Carbon Dividend/Carbon Tax

I’ve fallen behind on my blog reading, so I missed Greg Laden’s post a few days ago in which he tries to argue that carbon taxes aren’t really taxes. Actually, he seems to prefer to call them a “carbon dividend,” which is apparently the trendy new name for this idea. I googled and found this page at the Citizens Climate Lobby which explains it. It’s basically a carbon tax — shorthand for taxing the production of atmospheric carbon dioxide, usually by taxing the fuel that will be burned to produce it — with the added bonus of bribing people to like it:

100% of the net fees from the carbon fee are held in a Carbon Fees Trust fund and returned directly to households as a monthly dividend.

About two-thirds of households will break even or receive more than they would pay in higher prices. This feature will inject billions into the economy, protect family budgets, free households to make independent choices about their energy usage, spur innovation and build aggregate demand for low-carbon products at the consumer level.

Sigh. The billions of dollars it injects into the economy is, by basic accounting, exactly offset by the billions of dollars it takes from the economy, which will presumably hurt family budgets and reduce household choices in all matters. And the only way this increases demand for low-carbon products is by pricing high-carbon products out of the market. I suspect this chicanery is an attempt to head off criticism that carbon taxes are just another case of loving high taxes and big government. It’s understandable, but it ultimately feels dishonest. 

And no matter how many times Laden says otherwise, “carbon fees” or “carbon charges” really are taxes. In fact, they’re a very specific type of tax known as a Pigovian tax, after economist Arthur Cecil Pigou, who formalized the concept in the 1920s as a way to address a problem known as the “tragedy of the commons.” That’s the economics term for what happens when people have access to a resource they don’t have to pay for.

The idea is to get business incentives to align with society’s incentives. Under normal market conditions, when a bakery uses 1000 pounds of wheat flour to make 1000 loaves of bread, the benefit to society is that it gains 1000 loaves of bread, and the cost to society is that it loses 1000 pounds of wheat flour.

Those are also the costs and benefits facing the bakery: They have to buy 1000 pounds of wheat flour, and they get to sell 1000 loaves of bread. Because the bakery has to take market prices when buying and selling, they will only choose to bake bread if 1000 loaves of bread are worth more than 1000 pounds of flour. And since the price of flour and bread in their respective markets are determined by society, the bakery will therefore only choose to bake bread from flour if bread is more valuable to society than flour. In converting flour to the more valuable bread, they will be increasing the value of the goods available to society, and because the bakery faces the same benefit/cost trade-off as society, they have the right incentives to make a decision that is good for society as a whole.

Now consider a rancher who grazes his cattle in pastures not owned by anyone. The benefit to society is the resulting cattle, and the cost to society is the grass they consume. For the rancher, however, things are different. The benefit to the rancher is that he gets to sell the cattle, but the cost to the rancher is zero, because he doesn’t have to pay for the grass his cattle use.

The result is that the rancher derives a much greater net benefit from raising cattle than society does, which means the rancher has an incentive to raise far more cattle, using up far more grass, than would be best for society. Society would almost certainly be better off with fewer cattle and more grass, which could presumably be put to better use in some other way. In the worst case, so many ranchers raise so many cattle that they consume all available grazing land, at which point they have to stop raising cattle. Because Brits call public land “common land,” British economist William Forster Lloyd called this “the tragedy of the commons.”

It’s not hard to find examples. Catching a fish means one less fish in the sea, which is a cost for society as a whole, but not for the boat that catches the fish, and thus we get depleted fisheries like the Grand Banks, which pretty much ran out of cod after a few decades of commercial fishing. Chopping down a tree means one less tree for anyone else to use, but in old-growth forests nobody had to pay the cost of planting and growing the tree in the first place, so logging on public land (such a North American frontier land) led to deforestation and limited growth due to lack of lumber.

Not all examples of the tragedy of the commons involve direct consumption. Consider traditional industrial pollution, with giant factories belching smoke as they grind out manufactured goods. The goods they produce are a benefit to the factory owner, who gets to sell them, and to society, which gets to consume them. But the pollution is a cost only to society, which has to endure foul air.

To understand how this is similar to the cattle grazing example, it can be helpful to think not in terms of the cost of pollution, but of the cost some resource being consumed. So don’t think of the factories as creating dirty air. Instead, think of them as consuming clean air. Just as cattle are the benefit from the cost of consuming grass, factory goods are the benefit from the cost of consuming clean air. And since the factory doesn’t have to pay for clean air, the net benefit to factory owners is much higher than the net benefit to society. This gives factory owners an incentive to build a lot more factories and produce a lot more pollution than would be best for society.

(Note that while factory owners do suffer from general pollution like everyone else, they don’t suffer significantly from their own decision to pollute. The costs are distributed over so many people that their personal share is tiny. The costs they impose on any single other person is also tiny, but that cost can be considerable when summed across the whole of society. Alternatively, the cost per person can get quite high when the tiny personal cost of each polluting factory is summed across many thousands of factories.)

Pigou proposed a solution to this mismatch of incentives: Charge the factories for the clean air they consume. No one owns the air, of course, but through its power of taxation, the government can nevertheless charge factories for clean air, just as if it was a production input like flour. Then if the tax on using clean air truly represents the cost to society when it loses that clean air, then factory owners will be facing the proper incentive structure so that decisions they make to benefit themselves will also benefit society.

Economists prefer solutions like Pigovian taxes over government regulations because they are more flexible. Regulations tend to specify rigid rules and lock in narrow solutions. For example, a prohibition on a certain type of high-pollution industrial process would force all users of that process to switch to something else. That might be fine for 90% of the industry, but for the remaining 10% it might be economically infeasible. The would either go out of business or lobby Congress do carve out an exception or perhaps make use of some kind of exemption system built into the law already. This can quickly become a confusing and unpredictable mess where businesses live or die based on whether they can get government permission to do things a certain way.

Pigovian taxes, on the other hand, apply a relatively simple tax rule and let businesses and the market figure out a solution. So instead of banning a high-pollution process outright, they just increase the cost of that process by taxing the pollution. Now each business can figure out how to respond to that increase in costs. Most businesses would likely switch to an alternative, but for the 10% that find it too expensive, they could remain in business if they were willing to pay the taxes. That’s not a problem if the incentives are right, because what the business is producing is presumably more valuable than the clean air being consumed.

Of course, if the taxes were too expensive, they would still have to go out of business. But then they were never really a successful business anyway — they were just getting away with it because they were getting to pollute for free. Once they had to pay the full cost of what they were doing, they were faced with reality: They had been a net loss for society, and now they were experiencing that loss for themselves.

Anthropogenic global warming is also a tragedy of the commons. People and industries are dumping carbon dioxide into the atmosphere, and the Earth is warming up because of it. That imposes costs on everyone in the world, but the people releasing the carbon dioxide experience none of that cost. My knowledge of climate science isn’t good enough to figure out what resource they are consuming for free (The Earth’s carbon recycling buffer? Its energy handling capacity?), but they are definitely not paying the full social cost of using fossil fuels. At least in theory, a Pigovian tax — the carbon tax — would fix that.

Naturally, there are objections:

A resolution declaring carbon taxes to be “detrimental” to the U.S. economy sailed through the Republican-controlled House this morning with the support of most — but not all — of its GOP members.

Somehow, this is treated as controversial. But of course carbon taxes will hurt the U.S. economy. We’ve been using fossil fuels for many years without paying the full cost. Once that cost is imposed, we will begin to change our energy production technology to use less fossil fuels, either through increased efficiency or by switching to an alternative energy source such as nuclear or solar. Since those were not our first choices, switching to them represents a loss. It would have to, since using the more expensive energy necessarily means spending less on something else.

The world economy, on the other hand, experiences a net gain due to the reduction in greenhouse gases and, consequently, harm from global warming. The U.S. experiences some of that gain too, of course, but only a fraction of it.

Another objection is that it will be hard to determine the amount of the tax, since we’re talking about changes that will happen all over the world and far into the future. Given how much the world economy has changed in the last 300 years, I don’t think we can make reliable economic projections that far into the future, which makes it hard to calculate the level of carbon taxation needed to balance the harm. Any estimate we make will be not much more than a wild guess. But maybe that shouldn’t stop us from trying.

Note that the benefits of Pigovian taxes are obtained when the taxes are enacted and the people burdened by the tax change their behavior to be more in line with society’s welfare. Except for the relatively tiny cost of administering the tax, there’s no change to government spending. So if we impose a carbon tax, what should the government do with the extra revenue?

Well, if the government doesn’t need the money, the default position of most economists is that we should make the carbon tax revenue-neutral by lowering some other taxes. Let the American people keep their money and spend it however they want.

There’s an argument, however, that carbon taxes will hit poor people especially hard because energy costs are a larger proportion of the cost of living for the poor. Even if that’s not the case, the increase in energy costs will still increase the cost of living, which poor people will be less able to tolerate. For these reasons, many people think the carbon tax revenue should be used to increase aid to the poor, either by focusing the tax breaks on the poor or by giving them money with direct payments. The Citizens Climate Lobby’s “carbon dividend” proposal is to distribute the money evenly to everyone:

Equal monthly per-person dividend payments shall be made to all American households (½ payment per child under 18 years old, with a limit of 2 children per family) each month. The total value of all monthly dividend payments shall represent 100% of the net carbon fees collected per month.

In other words, they want to use the carbon tax to fund a Universal Basic Income (UBI) scheme.

I hate this kind of proposal. Whether or not a carbon tax is a good idea has nothing to do with whether or not universal basic income is a good idea. They are separate and unrelated decisions. The federal budget has to balance over the long term, but there’s no policy reason for specific line items like carbon tax revenue and UBI expenditures to match. If we want the government to help poor people with the increased cost of living due to rising fossil fuel costs, our expenditures should be based on the amount of help they need, not on how much money we’re getting from a single revenue stream.

Linking revenue and expenses this way is usually a cheap trick to justify a tax increase by tying it to something wholesome, e.g. “for the children.” Furthermore, if the carbon tax works as intended, fossil fuel use will decline by design, and therefore funding for the UBI “dividend” will decline. That’s a perverse relationship which could have perverse consequences. Either we will allow the “dividend” to decline and become less effective, or else UBI supporters will lobby to increase the carbon tax to raise more revenue, neither of which seems very smart.

(Or we will do something really stupid, like subsidize oil drilling to encourage more revenue-generating fossil fuel use. If that sounds too dumb even for our government, remember that the government used to run an anti-smoking public health campaign at the same time it gave subsidies to tobacco growers.)

The good news is that all of this may not matter. Solar energy has gotten a lot less expensive to produce than it was when I was a kid buying hobby solar panels to run a radio. Some estimates of costs indicate that utility scale photovoltaic solar power generation is actually cheaper than conventional production, without even factoring in global warming. If that’s an accurate estimate, it won’t be long before utilities switch to solar power just because it saves them money. Then we won’t need a carbon tax or a carbon dividend.