Do all economists agree that a Carbon Tax is the best way to address climate change?

Economist and former Chair of the Federal Reserve, Janet Yellen, is circulating a letter signed by “27 Nobel Laureate economists, 3 other former Chairs of the Federal Reserve and 15 former Chairs of the Council of Economic Advisers” that claims “A carbon tax offers the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary.”  The full statement consists of five, straightforward principles that outline the basics of how a Carbon Tax system might work in the U.S.

One of the nice, but frustrating, things about studying economics is that a set of people can study the same subject and come to dramatically different conclusions.  What I write below is my views on the carbon tax letter.  Fortunately, I work in a department that has one of the largest groups of experts in environmental economics at any academic institution.  I hope my colleagues–yep, I’m calling out Brent Sohngen, Sathya Gopalakrishnan, Allen Klaiber, Ian Sheldon, and anyone else in AEDE who thinks I’m an idiot–will weigh in on what I say (and disagree with me on some of the things), because understanding the controversies around different policies is the best way to design effective and long-lasting solutions to complex problems.

Read on…

The letter starts out:

Global climate change is a serious problem calling for immediate national action. Guided by sound economic principles, we are united in the following policy recommendations.

The five principles are (with brief comment):

I. A carbon tax offers the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary. By correcting a well-known market failure, a carbon tax will send a powerful price signal that harnesses the invisible hand of the marketplace to steer economic actors towards a low-carbon future.

The economics here are simple:  A carbon tax places a price on something (carbon emissions) that is currently free.  When something is free, we consume a lot of it.  When the price rises, we consume less (that’s the Law of Demand).  So putting a price on carbon will reduce the quantity demanded and ideally reduce climate impacts.  The only potentially controversial part of this I see is the claim that the tax is ‘the most cost-effective lever.’  In a world where we perfectly know the costs of reducing carbon, this may well be true, but I think we are a long way from knowing the costs of reducing carbon with 100% certainty.  Other might disagree on this.

II. A carbon tax should increase every year until emissions reductions goals are met and be revenue neutral to avoid debates over the size of government. A consistently rising carbon price will encourage technological innovation and large-scale infrastructure development. It will also accelerate the diffusion of carbon-efficient goods and services.

I’m going to return to revenue neutrality below.  In a perfect world we wouldn’t need an increasing tax.  If we know all current and future costs and benefits of carbon reductions, then we should be able to figure out what the current and future price of carbon should be without guessing.  But this takes me back to the issue of uncertainty (see part I.).  Taxes are the preferred economic instrument when things are well known.  But in a world of uncertainty, other economic policies, like cap-and-trade, may be more cost effective in reducing carbon emissions, and provide more flexibility for the market to set the price.  But, I do agree that raising the price of carbon will encourage innovation, infrastructure development, and carbon-efficiency.  Prices are an impressively powerful motivators.

III. A sufficiently robust and gradually rising carbon tax will replace the need for various carbon regulations that are less efficient. Substituting a price signal for cumbersome regulations will promote economic growth and provide the regulatory certainty companies need for long-term investment in clean-energy alternatives.

Prices create incentives.  Higher prices reduce consumption and provide the incentive for alternatives.

IV. To prevent carbon leakage and to protect U.S. competitiveness, a border carbon adjustment system should be established. This system would enhance the competitiveness of American firms that are more energy-efficient than their global competitors. It would also create an incentive for other nations to adopt similar carbon pricing.

I’m not a trade expert, but I talk to one fairly often (maybe we can get him to weigh in here).   Unless we can get a global agreement on a market-based carbon reduction system, border-adjustments seem necessary to me.  By definition, a carbon tax is going to increase the cost of operating in a carbon intensive industry.  If a single country goes it alone, a carbon tax decreases the competitiveness of those industries on the world market.  This would likely cause an influx of cheaper, more carbon-intensive goods into the domestic market, and potentially offset the carbon reductions from the domestic tax.  Adjusting the border-price of inputs and exports based on carbon-content reduces the incentive to import the cheaper carbon-intensive goods.

V. To maximize the fairness and political viability of a rising carbon tax, all the revenue should be returned directly to U.S. citizens through equal lump-sum rebates. The majority of American families, including the most vulnerable, will benefit financially by receiving more in “carbon dividends” than they pay in increased energy prices.

This is probably the most controversial part of this proposal, and perhaps the one where the economics are most misunderstood.  The idea here is to make a carbon tax revenue neutral, without distorting the incentive to reduce carbon.  So how would it work?  The government would set a tax on carbon and collect all of the revenue from the tax.  They would then turn around an redistribute the revenue from the tax in equal amount to each U.S. citizen.  In other words, each person would get a check each year for 1/nth of the total revenue collected from the tax.

But wait, doesn’t that ruin the point of the tax in the first place.

Won’t people just turn around and use the refund to offset the higher prices?

Well, no (and this is where economists are really smart…my opinion of course).

The carbon tax changes relative prices.  People make purchasing decisions based on relative prices.  If something becomes more expensive relative to another good, people will shift their purchasing toward the cheaper good, even if they have more income.  The change in relative prices guarantees that less of the more expensive goods, in this case carbon-intensive things, are bought.

So what do people do with the extra money?

To think about this, imaging you get a check in the mail for $500 at the end of the year.  What would you do?

The answer, to an economist, is ‘I would buy more of the stuff I want.’  But not all of that income (some might) is going to go to buying the carbon-intensive stuff–because that stuff is now more expensive compared to other goods.  So the extra income doesn’t change the incentive to buy less carbon-intensive stuff.

It’s a bit confusing, and bit counter-intuitive, but it works.  When the price of something goes up, people buy less of it, even if they have more money.  The only catch is that the amount of money you get back can’t be related to how much you spent on the carbon-intensive stuff in the first place.  That’s why the signers of the letter insist on returning the revenues in equal amounts to everyone.

So, where do I stand on the letter?

I like the idea.  I would prefer a cap-and-trade system where we cap the amount of carbon we want in the economy, and then allow people to buy and sell the restricted amount on the open market, letting the market set the price, but cap-and-trade seems to be politically toxic right now.

So if given the choice between no policy, and a carbon tax, I support the tax.