Cap-and-Trade and Econ 101

May 31, 2008

Next week, the U.S. Senate will debate the Lieberman-Warner bill, which would impose a cap-and-trade type system on U.S. producers that emit carbon. A well-designed cap-and-trade system that properly auctions off the rights to emit carbon is a de facto carbon tax. Supporters of cap-and-trade in the political arena rarely admit this because the word “tax” carries a negative connotation, whereas “regulation to protect the environment” sounds good to voters, even though both policies are designed to raise the price of energy consumption and production. This issue is very similar to other regulations that are typically off-budget such as the minimum wage, which is essentially a tax legally imposed on employers (and borne by consumers, owners of capital, and some workers) in order to redistribute income to low-wage employees. Its efficacy has been debated throughout the economic literature, but from an economist’s perspective there is little dispute that it is an off-budget equivalent to a tax/spend policy. (Legally, it’s not a tax.)

To analyze the cap-and-trade system and its soundness in terms of fiscal policy, policymakers and the public need to take a step back to the first day of Economics 101. Suppose there is a bag of potato chips. I want to eat those chips, but you have the legal rights to the bag. I cannot just take your bag of chips without compensating you. My taking the chips would make you worse off, so I must pay you for the right to decrease your potato chip consumption and therefore your well-being. There should be no dispute here, as long as we acknowledge the role of property rights.

The problem arises when property rights are less clear, as is the case with the environment. My driving a car that emits pollution and damages the environment hurts your well-being and that of every other person in society by some small amount, but you have no ownership over the environment. Unlike the potato chips where my taking the chips from you without compensation is illegal due to well-defined property rights, there are no such property rights with the environment. This is the famous “tragedy of the commons.”

In the absence of well-defined property rights, government regulation or a tax (subsidy) can improve societal well-being. Now, this does assume that government has sufficient information and capabilities to formulate welfare-enhancing environmental policies, and that government will actually be concerned with maximizing social well-being rather than some special interest. The government would be essentially establishing a quasi-market for a product that has no personal property rights. And in this quasi-market, I must pay the government (which is essentially the property owner acting as an agent on behalf of everyone else in society) for the right to harm everyone else.

There are other issues at play here, including uncertainty regarding the degree to which human action ultimately harms the environment, as well as the fact that a similar tragedy of the commons could occur on a global stage if the U.S. acts to combat climate change when other countries do not, possibly creating a race to the bottom. It is worth asking whether the U.S. would improve its own welfare by acting on its own.

Here’s one final point that is often overlooked by both sides: the economic indicators that we currently use do not measure societal welfare. When many conservatives point out the potential lost GDP from a cap-and-trade system or a carbon tax, they typically ignore the fact that GDP does not take into account the lost welfare from environmental damage caused by production. While figures quoting the lost GDP that would result from the imposition of a cap-and-trade system are useful, they rarely mention, even in passing, the environmental gain. Any first-year student of macro economics learns about this difficulty when introduced to national income accounting. The purpose of the income earned from GDP itself is to increase consumption and ultimately utility, but GDP does not measure everything that affects individuals’ well-being.

If there were a government policy instituted for three months that required every person to work at least 16 hours per day during that time period, GDP would temporarily increase dramatically. But leisure would be essentially non-existent, and actual societal well-being would fall dramatically. The same can be said for the environment. Due to the tragedy of the commons, lower output (as measured by GDP) could actually improve societal well-being because, after all, the tragedy is a result of overproduction from the perspective of society’s welfare as a whole.

On the other side of the aisle, we often hear talk of the number of “green jobs” that would be created by such a policy. Such talk is ridiculous too. The purpose of environmental regulation is not to create jobs; it’s to improve societal well-being by reducing emissions. Of course, any time a tax (or its equivalence) on one item is imposed, it will alter behavior. (It’s nice to see some liberals finally acknowledge that.) But in the short to medium run, the number of green jobs added from cap-and-trade would likely be lower than the number of total jobs lost due to the fact that production overall would fall (which, as pointed out above, isn’t necessarily bad).


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