A tax on carbon really is the best way for government to intervene in climate issues…but it will still be a mess.
In his seminal work The Economics of Welfare, early 20th century economist Arthur Pigou made a novel contention: the price of a good should reflect its cost. Pigou wasn’t referring simply to the monetary expense of producing at the optimal market output. Rather, he expanded the concept to account for the broader societal costs (and benefits) of producing and consuming goods in a modern economy. And thus the externality was born.
The theoretical underpinnings of externalities as market failures are pretty solid. While the traditional supply and demand model dictates that the optimal price is found where the quantity of a good supplied matches the quantity demanded, this often excludes the very real incidental impacts of market transactions. Consider cigarettes for instance. The cost of producing a pack of cigarettes ranges anywhere from six to twenty-six cents, depending on who’s doing the counting. What’s clear, however, is that negative economic and social effects of smoking—increased medical costs, lost productivity, shortened life expectancy, etc.—vastly outstrip the pennies spent to produce cigarettes or even the dollars spent to purchase them. The most recent analysis by the CDC pegs these external costs at nearly $300 billion annually. Pigou’s solution for this issue? Impose a tax on problematic markets so that prices more accurately reflect societal welfare.
As the national and international debates on climate change, fossil fuels, and carbon emissions continue to heat up, Pigou’s theoretical framework has proven increasingly important in shaping the relevant arguments. In particular, the idea of a tax on carbon (a manifestation of the creatively dubbed Pigovian tax) has fallen under an increasingly bright media spotlight. Conservative economist and columnist N. Gregory Mankiw has been advocating a carbon tax for years, NPR podcast Planet Money covered the proposal in 2013, and this week CNN dedicated the centerpiece of its front page to 4,500 words detailing the pro-carbon tax endeavors of a Washington State economist / stand-up comedian.
There’s a reason that the carbon tax is getting such traction. It’s viewed favorably by economists across the political spectrum, it promises to induce positive behavioral changes through market forces as opposed to economy-distorting regulations and subsidies, and it is, in theory anyway, revenue neutral. Taxing greenhouse gas emissions truly is a balanced and potentially effective method for staving off a global temperature increase. But as with anything that involves the Federal government, powerful special interests, and the economy in general, invoking a theoretical solution is simple. Translating that theory into a pragmatic and effective course of action is a whole different beast. And if there’s one practical problem that stands out above the rest, it’s this: pegging the societally optimal level of carbon emissions, and thus setting the societally optimal tax rate, is nearly impossible.
In a perfect world, the carbon tax would increase fossil fuel prices exactly enough to account for the negative societal impacts of greenhouse gas-induced climate change. Some aspects of this formulation are easy; we know with reasonable certainty the relative rate of carbon emissions for each of our fuel sources, and thus can appropriately apportion the tax. For example, since coal emits roughly twice as much CO2 as natural gas per British Thermal Unit of energy produced, coal consumption should incur a much steeper tax penalty.
Unfortunately, divining the societally optimal CO2 output is not nearly as simple a task as figuring out that coal is worse than natural gas. For one, it is an issue rife with personal, political, and social biases. Those who believe climate change to be a non-issue, or at least one that isn’t driven by human fossil fuel consumption, will likewise conclude that the appropriate tax rate is 0 because the market is already at the proper equilibrium. On the other end of the spectrum are those who would prefer to tax fossil fuels out of the market practically overnight. (Well, in twenty years, anyway.)
Even without ideological purists mucking things up, there is a lot of ambiguity in regards to the extent and impact of rising global temperatures. Models released by the National Oceanic and Atmospheric Administration swing a staggering 4.4 degrees Celsius between their minimum and maximum predictions for how much the Earth will warm by the end of the century. What that means economically is even harder to predict. A 2014 economic impact model from the Copenhagen Consensus Center asserts current warming trends will continue to bolster the global economy until 2025 and won’t be a net economic drag until 2070, and that’s assuming a rather dramatic warming of 3.6 degrees Celsius. While admittedly it is pretty much impossible that warming will stop at the 2025 sweet spot, this does illustrate that the debate needs to be a lot more nuanced than “solar good, carbon bad.” At least as far as the economy is concerned.
Faced with this degree of uncertainty, some people prefer to take a Pascal’s Wager type approach; since the effects of global climate change could potentially be cataclysmic, they argue, extreme measures should be taken to mitigate that potential as much as humanly possible. But for literally billions of people around the world, the arithmetic is not so tidy and straightforward. The types of extreme measures advocated (such as, you know, banning fossil fuels by 2030) carry with them very real economic consequences; consequences which will disproportionately burden the poor.
Even under the ideal circumstance of an optimally set tax rate accompanied by a well-functioning, equitable revenue disbursement system, there will still be short-term growing pains. The cost of energy will go up and that in turn will require people to devote either a greater share of their income to paying for power or force them to change their habits. That is, of course, the ultimate purpose of the carbon tax. That doesn’t make it any less of a hassle.
The moment a carbon tax pushes the price of fossil fuels above the societally optimal equilibrium, though, the deadweight losses incurred will become an unnecessary drag on the economy. This drag could be minor, resulting in little more than an inconvenience easily offset by the benefits of reducing the externalities of climate change.
Or it could be massive.
In 2015, after years of economic and regulatory pressure to reduce carbon emissions and promote renewable energy sources, over 80% of all energy consumed in the United States was still derived from fossil fuels. The real inconvenient truth is that the global economy remains hugely dependent on the mortal trappings of our dinosaur forebears. Yes, predictions of unchecked climate change bring with them portents of a dark future, but the specter of an excessive tax burden is potentially as bad or even worse. In short, the cure for global warming may indeed be worse than the disease.
None of this changes the fact that a Pigovian tax on carbon is still the best government policy for addressing the negative externalities of carbon emissions. Moreover, measures such as a gradual implementation schedule and offsetting tax rebates will go a long way towards mitigating the potential side effects of such a policy. But it does go to show that the challenge faced by policy makers is indeed far more complex than the elegant theory behind such proposals makes it out to be. Set the tax too low, and doom future generations to a tumultuous fate; set it too high, and stifle decades of humanity’s economic development, poverty relief, and overall progress. And we need to keep in mind that all of this is contingent on our ability to accurately predict the jointly ambiguous and shifting targets that are the extent of man-made climate change and the impact of the change on the totality of human society. It’s not a job I would wish upon anyone.
Alas, this is but one of the challenges facing the successful implementation of a carbon tax. Check back next week for an in depth look into the other issues that can likely will derail such efforts. Cheers!