Amplifying Oren Cass on a Carbon Tax, Part 2
Even professional economists, take note. Cass makes a great point that I haven’t seen stressed anywhere else. I’ll quote him first, then I’ll quote from my article to elaborate on his insight.
CASS: Nor does describing a carbon tax as “revenue neutral” do anything to improve its appeal. Promising to use the revenue for tax cuts or a rebate does not guarantee its best use or a net positive economic impact, nor does it make the policy somehow free. To the contrary, a revenue-neutral tax is guaranteed to be costly precisely because it holds government revenue constant while also increasing costs to private actors by driving them toward higher-cost energy technologies. The effect is most obvious in a world where the tax has driven emissions to zero, and government revenue comes from all of its pre-tax sources, except consumers also find themselves motivated by the tax’s existence to pay the full cost of electric vehicles and solar panels. In this respect, the tax operates much like the minimum wage; it imposes large and plainly government-created costs in the form of “off-budget” spending for which the government is never held accountable. [Bold added.]
And now here’s me, amplifying the above:
Suppose that the U.S. government implemented an outrageously high carbon tax—something like $2,000 per ton—and enforced it vigorously. The price of conventional gasoline would skyrocket some $16 per gallon, while electricity prices would soar because coal- and natural gas-fired power plants would suddenly have outrageous taxes to pay.
In this regime, the amount of U.S. carbon dioxide emissions would fall drastically, so that even with the very high rate of carbon tax, it’s possible that within a decade very little revenue would be coming in. (Remember, total carbon tax receipts per year are annualtons of emissions multiplied by carbon tax per ton.) In this scenario, the tax rates on labor and capital would have to be basically what they were before the new, draconian carbon tax, because of the assumption of “revenue neutrality.” In other words, if the draconian carbon tax isn’t bringing in much revenue since the carbon base gets driven to basically zero, then there isn’t much in the kitty to offset the pre-existing taxes.
So what can we say about the state of the conventional economy? It clearly isn’t benefiting from any “pro-growth” kick emanating from “Pigovian tax reform.” No, in this extreme scenario, the pre-existing distortionary taxes haven’t been cut at all.
However, the situation isn’t simply a wash. Even though it’s not bringing in new revenue, the massive $2,000 per ton carbon tax is definitely forcing Americans to alter their behavior. Nobody would be driving gasoline-powered vehicles, and all coal- and natural gas-fired power plants would be shuttered. Americans’ standard of living would have collapsed, as transportation and energy had become outrageously expensive.
…
It’s not enough just to observe, “Greenhouse gas emissions are a negative externality while we want to encourage work and saving.” The numbers matter. Even if “taxing bads, not goods” leads to a “win-win” upfront, it’s possible that the numbers move and cause the flipside to occur in a decade or two.
Let me make sure the reader understands the point of my exaggerated example. I picked a ridiculously high carbon tax of $2,000 per ton to make Cass’s point crystal clear. But even at a more moderate level, we still have to take into account the subtle mechanism at work: The more successful a carbon tax is at inducing people to alter their behavior, then the less revenue it raises. The impact of a carbon tax on the conventional economy is not necessarily directly proportional to the amount of revenue it raises, and so in general we can’t rely on catchy slogans like “tax bads, not goods.” To assess the economic cost of complying with a carbon tax—which could be compared to the ostensible benefits of avoided future climate change damages—we need to look at specifics. A very low carbon tax rate won’t raise much revenue, and so won’t allow for much tax reduction elsewhere, but on the other hand a very high carbon tax rate might not raise much revenue either.
” a revenue-neutral tax is guaranteed to be costly precisely because it holds government revenue constant while also increasing costs to private actors by driving them toward higher-cost energy technologies”
Not sure I agree with that. Here is how I see it, please point out if I have made any errors.
Taxes have deadweight losses. We know that. Externalities have deadweight losses too – you can see the triangles on the graphs.
The use of the hypothetical extreme tax where no revenue is raised is an excellent way to demonstrate the deadweight loss taxes. Tax shoes at $10,000 then the revenue stays the same but nobody has shoes. It just does not seem to be paticularly insightful in this situation as it applies to all taxes, except Pigovian ones.
We could use a similar extreme example to demonstrate that such taxes are beneficial. Say a bad has an externality that will cost every American £1000 a day in 5 years. However, for each individual this bad is better vaue by 1c than the alternative good which is identical in every other respect. We can stop consumption of this bad with a tax of $0.02 today and keep the revenue to Govt neutral in the bargain.
Each rational consumer will opt for the bad over the good without the tax. Every rational consumer will opt for the good over the bad with the tax. The tax is saving every American £1000 a day in 5 years. Net revenue = 0.
It is senseless to say that that, to paraphrase, the tax is guaranteed to be costly precisely because it holds government revenue constant while also increasing costs to private actors by driving them toward higher-cost option. It does indeed drive them to the higher cost option but that is a saving not a cost to the economy.
You can reasonably argue that the tax in the USA will not reduce the deadweight loss because of other countries, therefore the tax will not reduce consumption. Also that the level cannot be resonably assesed and I am sure there are other arguments against Pigovian taxes. However, those are different arguments.
The use of tthese simple illustrations misses out a lot of subtlety that is over my head. However, if we are to use simple illustrations they can cut both ways.
Cass’ argument is, in essence, the Laffer Curve, just applied to a different realm. The Laffer Curve states that government will take in no revenue from an income tax rate of 0%, which is apodictic. It further (and equally correctly) states that government will take in no revenue from an income tax of 100%, since nobody will bother earning a taxable income. Therefore, says Laffer, there exists a point beyond which further rate increases *reduce* the revenue generated by the tax.
Cass is saying much the same thing. His point is that it’s vastly too simplistic to “tax bads, not goods” because the taxation of alleged “bads” reduces the production of goods. Furthermore, this is a fundamental feature of a carbon tax; it is absurdly naïve to assume that (for example) the amount of trucking taking place in the economy will not decrease if the government forces the price of trucking up. This is the same lesson minimum wage fans are currently learning the hard way in the places they’ve successfully lobbied for massive increases.
Also, if I may say so, it would be lovely if, in future, you could restrain yourself from expecting interlocutors to perform currency conversions in order to understand your “simple illustrations.”
Profuse apologies. Please feel free to substitute $ for £ wherever they occur.
“His point is that it’s vastly too simplistic to “tax bads, not goods” because the taxation of alleged “bads” reduces the production of goods.”
In isolation a tax will reduce production of goods due to deadweight loss. If we tax shoes to high then we raise no revenue but cut production as everyone hobbles around slowly.
But with an externality, consumption also reduces the production of goods. If we poison everyone with pollution so they are constantly ill then production reduces. This is just like the extreme example of the 100% tax (or zero revenue tax) which is useful to illustrate the point even though nobody is considering taxing so highly or polluting so badly.
The simple model predicts that in the pollution poisoning everyone case, then the appropriate tax will increase production of goods. So if his point is that it is too simplistic to say “tax bads not goods”, he is being too simplistic because he misses out what makes them bads in the first place.
Harold wrote: “It is senseless to say that that, to paraphrase, the tax is guaranteed to be costly precisely because it holds government revenue constant while also increasing costs to private actors by driving them toward higher-cost option. It does indeed drive them to the higher cost option but that is a saving not a cost to the economy.”
Yep, this sounds right to me. Can someone please dispute Harold’s point here? I think he’s gotten to the heart of why we blog readers cannot understand what the tax interaction effect is all about.
Has subjective value theory all come to this?
I’d say the Laffer analogy tells against Cass here. Cass’ argument is the equivalent of saying that since a zero tax rate would bring in zero revenue, that shows tax rate cuts are guaranteed to reduce revenue. It doesn’t follow.
Josiah wrote:
Cass’ argument is the equivalent of saying that since a zero tax rate would bring in zero revenue, that shows tax rate cuts are guaranteed to reduce revenue.
That absolutely is not his argument.
His example is that if a carbon tax were so high that emissions were zero, it wouldn’t bring in any revenue to offset other taxes. That seems equivalent to judging the Laffer Curve by looking at how much revenue a zero tax rate would bring in.
Let me make sure the reader understands the point of my exaggerated example. I picked a ridiculously high carbon tax of $2,000 per ton to make Cass’s point crystal clear. But even at a more moderate level, we still have to take into account the subtle mechanism at work: The more successful a carbon tax is at inducing people to alter their behavior, then the less revenue it raises. The impact of a carbon tax on the conventional economy is not necessarily directly proportional to the amount of revenue it raises, and so in general we can’t rely on catchy slogans like “tax bads, not goods.” To assess the economic cost of complying with a carbon tax—which could be compared to the ostensible benefits of avoided future climate change damages—we need to look at specifics.
Josiah I understand the confusion now; some of what I wrote is giving the wrong impression. The problem is that I think people misunderstand what Laffer was doing.
Even in the case where a tax rate reduction leads to a drop in total tax receipts–so a “tax cut” is a “tax cut”–the reduction in receipts is not as big as you would have expected, using a static approach. So it’s not just that Laffer has a point in certain circumstances; in general the dynamic approach shows the more correct way to think about tax rate changes.
So in the context of Cass and carbon taxes, I’m saying that in a super exaggerated example, it’s obvious that the typical discussion is flawed. But that flaw exists even in the case where a carbon tax brings in (say) $300 billion in annual revenue. Even if you think that’s great because it fuels corresponding rate reductions in payroll and corporate income tax, notice that over time the economy responds by reducing carbon usage. So that tradeoff gets worse and worse over time, even if it doesn’t go to zero.
The whole point of the carbon tax is surely to reduce consumption to the level it would be if people felt the externalities themselves. This will give us the optimum production and consumption.
As the tax incrementally increases the deadweight loss of the externality reduces to zero at some point. Then as tax increases the deadweight loss of the tax takes over and we get a loss.
Once we have reached that zero point, then further taxing is the same as taxing any other good
It s not as simple as tax bads not goods, that is true. The level of tax must be appropriate.