02 Oct 2012

Carbon Tax Swaps and the “Tax Interaction Effect”

Climate Change, Economics, Shameless Self-Promotion 8 Comments

I have the EconLib article this month, on the above. Here’s the introduction:

For years, many economists have advocated a tax on the emission of carbon dioxide and other greenhouse gases as a way to correct the negative externality of manmade climate change. More recently, even a growing number of conservative economists have embraced a carbon tax, not only as a way to correctly align market forces, but also as a way to offset other, more distortionary taxes. The slogan underlying such “carbon tax swap” proposals is that the government should “tax bads, not goods.”

Although the thinking underlying the conservative case is correct, there is a potential downside from a carbon tax swap. This negative side effect is rarely mentioned in any but the most technical discussions. It is the “tax interaction effect.” A new carbon tax can exacerbate the harms caused by pre-existing taxes, thereby offsetting the potential environmental benefits. What’s worse, not only can the tax-interaction effect operate in theory, but also numerical simulations suggest that it might be very large in practice, greatly reducing the “optimal” carbon tax.

This is actually a high-brow article, though my editor kept me speaking English. The backstory is that I am preparing a fairly extensive study for the Institute for Energy Research on carbon tax swap deals, and I came across this “tax interaction effect.”

Here’s the shocking thing: It is theoretically possible, and empirically considered likely the case by the experts in the field, that the more distortionary the tax code currently is, then the weaker the case for imposing a new carbon tax becomes, even if the revenues from the tax are used to reduce dollar-for-dollar other, distortionary taxes. This is true even if the carbon tax so imposed is a textbook, Pigovian “optimal” tax, that perfectly compensates for the negative externality of carbon emissions.

As I remarked at Daniel Kuehn’s blog (when he linked to my article), this result struck me as so counterintuitive at first, that I didn’t believe it. But if you work through the EconLib article, you should be able to see how it can be true.

8 Responses to “Carbon Tax Swaps and the “Tax Interaction Effect””

  1. David Friedman says:

    At a tangent to your post … . I’m not convinced that we know the sign of the externality from producing CO2, an issue I’ve discussed on my blog. There is little a priori reason to think that a climate a few degrees warmer or cooler than the present would be worse for us; the present climate wasn’t designed for our benefit, and humans prosper across quite a wide range of climates at present.

    The usual economic arguments depends on adding up positive and negative externalities, but that’s a very chancy procedure when most of the numbers are uncertain, as they are in guesstimating effects over the next century or so. Make generous estimates for the negatives and you have an “objective proof” that the sum is negative, reverse the procedure and get a similar proof that it is positive.

    • Brent says:

      I think this is one of the best points in the whole global climate change debate (sorry, I know the ‘debate is over’). But it seems like this is the biggest and worst assumption of all… any change will have costs, of course, but it will also have benefits. The present value of the costs, which would likely occur sooner, may outweigh the more distant benefits, but since environmentalism is “for the next generations”, I’d love for them to be forced to make the opposite argument that we should (selfishly) keep the climate from changing so that “our generation” benefits (at the expense of later generations).

      • David Friedman says:

        To fill out my point a little, there are two big, predictable benefits, two predictable, but not obviously big, costs.

        One benefit is longer growing seasons—I gather there is some evidence that that already is having some effect.

        The other is an increase in the land area suitable for human use. The current limit is cold not heat—the equator is inhabited, the poles are not. Global warming is unevenly distributed because water vapor is a greenhouse gas, and the more of it in the atmosphere the less the effect of an increase in CO2. The warmer it is, ceteris paribus, the more water vapor in the air, so cold regions, and cold seasons, will warm more than hot. That’s a good thing on net, since the colder it is the more likely warmth is to be an improvement. In particular, it means pushing the boundary of the inhabitable area of the northern hemisphere towards the pole, probably by several hundred miles. My very rough calculations suggest that that increases available land by a couple of orders of magnitude more than sea level rise decreases it.

        Sea level rise is one predictable negative but not, on current projections–a foot or two by the end of the century–a very big one. The other is simply change. We are optimized against current conditions, so any change means that some of our sunk costs get wasted–insulation of houses that now need it less, experience with a crop that is no longer optimal where it had been grown. That would be a big cost for rapid change, but it should not be very large for warming of about .03 degrees per year, which is roughly what the IPCC figures suggest, with a substantial range of uncertainty.

        All of which makes me suspect that the net externality is positive—but it is very hard to be sure. For some further discussion, see the posts on my blog and comments thereto.

    • Bob Murphy says:

      Dr. Friedman, yep, I remember your post at your blog on that; I forwarded it to some people at the time. I actually do not favor a carbon tax–see my paper in the Independent Review, critiquing Nordhaus on this subject–but in this EconLib piece I wanted to isolate just the tax interaction effect. I think Bovenberg and Goulder probably still favor a carbon tax, just a much more modest one, so I wanted to be modest in my claims here.

    • Matt Tanous says:

      Something comes to mind about demonstrating harm first, and enforcing strict private property rights, instead of abstract harm “to society” (i.e. “social cost”) and vague externalities with unknown signs.

  2. Blackadder says:

    Excellent article.

    • Bob Murphy says:

      See Blackadder? You won’t get any pushback from me in this thread. Isn’t this nicer than fighting?

      • Blackadder says:

        Niceness is overrated.

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