The Carbon Tax/Cap-and-Trade Royal Rumble

There's an internet fight going on about how to limit emissions of greenhouse gases. In Corner #1, we have the Cap-and-Trade Kids, advocating limits on the amount of gases emitted. In Corner #2, we have the Pigou Clubbers, arguing for a carbon tax. Backing cap-and-trade are President Obama, Senator McCain (during the campaign), the European Union, and much of the rest of the world. Backing the carbon tax are ... Andrew Sullivan and a bunch of economists, nominally led by Harvard's Greg Mankiw. This seems a little lopsided.

What's interesting is that there are those arguing that the fight should be called off before a punch is even thrown. The winner will have to take on The Status Quo, and cap-and-traders want to go into that fight unblemished. Since they're the only ones with a chance, the argument goes, the Pigou Clubbers should toss in the towel now.

This raises some interesting questions. Is there any difference between cap-and-trade and a carbon tax? Is cap-and-trade the only politically viable approach? And would either have a chance against The Status Quo, who is drawing new fans in the midst of the economic downturn?

First, there is a difference. Cap-and-trade can do a very good impersonation of a carbon tax when we know the demand for emissions with certainty, when we do a great job of regulating, and when we auction off all the emissions permits. If we're uncertain about the demand for producing emissions, if it is hard to keep tabs on what various emitters are doing, or if politics intrudes into the process of handing out emissions permits, then the two approaches veer apart.

For ease of use and immunity from political meddling, the carbon tax is the clear winner. Taxes can be applied early in the fuel distribution process, which makes the logistical task much easier. That sort of upstream application would make attempts at political interference much more transparent, as well. So what about uncertainty? The big critique of a carbon tax is that it cannot guarantee a country will come in under a pre-set emissions cap. If the desire to pollute is really, really high one year, we could find that a given tax won't serve as a sufficient deterrent, and we'll blow past our limits.

For ease of use and immunity from political meddling, the carbon tax is the clear winner.

Europe, though, has had the opposite problem with their cap-and-trade system. In the first phase of the program, they printed more permits to pollute than anyone wanted. That drove the price of permits near zero, deeply annoying anyone who had paid up for the right to pollute. It also meant that the system was ineffective in restraining pollution. That would be hard to do with a carbon tax.

The Cap-and-Trade Kids argue that, whatever the economic merits, their approach is the only one with a political chance. But why? Carbon taxes have certainly been seen as a political third rail, at least since President Bill Clinton dropped a proposed BTU tax in 1993. People don't want to have to pay more for energy. But how does cap-and-trade overcome this critique? If it's going to rein in eagerness to pollute, it will have to raise the cost of pollution. It may be possible to win support by pretending this won't happen, but it's worth thinking hard about whether such deception is a sound basis for creating a major long-term policy.

And what of the big ruckus with The Status Quo? Australian cap-and-traders just postponed their fight. Prime Minister Kevin Rudd gave a number of reasons, including the need for business certainty (a plus for a carbon tax, by the way) and the impact of the global financial crisis. Does it make any sense to raise taxes, implicitly or explicitly, in the midst of a recession?

Actually, it might. It would depend what we did with the revenue. Imagine we used it to finance a cut in payroll taxes. That would make it more expensive to pollute, but cheaper to hire people. That could be a nice combo. I wouldn't bet much on the political chances of the carbon tax, but it's got enough promise to at least go down swinging.

Philip I. Levy is a resident scholar at AEI.

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Philip I.
  • Philip I. Levy's work in AEI's Program in International Economics ranges from free trade agreements and trade with China to antidumping policy. Prior to joining AEI, he worked on international economics issues as a member of the secretary of state's Policy Planning Staff. Mr. Levy also served as an economist for trade on the President's Council of Economic Advisers and taught economics at Yale University. He writes for AEI's International Economic Outlook series.

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