Climate Bill Confusion

The Boxer-Lieberman-Warner climate bill is being debated in the Senate: This is important stuff—the first real attempt in the United States to regulate greenhouse-gas emissions. Does the bill make sense?

Its main purpose is to create a cap-and-trade system, and there has been a recent debate in the blogosphere about whether a cap-and-trade system is better or worse than a carbon tax. The issue is probably moot: For no doubt political reasons, a cap-and-trade system is the only system on the table. But it is worth understanding the difference between the two.

Imagine that there are only 10 people who engage in activities that cause greenhouse-gas emissions; perhaps they each burn one gallon of gas per year in their factories. We decide that, from the standpoint of the climate, it would be better if a total of nine, rather than 10, gallons of gas are burned per year.

We could achieve this goal in two ways. Under a cap-and-trade system, we issue nine permits to burn one gallon of gas. You have to own a permit in order to obtain a gallon of gas.  Voilà : We have solved our problem. Only nine gallons of gas will be consumed.

Under a tax system, we make anyone who buys a gallon of gas pay a tax. Suppose that each of our 10 people is willing to pay different amounts for a gallon of gas—because they gain more or less from burning that gallon. For example, one person is willing to pay $4, one person is willing to pay $4.20, the third person is willing to pay $4.30, and so on. Suppose the untaxed price of gas is $4 per gallon. To ensure that only nine gallons are consumed, we set the tax at 10 cents. Now the $4-person won’t buy any gas; the others will. Our goal is achieved.

So, the two approaches have the same effect on the climate. One involves setting a price floor; the other involves setting a quantity ceiling. Most economists prefer the tax approach, however, because if you get the tax slightly wrong, the social costs are likely to be lower than if you get the quantity limit slightly wrong. To see why, suppose that there is an emergency and it suddenly becomes important for all 10 people to have a gallon of gas. Under the tax system, the lowest-value user can simply pay the tax; under the permit system, one person is out of luck. (The story is a bit more complicated than this; see here ; and anyway, a cap-and-trade system can be given safety valves that perform the same function.)

Brad DeLong thinks that the two systems have different distributive effects. But we can distribute however we want to. For the cap-and-trade system, we could auction off the permits, charge a low price, charge a high price, or give them away for free. If we sell them, we can give the revenue to whomever we want to give it to. We could even give the money back to the buyers minus the tax that they would pay under the tax system, in which case the distributive effect would be the same as that of the tax system that I described above. Similarly, under the tax system, we could take the revenue we collect and give it back to everyone we taxed except for the 10 th guy who refrained from buying the gas—and we’d have the same distributive effect as that of the initial cap-and-trade approach.

Everyone seems to fear that under the bill’s cap-and-trade system, Congress will give away the revenue to people who don’t deserve it. Maybe so, but Congress could do the same thing if it imposed a carbon tax. Revenues from the tax have to go somewhere, after all. Some people want Congress to give away the permits for free so that it doesn’t obtain revenues that it would then squander. But if the cap-and-trade system means anything, it means not everyone will get a permit who would like one. That means Congress will have to pick and choose among those to whom it gives permits, and again we have the same risk of abuse, including lobbying and favoritism.

If the permits are auctioned off, what should be done with the trillions of dollars that are raised? Lieberman would invest it in research into clean energy.  That’s a bad idea: The government has no insight into where the research dollars should go. The whole point of a cap-and-trade system or (equivalently) a tax in the first place is to get industry to make those research decisions so that the government does not have to. If it won’t do enough, then fewer permits should be issued, which will increase the pressure to find alternative sources of energy.  Robert Reich says give the money back pro rata to American citizens.  But why do that?  The government gets revenue in all kinds of ways-say, by auctioning off the spectrum or by licensing lands for grazing or by charging fees for green cards-and no one thinks that the money should be returned to taxpayers pro rata. People think that Congress should spend this money or, if spending is already adequate, tax people less. The cap-and-trade money should go into the Treasury with all these other sources of revenue. Taxes can be lowered, debt retired, or ordinary spending increased. Congress can misspend our money, but that is true whether it gets our money from incomes taxes or permit auctions. There is no reason to treat the revenues from these two sources any differently.

Aside from the uncertainty issue, which favors the tax system, there is no reason to favor one system over the other. They have the same environmental effects for (roughly) the same cost to the economy. We can redistribute wealth however we want, as we always can, system or no system; and whenever Congress acts, it can misbehave if it chooses to, and lobbyists will be involved, regardless of the type of law Congress ends up enacting. So why the enthusiasm for the cap-and-trade system? Something about the absence of the word tax in its name?