David R. Henderson  

Carbon Taxes: The Tax Interaction Effect

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UPDATE: I made an important mistake. Robert Murphy corrected me in an e-mail. Correction below.

Robert P. Murphy, one of the economists who writes frequently for Econlib, has published a number of pieces on the "tax interaction effect." He has recently published another that is well worth reading. Before getting to his article, here's some background.

Many economists, when they hear about a tax on carbon to address the issue of global warming, tend to have a knee-jerk reaction in favor. This reaction is based on two things: (1) their belief that global warming is a problem, and (2) their economics training, which tells them that a Pigovian tax on a negative externality is a better solution than regulation because, if the tax is set correctly to reflect the costs of that externality, various carbon users will adjust optimally and use the efficient amount of carbon.

In a world starting with zero taxes on anything, a tax on carbon would be optimal, assuming, I remind you, that global warming is a problem.

But the academic literature on carbon taxes has moved well beyond that simple world. In the world in which we live, where there are many taxes, the case for carbon taxes is no longer so clear. And the reason? It's that there is an interaction between carbon taxes and other taxes. The leading academic economists in this literature are A. Lans Bovenberg and Lawrence H. Goulder. As I've written earlier, 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.

The person who has done the most to publicize and explain that result is economist Robert P. Murphy. He wrote about it for Econlib in "Carbon Taxes and the 'Tax Interaction Effect,'" Econlib, October 1, 2012. He has also written about it in "More Destructive Than You Think: Clarifying the 'Tax Interaction Effect'" and, extensively, in "Carbon 'Tax Swap' Deals: A Review and Critique."

About a year ago, I tried, unsuccessfully, to get good economists who favor a carbon tax to address this issue. As far as I can tell, they have not. This next statement is strong, but, as far as I can tell--and I could be wrong--the majority of economists who have embraced the carbon tax do so as a matter of faith and have simply not considered--and may not even be aware of--the Bovenberg/Goulder/Murphy critique.

But that hasn't deterred Bob Murphy. In a recent post, "Conservatives Need to Get Real About Carbon Tax's Alleged 'Double Dividend,'" Murphy highlights a recent Goulder article that digs further into the tax interaction effect. The article is "Climate Change Policy's Interaction with the Tax System," and is published in Energy Economics. Murphy quotes the following from Goulder:

Although the initial theoretical analyses tended to reject the double dividend, a second wave of models offered more scope for the double dividend by acknowledging additional potential channels for beneficial efficiency impacts from green taxes. One such channel is an improvement in the relative taxation of capital and labor. If, prior to introducing the environmental tax, capital is highly overtaxed (in efficiency terms) relative to labor, and if the revenue-neutral green tax reform shifts the burden of the overall tax system from capital to labor (a phenomenon that can be enhanced by using the green tax revenues exclusively to reduce capital income taxes), then the reform can improve (in efficiency terms) the relative taxation of these factors. If this beneficial impact is strong enough, it can overcome the inherent efficiency handicap that (narrow) environmental taxes have relative to income taxes as a source of revenue. Similarly, if the initial tax system is highly distorted in terms of consumer goods, and the green tax reform improves the system in that dimension, then the double dividend can occur after all.
...

The presence or absence of the double dividend thus depends on the nature of the prior tax system and on how environmental tax revenues are recycled. Empirical conditions are important. This does not mean that the double dividend is as likely to occur as not, however. The narrow base of green taxes constitutes an inherent efficiency handicap...Although results vary, the bulk of existing research tends to indicate that even when revenues are recycled in ways conducive to a double dividend, the beneficial efficiency impact is not large enough to overcome the inherent handicap, and the double dividend does not arise.


Did you notice that? The best shot we have at having the carbon tax not move us further from the optimum is to have it replace taxes on capital. Do you see that happening in the current political environment? Moreover, as Goulder points out above, even if the carbon tax did replace taxes on capital, it would still not clearly improve efficiency.

UPDATE: Robert Murphy, who has clearly mastered the literature more than I have, writes me to correct a mistake I made above. Here's his correction, as edited by me:

Strictly speaking, Goulder, in that quotation, is simply discussing whether there is a double dividend. So, if there's not, there still could be a case for a carbon tax; it just would optimally be set at lower than the social cost of carbon (i.e. the textbook Pigovian case).

The way your post reads right now, it looks as if you're saying, "If a revenue neutral carbon tax were implemented and didn't phase out capital taxes, it would move us away from efficiency." [DRH note to Bob. You can delete the "might." I was saying exactly that, due to my too-quick reading early in Pacific Standard Time. So you're right to correct me.]

But even though it would make the tax code more distortionary vis-a-vis conventional economic growth, it would also reduce climate change damages (if the models in which global warming is a problem are right, etc.), and so, on balance, might be better than the status quo.

Here's a specific hypothetical numerical example. Suppose the Pigovian externality from a ton of CO2 is $30. The government levies a carbon tax of $30/ton. Because of the tax interaction effect, this is not the optimal policy; the optimal rate should really be only $20/ton.

But implementing a $30/ton tax is better than a $0/ton tax, because the incremental deadweight loss from the tax code is lower than the marginal reduction in climate change damages.


Comments and Sharing






COMMENTS (18 to date)
MikeP writes:

Recapitulating the simple test for the Pigou Club I presented on the last post...

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 resource that societies used to tax before they realized how phenomenally inefficient it is to tax narrow economic inputs that are used to add value to labor and capital.

Jason Scheppers writes:

I am just an engineer who thinks he knows something about economics so forgive my statements that seem to have little effect on economists.

The problem is not only if you have "the price right", but to whom the payment is made. If payments are made to current others, the tax recipients spend the tax receipts on only slightly less carbon intensive purchases than those deferred by the taxees. Those receipts distort the market they enter because they are unearned.

The payment, if there is a problem, should be made to the "we" in the future who suffers from the climate change. "We" are all to short sighted to make that happen.

For proof I cite the natural experiment of Canadian British Columbia, where they have instituted a revenue negative (more refunds than taxes). While they find a decrease in the carbon emission on items they tax, the total carbon emissions for the province have only been reduced by the same amount as Canada's non carbon taxing provinces. A price is not a price if it is handed back under the table.

BC Carbon Tax Progress Report
http://www.sustainableprosperity.ca/dl1026&display

Canada Province GHG emissions.
https://www.ec.gc.ca/indicateurs-indicators/default.asp?lang=en&n=BFB1B398-1

Bob Murphy writes:

Thanks for the post David. This issue of the tax interaction effect is "no big whup" for people who think human-caused climate change is one of the most pressing issues humanity faces, since (in their view) the status quo is so awful.

However, there are many conservatives and libertarians who are agnostic on the climate impact of CO2 emissions, but believe that a revenue-neutral carbon tax swap deal surely makes sense just on narrow economic grounds. *That's* totally wrong, as I hope David's post here underscores.

Hazel Meade writes:

The rationale for the carbon tax on the basis of negative externalities seems to presuppose that the tax would actually be directed towards mitigating the effect of the externality. Of course, nobody has actually proposed that. The asusmption is that carbon tax revenue would go into the general treasury. As a result there is no reason to think that a carbon tax would either be proportional to the actual costs of global warming, OR that the revenue raised would be used to compensate it's victims.

This is my main problem with it. Not that it will interact with other taxes, but that it will just become a political excuse to arbitrarily raise revenues, and spend it on whatever pet projects the government wants money for.

If the carbon tax revenue went into some sort of escrow account to be exclusively used to mitigate the costs of climate change, and it's level was set to the rate needed to match outlays, then it would be much more palatable. Obviously there would still be the problem of administering the fund so that it ONLY spends money on costs that can be scientifically pinned on carbon-induced climate change. But in the ideal that would be the correct way to do things.

David R. Henderson writes:

@Hazel Meade,
Those are all good criticisms. But your last sentence causes me to think that you would do well to read Murphy’s piece.

Ed Hanson writes:

David;

I may be the last old fogey in my thinking, but I can postulate a third alternative to the part of the (in bold) quote from your post:

"In a world starting with zero taxes on anything, a tax on carbon would be optimal, assuming, I remind you, that global warming is a problem."

There is another possibility. That global warming is a problem, but it's cause is not anthropomorphic, but due to external factors, for examples, change within the sun or earth solar interaction. I submit in that case, reducing energy production efficiency would work against mitigation of the problem.

It is not just the analysis whether a problem exists, but if it exists the misreading thevcause of the problem could lead to greater detrimental effects.

Ed

David R. Henderson writes:

@Ed Hanson,
True.

ColoComment writes:

No, Ed. You're not the "last old fogey" in your thinking.

In addition to considering that any proposed carbon tax (however implemented) may be a solution in search of a problem caused, primarily or in substantial part, by other factors, where is the analysis of benefit v. detriment if, in fact, global warming is happening?

Does no one consider that on a planetary basis it might cause "better" results than "bad" results [for the environment, humankind, survival of maximum number of flora and fauna, etc.], all else equal?

The conclusion that global warming would be a "bad" thing, is assumed, it seems by everyone.

Thomas Sewell writes:

Not to pile on too much on top of the other points already made, but shouldn't any accurate analysis of the optimal Pigovian tax rate also be weighted based on your estimate of the probabilities for each interaction?

We're primarily dealing with unknowns here, right? It seems a bit of a fallacy to treat everything in the cost/benefit calculation as if it's 100% known what the impacts will be.

My personal analysis (alright, SWAG, not calculation) is that a carbon tax would be a net negative, but if someone believes otherwise and is publishing that opinion in a more formal setting than a blog comment, I don't think it would be too much to ask to get their estimate of the various probabilities broken out.

David R. Henderson writes:

@ColoComment,
The conclusion that global warming would be a "bad" thing, is assumed, it seems by everyone.
Not true. I don’t assume it. I know of many others who don’t either.
@Thomas Sewell,
but shouldn't any accurate analysis of the optimal Pigovian tax rate also be weighted based on your estimate of the probabilities for each interaction?
Yes. I think you, and many others, are missing Murphy’s point. It is that even if global warming is a problem, even if it’s caused by humans, and even if it’s certain in the absence of a carbon tax, the computed carbon tax is less than the traditional literature has said.

ColoComment writes:

Thank you for that response. My concern is somewhat relieved to hear that there are many others who do not make this possibly unwarranted assumption: would you do me the great favor of pointing me in the direction of a few so that I could begin to read their work?

Edogg writes:

This 2013 CBO report discusses the tax interaction effect and some other issues brought up in the comments.

Effects of a Carbon Tax on the Economy and the Environment

This paper (Parry and Williams, 2011) argues that, for income taxes, the tax recycling benefit could exceed the tax interaction cost due to inefficiencies such as the preferences for housing and employer-provided health care.

http://www.rff.org/RFF/Documents/RFF-DP-11-02.pdf

David R. Henderson writes:

@ColoComment,
Here’s one that I commissioned for my Encyclopedia.
http://www.econlib.org/library/Enc/GlobalWarmingABalanceSheet.html

David R. Henderson writes:

@Edogg,
Thanks. I’ll take a look.

David R. Henderson writes:

@Edogg,
I just read the relevant sections of the CBO Report you cite above. The relevant part is on pp. 10-12. Their conclusions agree with what I wrote above. Will check the RFF study later.

Edogg writes:

Some points about the links I posted:

-I think it's a little heartening that a CBO report covers the points it does. It mentions the tax interaction effect, that there could be positive and negative effects of global warming, the potential for other countries to increase carbon dioxide emissions in response to a US carbon tax, and various implications of our uncertainty about the social cost of carbon.

-The report was apparently sent to Robert Murphy, Lawrence Goulder, someone with the Heritage Foundation, someone with the Cato Institute, and others for review. (I know this doesn't mean they had any substantive input.)

-I don't mean to imply that the Parry and Williams conclusively means that Murphy is wrong. I just thought it was an important point that the income tax is not a simple labor tax.

ThomasH writes:

I think the best combination of tax changes in response to the CO2 emissions externality would be a carbon tax and a progressive consumption tax combined with elimination of payroll taxes and corporate taxes.

MikeP writes:

I think the best combination of tax changes in response to the CO2 emissions externality would be a progressive consumption tax combined with elimination of payroll taxes and corporate taxes.

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