Mankiw on Taxes and Global Warming

September 17, 2007

Greg Mankiw, founder of the Pigou Club, had a column in the New York Times on Sunday describing the issue of using government policy to curb greenhouse gas emissions. From the New York Times:

In the debate over global climate change, there is a yawning gap that needs to be bridged. The gap is not between environmentalists and industrialists, or between Democrats and Republicans. It is between policy wonks and political consultants.

Among policy wonks like me, there is a broad consensus. The scientists tell us that world temperatures are rising because humans are emitting carbon into the atmosphere. Basic economics tells us that when you tax something, you normally get less of it. So if we want to reduce global emissions of carbon, we need a global carbon tax. Q.E.D.

Mankiw also shoots down the argument for mandated fuel efficiency standards, and he goes on to describe the issue of whether to use a carbon tax or a system of cap and trade.

Another popular proposal to limit carbon emissions is a cap-and-trade system, under which carbon emissions are limited and allowances are bought and sold in the marketplace. The effect of such a system depends on how the carbon allowances are allocated. If the government auctions them off, then the price of a carbon allowance is effectively a carbon tax.

But the history of cap-and-trade systems suggests that the allowances would probably be handed out to power companies and other carbon emitters, which would then be free to use them or sell them at market prices. In this case, the prices of energy products would rise as they would under a carbon tax, but the government would collect no revenue to reduce other taxes and compensate consumers.

One of the assumptions inherent in all these proposals is that the government has some information to set the optimal cap-and-trade system or the optimal carbon tax rate, and that the government can measure the negative externality. On average, the scientists and economists advising the government may be right. (There is no reason to believe that there would be systematic biases in one direction or another.) However, there could also be a large variance in the estimations, leading to possibly huge negative consequences in either direction if the government is wrong (such as huge losses in economic output or destructive ramifications from global warming). Either way, if expected harm from global warming does exist, then we may be doing too little right now, but when the variance comes into play, whether we are currently doing too little would also depend upon society's preference for risks and time value of money.

So which would require the government to know more information -- cap and trade or a carbon tax? It depends on what we are trying to maximize. If the government merely sets a pollution amount and wants to hit that target, then obviously cap and trade is optimal. However, if government is attempting to maximize social welfare in the traditional welfare economics framework, then there are certain cases where the information requirements to establish an optimal carbon tax are actually smaller than the informational requirements to establish an optimal cap and trade quantity.

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