing welfare changes, I can tolerate phrases like "net social welfare," understood in the Kaldor-Hicks sense of compensating variations. But too often -- especially when discussing macroeconomic models -- people think of "harm to the economy" as a GDP change or something similar, and proceed to confuse measures of economic activity with measures of human welfare. But I know you are not guilty of that; I'm just being picky about language.

I think your argument starts to get wobbly when you assume that the carbon tax revenues are redistributed in a lump-sum rebate. It's not that I find this politically implausible (I know you agree that it is); but, even as a hypothetical, it leads us off track. Any method of distributing those revenues will have incentive effects. Will they exactly offset the income effect of the carbon tax? That is unknowable, but it seems unlikely. There are three types of income-compensated demand curves: (1) the original Hicks definition (welfare neutral), which we cannot determine; (2) the more commonly used Laspeyres-indexed compensation; and (3) the less generous Paasche-indexed compensation. Only the third type involves revenue-neutral compensation, and it would be surprising if it also corresponded to the welfare-neutral type 1.

More broadly, I don't doubt that there are tax interaction effects of various sorts, but my intuition about their relative magnitude and direction, and especially their probative value, is not the same as yours.

Consider a different hypthetical. Suppose that the domestic social cost of carbon is zero -- the U.S. is simply not vulnerable to the effects of climate change. But suppose there is a substantial international externality; and, pursuant to a treaty, some competent international body has found that the U.S. must pay compensation. Knowing that carbon emissions cannot be eliminated, and recognizing the virtues of economic efficiency, this body imposes a tax equal to the external SCC, with the revenues paid to the overseas victims. The U.S. might appeal: "That's too high; we have an income tax and, in view of the tax interactions, a lower carbon tax would be optimal." The response would likely be: "From our perspective, the U.S. economy, including its political system, is a black box. We are agnostic about the production function inside of it. We only know that you are producing harmful carbon, which we are willing to tolerate at the price that we named. We need not know more. This is how all trade works, n'est ce pas?" (The Pigovians shout: "Yes! We are all Coasians now!")

This would leave the U.S. government to solve the internal problem of how to come up with the revenues to pay the international SCC tax. One obvious option is to pass the tax through to the entities that actually emit the carbon, such as coal-burning utilities. Another option would be to raise the income tax on everyone. I can imagine the owners of coal deposits and complementary capital making the argument: "No, it would be inefficient to tax us. The income tax has a much broader tax base; it will be more efficient to tax income."

"But wait," say the environmentalists, "that would hardly reduce emissions at all!"
"So what?" say the coal interests. "The U.S. is indifferent to the level of emissions."
"Not if they are taxed! The level of emissions determines the level of the tax burden."
"Point taken," say the black hats. "That argues for taxing carbon, but we think the argument for taxing income is stronger."

In this scenario, I favor a straight pass-through tax on carbon. It might be the case that, because of ubiquitous tax interaction effects, this is not exactly the optimal tax. But that is true of all prices in the economy -- we can think of reasons why the price of anything might be somehow distorted. But simplicity is a virtue in the tax system; I say let the carbon emitters pay the carbon tax. Otherwise, tomorrow they will be arguing that U.S. taxpayers should pay for the labor and other inputs that they employ. After all, there's that broad tax base to be tapped . . .

With the exogenous tax (or, alternatively, with a requirement that carbon emissions be offset with allowances bought overseas), it seems pretty clear that carbon emitters ought to pay their own way, and not ask for subsidies from general taxpayers. The scenario where the U.S. gets to keep the revenues is, admittedly, different. But I am skeptical of arguments for either raising OR lowering the level of the Pigovian tax, when those arguments draw on CGE or macroeconomic models. Not that those arguments have no validity, but they are inevitably incomplete and typically biased. There are any number of distortions that one might be called on to correct (the Renminbi is too low, the Euro is too high, the labor force is not in equilibrium -- we're creating jobs!, etc., ad nauseam). The safest course, I think, is to evaluate the case for a Pigovian tax on its microeconomic merits, and to avoid venturing further into planning space.

Pajser writes:

If Hollywood corrupts people, and I cannot hire serious, honest workers because of that, it is externality. But, if coal plant burns my crop, it is an aggression. Is it negative externality also? Maybe, I don't care. Surprisingly, libertarians who emphasize non-aggression principle are usually on the side of polluters.

ThomasH writes:

Considering the uncertainty about what the optimal carbon tax would be and the fact that it is not a live political issue, it does not seem odd that most of the discussion even when for for instance numbers are used to not include the tax interaction which only ocurrs in one of the cases laid out anyway.

Pajser writes:

Brian, well explained. Pure libertarian solution would be "No pollution guys. Economy will suffer but non-aggression is more important than wealth." We have two corruptions of libertarian principles.

  1. OK, polluters, you can pollute; it is aggression, but state will tax you and compensate your victims. They will lose their freedom, but not the justice. The reason we give up from freedom is - more wealth.
  2. OK, polluters, we'll not tax you as much as you deserved, we'll tax your victims a bit. The reason we give up from justice is - more wealth.

jure writes:

there is problem not only with tax effects, but with assumption nr.1 and nr.2, namely that co2 is the problem.

Shouldn't we then tax every additional baby born in this world, since humans use oxygen and exhalate co2? And why anyone even assumes that human impact on nature is a priori bad for human??
And effects of co2 tax are gonna decrease the profitability of research for new energy sources, because oil is for now food of food, fuel for new fuel etc.

Andrew_FL writes:

@jure-The CO2 people exhale has no significant impact on the atmospheric concentration.

ThomasH writes:

@ Mike
As a matter of fact if water producers, say those that withdraw from an aquafer, do not take into account the value to other person who wish to withdraw water from the same aquafer, then it could make sense to tax each producer for her withdrawal and rebate the proceeds to the owners of the aquafer.

MikeP writes:


It would make even more sense to have the owners of the aquifer charge those who withdraw water from it exactly for the water they withdraw.

Novel, huh. Don't invent commons or externalities when you don't need to.

Adam writes:

The keystone analysis of the TIE and environmental instrument choice is Parry et al, JPubEcon, 1999. The cost effectiveness for an externality tax, a performance standard or a technology standard as the required level of externality reduction increases. Here's a link to the unlocked working paper: http://www.rff.org/documents/rff-dp-98-22.pdf

Hanemann analyzed the SO2 trading program to reveal some very interesting facts. First, the program led to very little inter-firm trading. Second, performance standards led regional power companies to reallocate power production across generating stations using different fuels and different technologies in order to minimize their intra-firm cost of achieving the standard. See: http://oxrep.oxfordjournals.org/content/26/2/225.short.

Finally, I'd echo the skeptical message of other commenters. The products of legislation and regulation are far removed from the almost ideal cases of economics. Take the obamacare marketplace as a case in point. As Adam Smith Stengel might say, it's the 'man of system' all over again.

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