A pair of Democratic senators just announced legislation that would tax carbon emissions and use the proceeds to fund clean-energy projects and provide rebates to consumers. They know the bill is almost certain to fail in the GOP-majority House. When it does, it will set the stage for the executive actions on climate that President Obama promised during Tuesday's State of the Union address.
Any bill that prices carbon, even if the revenue is used to offset other taxes, will be shot down by congressional Republicans. But the carbon-tax issue puts the GOP at odds with many of their own party's economic thinkers.
A number of the nation’s leading conservative economists, who as a rule do not like taxes, are touting a federal carbon tax. That group includes Gregory Mankiw, a former Romney adviser and George W. Bush-era chairman of the Council of Economic Advisors; Douglas Holtz-Eakin, Sen. John McCain’s 2008 chief economic adviser; and Art Laffer, progenitor of Reagan’s treasured Laffer Curve.
Such a tax could raise an estimated $1.5 trillion over 10 years and help wean the country from carbon-intensive fuels. And with Congress set for a season of budget fights and Obama renewing calls to overhaul the tax code, the carbon tax is likely to keep popping up.
So, it’s worth understanding why the economics of a carbon tax might make it appealing to some conservative economists, and why many political arguments about taxes don't apply to it.
A "Pigovian" Tax
A carbon tax is a special kind of tax called a "Pigovian" tax, named after 20th-century British economist Arthur Pigou.
Normally, a competitive market produces just the right amount of a good. If there are not enough people selling glue, its price will rise and people will cash in by selling more glue. If too many people are selling glue, the price will go down, and some people will find it’s not worth their while to sell glue anymore. Either way, the market should settle at the point where the cost of producing more glue is equal to the value people place on that additional glue.
But Pigou realized that if a producer wasn’t paying for the full cost of producing a good, they would produce too much of it anyway and everyone else would foot the bill. Imagine that making glue is expensive because it costs a lot to cart away all the horse carcasses used in its production. There’s not going to be a lot of glue because only people who really like glue will be willing to pay to produce it.
Now imagine that instead of carting away the dead horses, glue factories realize they can dump them in nearby rivers for free. All of a sudden, it becomes a lot cheaper to make glue, so the price goes down. At a price like this, you can’t afford not to buy glue, so people consume more of it, and new glue factories pop up.
It all looks like economic growth, until the dead horses start piling up, and people start getting sick. Then they get a bunch of medical bills and the government has to spend money cleaning up the river. The sticky-fingered glue barons don’t mind much, because they can afford to buy the expensive houses upriver, and when the cost of cleanup gets spread to everyone, the cost to them is a pittance compared to their newfound glue fortunes.
Meanwhile, the tape users are fuming. They’re getting sick from glue they don’t even use, and the horse-dredgings are driving up their tax bill. And because a bunch of the former tape-makers have jumped on the glue bandwagon, there’s now a tape shortage. It’s a mess.
When you account for the costs of sickness and cleanup, each tub of glue costs $20 to produce. But the glue factories don’t pay for this, so they can sell glue at a going rate of $12. Glue that’s only worth $12 is being made at a cost of $20, so $8 is being wasted on each new tub of glue.
In this case, Pigou would prescribe an $8 tax on glue. Now, it costs glue factories $20 to produce glue, and only people willing to pay that much for glue will buy it. Less glue is produced, so fewer dead horses end up in the river, and the revenue raised from the tax can be used deal with the problems caused by the ones that do.
How It Works in the Energy Market
The dysfunctional glue market looks a lot like the current energy market.
Carbon, like the dead horses, creates what economists call a negative externality. A negative externality is the cost of an economic transaction that’s not borne by either the buyer or the seller, and is instead pushed onto society. It distorts markets and leads to inefficient outcomes, such as producing $12 worth of glue for $20.
A Pigovian tax corrects for a negative externality by making sure buyers and sellers pay the true cost of a good or service.
In this case, high-carbon fuel looks cheap on paper, because the costs to the producer don’t include the costs of global climate change or dependence on foreign oil. So, too much high-carbon energy is consumed. The producers don’t mind, because the extra costs are spread to everyone, while much of the benefit accrues to them. The people who use the most fossil fuels also benefit from buying lots of underpriced energy. Meanwhile, residents of places like New York and New Orleans, who don’t consume all that much carbon, pay the costs of the uptick in extreme weather that scientists say is linked to carbon emissions.
A tax on carbon would raise the price to include the trust cost of burning it, so that the economy doesn’t end up producing $12 worth of energy at a cost of $20.
By making carbon emissions more expensive, it would cause them to decrease. It would also lead to increased use of low-carbon energies — natural gas, wind, solar — which suffer from society’s de facto subsidy of carbon emissions.
Why It Appeals to Conservative Economists
So, why do some conservative economists who normally oppose new taxation support a carbon tax? Because a carbon tax, like any Pigovian tax, taxes something we want less of. And when you tax something, you get less of it. Even for the remaining cohort of climate-change deniers, Mankiw lists a slew of other downsides to carbon emissions in his Pigovian manifesto.
Taxes on alcohol can also be considered Pigovian taxes, because alcohol consumption can have harmful effects for society because it can contribute to crime and lost productivity at work. Taxes on cigarettes fit the bill, too, because of the public health costs of tobacco use.
But most taxes, especially at the federal level, tax things we want more of: labor, investment, business activity.
Depending on how broadly or narrowly you define economic growth, these taxes either arguably or definitely hurt growth.
But a Pigovian tax creates economic growth by allowing markets to allocate resources more efficiently. Think of all the wasted resources that went into making those jars of glue that cost $20 but were only worth $12. When the market produces the right amount of glue, those resources are freed up for more useful purposes.
Liberal economists tend to like a carbon tax, too, but usually differ with conservative economists over what to do with the revenue. They’re more likely to see the revenue as an opportunity to extend government services, subsidize alternative energy, or, in the current economic environment, pursue some other form of stimulus.
Conservative economists are more likely to advocate using the revenue to lower rates on other taxes, give everyone a tax rebate, or pay down the deficit. It’s these latter uses that are likely to dominate the discussion of a carbon tax in the coming months.