Some Thoughts on Carbon Taxes, Cap-and-Trade Programs, and Income Distributions

An alternative to the carbon tax, cap and trade programs, solves some of the distributional concerns of the carbon tax, but create another set of distributional problems. Most carbon cap and trade programs are similar: each program sets a carbon cap by issuing carbon permits to polluting firms. Each permit gives the firm the right to emit one ton (or equivalent) of carbon. High cost firms, that is, firms that have difficulty reducing carbon, might rather have a permit than pay high costs. If the firm recognizes that its cost of abatement is higher than the abatement cost of a lower cost firm it could propose a trade. The lower cost firm will be willing to sell a permit as long as the permit price exceeds the cost of removing an additional ton of carbon. A competitive permit market will result in a permit price equal to the efficient carbon tax.

Any cap and trade program must find some way to distribute the permits initially. A give-away results in a windfall to polluting firms. An auction generates revenue that must be redistributed.

In terms of the market failure, the social cost of carbon, both a carbon tax and carbon cap-and-trade will achieve the optimal abatement level at the minimum cost. The only difference is the distributional implications. The cost to the firm is lower for carbon cap-and-trade. The government receives tax revenue with a carbon tax. Both policies are preferred over technological or output standards (i.e., command and control regulation).

Proponents of carbon taxes like to say that taxes are preferred over cap-and-trade because taxes raise revenue that can be used to reduce distorting taxes on labor and capital. If a country has a budget surplus or a minor deficit, we'd say OK. But there is prima facie evidence that taxes on labor and capital are too low, not too high. In the U.S. we have a big budget deficit that is basically a big tax increase on our kids and grandkids. This big tax increase is discounted away, sure, but we think it is an important long-term problem, just like climate change.

If a carbon tax raises revenue, the additional revenue could be used to reduce the budget deficit. This dissolves the efficiency claims about a preference for a carbon tax over cap-and-trade. If carbon tax revenues should not necessarily be used to reduce taxes on labor and capital then it is no more efficient, due to additional revenue, than cap-and-trade.

One of the main objections, it seems, to the current cap-and-trade policies is that the permits might be given away, making money for those firms that receive them. We say big deal. We think the current income distribution is flawed, and Paul Krugman doesn't make our skin crawl.

Environmental and other policies (e.g., trade, health care, etc) affect income secondarily as well as the primary problem they are meant to address. It seems that we should worry much more about a policy’s primary effect, rather than secondary effects, such as effects on the income distribution. In that context, carbon cap and trade and carbon taxes are roughly equivalent.

John Whitehead
Professor
Economics
Appalachian State University
Co-founder, www.env-econ.net

Tim Haab
Professor
Agricultural, Environmental and Development Economics
Ohio State University
Co-founder, www.env-econ.net