Taxing Carbon?

After an absence of a decade, the carbon tax is back under discussion in the Congress--even if it might be a bit of a Trojan Horse this time around. However, much has changed since 1993's "BTU Tax" fight. Climate change was just emerging as an issue, then, and the price of gasoline stood at $1.10/gallon--the equivalent of about $1.45 in current dollars. Cheap fuel was our right. But with increasing numbers of Americans coming to accept that climate change is a big, looming problem, and the days of cheap gas apparently over, the response this time might just be "Why not?" instead of "Why?"

As my regular readers know, I believe cap & trade is the preferred mechanism for establishing a price on carbon dioxide and other greenhouse gases emitted to the atmosphere. However, I recognize that some very smart people have concluded that a carbon tax would be more effective and efficient, with its lower administrative requirements. Taxing emissions isn't such a bad idea, especially if you view this as a kind of tariff on legacy energy sources that were developed in a world in which carbon emissions didn't matter. After all, until the establishment of the income tax in 1913, the federal government got much of its revenue from tariffs. The biggest problem with this idea is not that it's a tax, per se, but that someone will have to determine its level. Set it too low, and the planet keeps warming for decades; too high, and the economy goes into a slump and even more industry goes to China, which is one-fourth as energy-efficient--and hence emissions-efficient--on average as we are.

This is where cap & trade shines, at least in principle. Markets do price discovery better than anything else ever invented. If you doubt that, look at eBay. Greenhouse gas emissions may not be Aunt Martha's antique china, but I defy anyone to calculate the correct level of carbon tax to reduce emissions by the desired amount without triggering a recession. (It wouldn't do that if it were truly revenue-neutral, but the chances of that seem even lower than the odds of a carbon tax passing in the first place.) Our models of the economy are good, but are they that good?

I also doubt we could gauge the right carbon tax level by observing the European cap & trade system, which implements an idea we talked them into during the negotiations for the Kyoto Protocol. The basis of comparison is weak, because the EU emissions trading system is too limited, and the European and US economies have significant sectoral differences. Nor can you look to European consumers for hints on how their US counterparts might respond to a carbon tax, since consumers in the EU haven't seen anything remotely resembling free market prices for transportation for decades, with the exception of discount air fares, and are already taxed to the hilt.

Whether Representative Dingell's proposal reflects a change of heart on this issue, or merely a prompt to his colleagues to acknowledge the costs of addressing climate change, there is much to recommend a carbon tax: it would be simple, transparent, predictable and relatively easy to assess. Its application would reveal the relative greenhouse gas contributions of our various energy sources, including corn ethanol, which would attract a higher tax than many might assume, when all its fossil fuel inputs are properly tallied. But I still see the determination of an efficient level for the tax as the fatal flaw in this idea. Perhaps a hybrid approach, with businesses subject to cap-and-trade and consumers paying a carbon tax based on the average emissions market level for the previous period, could overcome this shortcoming. In any case, the upcoming debate between advocates of these two mechanisms should be quite interesting to watch.