The Carbon Tax: Not All It's Cracked Up to Be

I knew that policies such as tax increases and spending cuts were being discussed in the "fiscal cliff debate," but only very recently did I find out that a carbon tax was part of the debate. Why would climate change become a part of the debate? Aside from Hurricane Sandy, the answer is that politicians would expect revenue windfall to deal with fiscal woes. This led me to wonder whether the carbon tax would be effective.

The carbon tax is a Pigovian tax levied on the amount of carbon emitted in order to reduce carbon emissions. I have expressed skepticism about anthropogenic global warming, but over time, that position becomes harder to justify, so for the purpose of this blog entry, the assumption made is that man-made global warming is real and needs to be addressed.

As shown in the graph below, the idea is that the free market encourages individuals to produce more carbon via their energy consumption than is socially optimal. The consumer of energy is not bearing the real cost of emitting carbon into the atmosphere. The carbon tax raises the price of consuming carbon-based energy so that the consumer faces the full social costs. In addition to addressing and discouraging a negative externality, the idea is to incentivize investment in alternative energy, which would not only be great for the environment, but would help with long-term energy concerns. There is also the previously mentioned benefit of collecting revenue for the government. Arguably, one can contend that the carbon tax is simpler, more effective, less corruptible, and more transparent than cap-and-trade (that debate can be explored here and here). Voilà, the argument for a carbon tax in a nutshell.
    

As lovely as all of that sounds, I have my reservations about a carbon tax for a few reasons:

1. Other effects of taxation. What is implicit within taxing carbon emissions is that factors of production (e.g., labor, capital, and investment) are also being taxed because energy is an input of production. Much like consumers, a majority of producer behavior can be attributed to incentive structure. Much like with protectionism, the carbon tax can either discourage work and investment in this country, or the tax can incentivize companies to outsource to countries with less regulations and taxes, both of which would slow down economic growth. A decrease in GDP growth would not be good for the economy, but cutting back on consumption might not necessarily be a bad thing, so there's a trade-off. Something else to consider is the issue of the tax-interaction effect, which is elucidated upon by economist Robert P. Murphy.
2. Offsetting costs and revenue neutrality. My objections in the first point can mitigated by offsets by the revenue collected via "pro-growth" policies. Revenues can be used to deal with the debt or they can be used for other public funding. Additionally, the carbon tax can be revenue-neutral, meaning that a carbon can be offset by decreasing [or eliminating] other taxes, such as the corporate tax or the income tax. A revenue-neutral carbon tax is something that conservatives are even willing to get behind. It's all picture-perfect until you run into political reality. This assumes that tax revenue will be adequately appropriated and will not be caught up in politics like other tax revenue. Also, I had similar apprehensions about the prospectives of the value-added tax being revenue-neutral. Especially during a fiscal cliff debate, what is the probability that the government is going to consider cutting taxes to the point where the carbon tax would be revenue-neutral? We have to fund a welfare state with increasing entitlements, so I would safely bet that those odds are low.    
3. Regulations and expansion of Big Government. Without the carbon tax, the government's next option would be to use the Clean Air Act to regulate carbon. Considering how micromanaging this bill is, effectiveness is in question. The carbon tax would simplify the process. Rather than a plethora of regulations, the carbon tax would directly address carbon emissions without the EPA's involvement. Much like with the second point, my issue here is that the carbon tax would not be in lieu of the EPA, but rather in addition to EPA involvement. Carbon is emitted by oil, coal, and natural gas consumption. Since these three energy sources consist of approximately 83% of energy consumption, it gives the government a carte blanche to regulate many facets of American's lives, which is very disconcerting. 
4. Elasticities and Deadweight Loss. One of the advantages of the markets is that prices are reflections of supply and demand. This means that the mechanisms in the market can determine a consumer's willingness to pay (WTP), as well as the value of inputs and outputs. When the government levies a Pigovian tax, it has no way of knowing the external cost of carbon (i.e., value of the output) and how much it should tax. For all the government knows, it is overvaluing the emission of a ton of carbon if it taxes too high. Another issue with potentially taxing too high is with respect to elasticity of demand. This is important if your primary goal of the carbon tax is to cut back on carbon emission. If a good is inelastic, such as gasoline, the consumer will be relatively unresponsive to an increase in price, which means that it would take a substantial tax burden to get the desired effect. If the government keeps raising taxes with little change in carbon emissions, not only has the government angered its citizenry, but it also has done very little to cut back on carbon. In addition, both the Brookings Institution and Heritage Foundation express concern for deadweight loss, which means that the inefficiencies and the distortions in the carbon tax are larger than in other taxes. 
5. Regressiveness of the carbon tax. A carbon tax is a flat tax in the sense that it taxes at a constant marginal rate. However, because the poor spend a higher percentage of its income on such goods as utilities and transportation than the rich do, it has a regressive effect on the poor. This will be compounded by the notion that in all probability, businesses will just pass the cost of carbon onto its customers, meaning that it would not even directly affect the producers. The Congressional Budget Office (CBO) recognizes this and has suggested some policies to keep the overall tax burden progressive. Like our current taxation system, I would expect a bunch of exemptions and loopholes to exacerbate the issues of overburden and inefficiencies that arise.
6. Free rider effect. It has been called global warming for a reason. The spillover effects of carbon emissions affect the entire world. Therefore, the big emitters have to be on board. If developing countries such as China or India are more concerned with economic development (read: increased carbon emissions) than they are with fighting climate change, it is more challenging, if not downright impossible, of a task. Plus, America has been cutting back on its rates of emissions to the point where the downward trend has resulted in a 20-year low. 
7.  Effectiveness of the tax. I started to cover this idea in my fourth point. In addition to dealing with inelastic demands, there is also the question of the extent to which carbon taxes will incentivize industries to invest more in alternative energy. I don't doubt that more expensive fossil fuels will make businesses want to develop green technology faster. Much like with education, throwing money at the problem doesn't automatically solve it, which does nothing to mitigate the high costs of alternative energy in the short-to-medium-term. Although technological process does not have a linear trend, there is only so much progress that can be made. I would opine that the tax doesn't necessarily help with speeding up progress. The increased incentive for industries to invest in green technology is [partially] offset by the revenue it would have acquired had it not been taxed. The carbon tax revenue would help with research and development (R&D) only if the government decides to a) appropriate it to R&D, and b) if the government doesn't get caught up in its inherent efficiencies (better known as government failures). 

Conclusion: If it will take years, or even decades, to wean off of fossil fuels, then punishing Americans  is infeasible without readily available alternatives, thereby making it an ineffective tax (assuming your goal was carbon emission reduction). As brought up in the World Bank's famous Stern Review, the policy that will make or break our efforts on climate change will be in developing technology, which means more R&D. A carbon tax can theoretically fund R&D, but that is not what is worrisome. The Copenhagen Consensus Center (CCC), an international think-tank, came up with a list of the most pressing issues the world faces. Interestingly enough, its panel with well-reknowned economists, thought that climate change was low on the priority list. Even when it looked at the topic of climate change, the carbon tax was ranked as a "very poor" policy. The CCC looks at technologies that would cost a lot less while doing more to solve the problem. As such, my bottom line is that rather than implement a punitive tax, we should focus the discussion of climate change on R&D. If we're going to spend money on the problem, we might as well spend it wisely, right?

10-30-2014 Addendum: This study from the Macdonald-Laurier Institute looks at the carbon tax, particularly from the point of view of the tax interaction effect.

1-12-2014 Addendum: The Heritage Foundation recently put out a piece on why carbon taxes aren't a good idea. Worth the read.