Carbon Tax is the Better Solution

For many years we have had a debate about how to solve the problem of fossil fuel pollution. We have seen many topdown micromanaging regulations, such as limits on the miles-per-gallon in new automobiles, lightbulb regulations, subsidies to “green collar” industries, and others. A debate also exists about the proper replacement for fossil fuels, whether it be solar, wind, geothermal, nuclear, etc... Right now, Congress is considering cap-and-trade, which would limit the amount a pollutant can be used, in this case, carbon. Companies would need to have carbon credits to pollute, and the credits represent one ton of carbon dioxide. If companies wish to increase their pollution, they would need to buy credits from those who pollute less than their credits allow. All these policies might be better than nothing, but that says very little. A carbon tax is the better solution, due to its incentives and the fact that it treats the disease, not the symptoms.

Whenever we have a problem, and whenever we are proposing a solution, the first question to ask is, “What are the incentives?” For the problem, what incentive do people have to do what they are doing right now? For the solution, what incentives will this create, both for individuals and business, and for the government?

In this case, why do people prefer carbon-based energy sources? Because they are cheaper. Why are they cheaper? Because they cost producers less to produce. Why do they cost less to produce? Because they impose many of the costs on third parties. In other words, the buyer, seller, and workers are all better off from the transactions, but everybody else is worse off due to the increased fossil fuel pollution (technical term is externality). The more one can pass costs onto third parties, the more it makes “economic sense” to individuals to engage in the transactions. With other energy sources, people do not have that “luxury” and the costs are internalized, therefore costs more to those engaging in the transaction. The main reason carbon is more appealing now is that.

Cap and trade seeks to internalize the costs of carbon pollution. One way it can be implemented is to cap carbon emissions at their current level, and give credits to those who currently pollute in the amount they do, and allow them to sell any surplus credits they end up with (cap and trade). For example, Firm A has credits for 150 carbon tons, and Firm B has credits for 50 carbon tons. Let’s say the penalty for going over is $1,000 per excess ton. Firm A was able to get by with just 125 carbon tons, so it can sell the remaining 25 tons to Firm B, who is likely to go over its quota. Firm A sells the remaining 25 tons to Firm A for $750 per ton, for a total of $18,750. Firm A then make a profit of $18,750 and Firm B saves $6,250 ($25,000-$18,750). Another way is for government to cap emissions, then auction off every emissions credit, each to the highest bidder.

These ideas may sound great in theory, but then comes the first question: what are the incentives? With the first way, the government is rewarding those who polluted more by giving them more free pollution. Furthermore, it essentially puts new firms at a disadvantage, as they will need to buy all their credits from other firms. With the second way, those who pollute more now will pay more, which makes more sense. However, this puts a perverse incentive on government to continually increase the cap. If government gets revenues from the auction, it would then get more revenues if it allowed more credits to be auctioned off. Some have proposed mitigating that by requiring all revenues be redistributed back to citizens, as a citizens’ dividend (i.e. the oil dividend in Alaska). This would get rid of that incentive, but if government makes that law, government can repeal that law. For example, they could increase the cap one year to ease the deficit, keep the citizens’ dividend at where the cap was last year, and the rest goes to deficit reduction. But, if we ever learn anything from government, once they have a revenue source, they don’t give it up.

A better solution is a carbon tax. A carbon tax would tax the extraction of fossil fuels (coal, petroleum, and natural gas) based on how much carbon they emit. We are able to calculate how much weight of carbon each unit of each fossil fuel is able to produce, and we would tax based on that. For example, put a $28 tax per ton of carbon, or a $0.014 tax per pound of carbon. A firm that emits 2 tons of carbon would pay less than a firm that emits 20 tons of carbon. This way, those who pollute more would pay more. New firms would be on a level playing field with current firms. If the government has any incentive, it would be to increase the tax on carbon, reducing its use even more. That would not be such a bad thing.

Now, a tax on carbon should be distributed back to the people as a dividend to ease the regressive nature of the tax (in practice, the lower your income, the higher % of your income this tax hits). However, even if the government spent it as any other revenue, it still would not have a perverse incentive like with cap and trade. With cap and trade, the government gets money by allowing more carbon. With a carbon tax, the government gets more money by raising the cost of carbon. Sure, government would get more if the tax rate stayed the same but carbon usage went up, but government has no control over that. People and firms, on the other hand, control how much carbon they use, and taxes serve as a disincentive to them.

Unlike other policies, such as miles per gallon limits, bans on incandescent lights, and subsidies to various “green collar” industries, a carbon tax lets the market determine a winner. You may be thinking how, given a carbon tax puts the carbon industries at a disadvantage, right? No, right now government is making carbon industries the winner by letting them impose their costs on third parties. A game is only fair when everyone plays by the same set of rules. “Green collar” industries are not able to impose costs on third parties, not due to laws, but because their energy source does not result in it. With a carbon tax, everybody has internalized costs, everybody is playing by the same set of rules, and the outcome is fair.

“Green-collar” industries are not providing a public good, they are just not providing a public bad. Put another way, not stealing is not the same as giving. Subsidies for “green collar” industries suggest they are providing a public good, when they are not. The problem is not that, “green collar” are providing benefits to others that need to be internalized. Carbon industries are simply providing a public bad, or imposing costs on others, and that is the problem. The carbon tax is the best solution because it takes care of that, lets the market determine winners, and has the correct incentives.