Pigovian taxes and government credibility

Most economists are inclined to agree with Greg Mankiw that a high tax on carbon, reflecting the best estimate of its social cost, is the best way to mitigate the effects of carbon emissions. [Edit: In this posting I consider a carbon tax to be roughly equivalent to cap-and-trade - of course there are differences but my point applies to both mechanisms]

In theory, this should encourage the right mix of reduced growth in consumption, development of energy-efficient technology, and compensation to those affected by climate change. Economic theory says that the market will respond in the most efficient way to a tax which fully reflects the external costs of the activity (known as a Pigovian tax after economist Arthur Cecil Pigou who was an early proponent of the concept).

In particular, it should not be necessary for the government to subsidise research into green technologies - they might pick the wrong ones, and they will probably end up wasting more money than the market would if left to itself. If green technology is a better way to solve the problem than simply cutting our energy usage, the market will say so. If a mix of both is the best solution, people trading in their own interest will find the right balance.

So is it economically illiterate for the Obama administration to be proposing such subsidies? Not necessarily.

There's a specific reason why a carbon tax might not work, and why it might not stimulate the optimal levels of R&D investment that economic theory indicates.

That reason is the inability of governments to credibly bind themselves in the future. Congress might pass a carbon tax in 2011, and then rescind it in 2014 with a tough mid-term election coming up. Or a presidential candidate in 2012 or 2016 might run on an anti-carbon-tax platform. Or the optimal level of the tax might be underestimated and future Congresses may be unwilling to increase it. For example, the Waxman-Markey bill currently passing Congress contains a cap-and-trade provision which is probably not sufficient to achieve what the US needs to do and may not in itself stimulate much investment. (note that something similar happened in Europe in 2007, when carbon prices dropped by over 99% in a couple of years as it became clear that the caps were too high)

Because investment in green technology must by necessity be carried out before it earns a return, such investment relies on the future being predictable. If I could be convinced that a carbon tax would stay in place for the next 30 years, that might be sufficient certainty for me to invest in developing energy-saving technology. But if I can only see it sticking around for the next four or six years, I probably won't invest.

Politically, the price of carbon credits in the near term will almost certainly be lower than optimal: because the expected energy-efficient technologies do not exist yet, and voters will fiercely resist an increase in their current costs which they will see as unjust because they have limited options for offsetting it. A future increase, to be imposed in several years when these technologies have been developed, would be more politically achievable but few investors will commit on the basis of a hypothetical future tax.

In this circumstance, the optimal solution may in fact be to subsidise research. Companies will then have a short-term incentive for research in which they can more readily believe than the 'jam tomorrow' of a carbon tax which has to survive at a high rate until 2030 or beyond.

And indeed this is just what Obama proposed during the election campaign (and in his inauguration speech), and is one of the many provisions in the Waxman-Markey bill. Is it possible that the politicians understand incentives better than the economists?

Because of the subsidies, this green technology may be over-supplied in comparison with the optimal solution. If so, it should be cheaper, and consumers will adopt it even with a slightly lower carbon tax than would otherwise have been required. Thus a lower tax will achieve the same emissions reduction - or, alternatively, a higher cut in emissions will be achievable for a given tax hike (of course other tax rises will eventually be required to pay for the subsidies, and Pigou's theory indicates the total bill will be more expensive than the optimal carbon tax. That's the cost of this approach).

It's important to remember that this solution is still economically less efficient than a permanent Pigovian tax. But short of passing a constitutional amendment, it may be impossible for the US government to credibly bind itself to keep such a tax in place over the long term.

(There are other problems with the idea of a carbon tax - such as the question of coordination among countries. There are also other problems with the Waxman-Markey bill. Both are outside the scope of this article. But some notes on the international coordination question:

The tragedy of the commons is an issue here - a country which reduces its impact on global carbon levels bears all the costs but gains only a small fraction of the benefits. Without international agreement, countries can easily free-ride on others and so everyone has an incentive to keep burning carbon. And there are debates about the level of effort different countries should make.

Even the EU didn't have the power in its own right until 2007 to enforce energy policy among its members - though there was enough cultural similarity and common interest between the countries that they were able to negotiate a solution, the EU Emission Trading Scheme. This is a cap-and-trade scheme rather than a carbon tax, but in this posting I'm treating them as variations of the same idea.

However, countries can and do sometimes impose a carbon tax unilaterally. Those which have committed themselves to a reduction in emissions under the Kyoto agreement can use this as a mechanism to fulfil their promises.

Crucially, the US is not one of those countries. It has no external commitment to reduce carbon - and even if it had, one could doubt whether it could be enforced - and this leads to a critical problem with the Pigovian thesis: the credible binding issue described above.)


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