Monday, January 5, 2009

Carbon Taxes - Nice Idea But They Won't Get The Job Done

Recently there has been renewed discussion in the US of using carbon taxes to reduce CO2 emissions. I should start by saying that of the various unilateral mechanisms this is probably the best idea. However if the goal is to solve the problem of atmospheric CO2 doubling this is a completely ineffective idea for a number of reasons. The first is that the amount of tax required would be far to high to be politically acceptable. The second is that even if that were accomplished in the US it would simply push energy consumption for manufacturing to other countries. Finally policies designed to keep that from happening are not practical.

As I stated a uniform tax is by far the best way to reduce CO2 output. It involves the least political meddling. It is easy to understand. And it would allow consumers and industrial users to make optimal choices about the best way to deal with the new circumstances. So if our goal is to reduce CO2 output by a modest amount over the coming decades then I vote for a carbon tax. But there is no way this will get close to getting the job done.

Assuming that we don't take any steps other than those that reduce CO2 output we need to reduce that output by at least eighty percent globally from current levels in the fairly near future. But putting off the global discussion for a moment we can take a look at what type of tax would be necessary to achieve an eighty percent reduction of CO2 output in the US alone.

The people proposing this seem to be ignoring the fact that there is already some limited experience with carbon taxes. The US and Europe have taxes on gasoline. Of course they are much higher in Europe. Also Europe has, since about 1999, implemented some limited forms of carbon taxes. A discussion of these taxes and the results can be found in the AR4 WG3. Specifically the taxes levels are discussed on page 481, and a discussion of the results can be found on page 756. The WG3 report can hardly be viewed as optimistic on the issue.

As an example in the UK a roughly 10-20% tax was placed on the industrial use of power from various sources. Even at that level there wasn't the political will to include all power users. The experience was similar in Germany where heavy users were exempted. In the case of the UK the estimate is that this reduced consumption by about 2%, which is a bit short of the 80% goal.

There has also been quite a bit of research on the price elasticity of energy. As one might expect the elasticity is pretty low. Even the recent experience of the massive increase in the price of oil showed that figures of -.20 might be high. (This would mean a .2% decrease in use for each 1% increase in the price.) Even using this figure the price of energy would have to quadruple in order to reduce the use by 80%. This would mean a tax rate of 300%. I'll hold my breath waiting for someone to propose that. You can take your pick of what tax rate would even be possible, but if one could be passed I am certain it will be nowhere near high enough to even move the needle more than say ten points. And that would probably be political suicide.

Here is the IPCC take on energy price elasticity;

The effect of energy taxes depends on energy price elasticity, that is the
percent change in energy demand associated with each 1%
change in price. In general, residential energy price elasticities
are low in the richest countries. In the UK, long-run price
elasticity for the household sector is only –0.19 (Eyre, 1998), in
the Netherlands –0.25 (Jeeninga and Boots, 2001) and in Texas
only –0.08 (Bernstein and Griffin, 2005).

I should note that it is a clear understanding of this equation that has caused the Europeans to try cap and trade to achieve their CO2 reduction goals. This is a kind of hidden tax with many disadvantages. But its biggest advantage is that it isn't called a tax. I think we are already seeing the problem however. If they set the targets low enough to have a significant effect, then they wind up backing down. But cap and trade is a discussion for another time.

Some make the argument that a tax would spur development of technologies that would get us some or all of the rest of the way. It certainly would cause some substitution of more expensive non carbon producing energy. This is a part of the long term elasticity, which is probably somewhat higher than the studies quoted above would indicate. I don't know that there is any evidence that it would cause the alternatives to get cheaper. Perversely it could have the opposite effect as the incentive to make alternatives less expensive would be reduced.

But even assuming that we could impose this carbon tax, and it did over time achieve the desired result in the US, it would have almost no effect on global emissions. After all this wouldn't slow CO2 output anywhere else. To make matters worse it is likely that a good portion of the reduction in the US would be achieved by exporting CO2 output to other countries. To be effective a carbon tax would need to be global in addition to being very large.

Some have proposed solving this portion of the problem by taxing imports from countries that don't tax carbon at least as high as we do. This has three problems. It is unworkable, it would likely cause a trade war, and it won't achieve the objective. (In the following paragraphs I use China as a proxy for the entire developing world.)

It is unworkable because there is no way of knowing the energy content of something being imported. Would we have a giant bureaucracy that assesses every item from every "non-compliant" country? How could they know whether the energy for a particular product was from a produced at a Chinese coal plant, or from Three Rivers Dam? If they don't differentiate then where is the incentive for China to use clean power, it is just an import tariff on Chinese goods. So China would still want to produce goods using the cheapest possible power. I guess we could assess China's overall CO2 output per unit of energy and hit every product based on our estimate of the amount of power it takes to produce. But that provides no incentive for energy efficiency, and it does provide a lot of incentive for obfuscation and argument. And we would have to make these types of judgments for every country, and every product. It is hard to imagine anyone thinking that this is practical.

The likely effect of this type of policy would be a trade war. The countries hit by this "energy tax" would view it as a tariff. Even among countries that think a tax is a good idea there would be endless arguments over the right amount of tax for various energy inputs. In retaliation they would impose tariffs on US goods and investments etc. For the results of this take a look at Great Depression in Wikipedia.

Finally it wouldn't achieve the objective. Even if China quietly accepted our tariff it wouldn't cause them to emit less CO2 it would just increase the costs of imports. We aren't China's only market and if their other customers don't coordinate then we wouldn't have that much influence. In fact the history of these kinds of things is that other countries would use this to gain advantage in the Chinese market.

Some have commented on the fact that things like VAT on imported items have been imposed without issue. There are two fundamental differences between a VAT and a carbon tax. First VAT is imposed based on the type of item not on the inputs to the manufacturing of the item. Second VAT on imports normalizes a tax regime relative to domestic products rather than penalizing foreign products.

The fact that VAT is based on the type of item is a crucial difference. When the item is coming into the country it is easy to see if it is a car, or clothing, or furniture. So it is feasible to determine the amount of tax that needs to be charged to normalize it with products manufactured domestically. In contrast there is no way to tell the amount of carbon that was output in the manufacture of a particular type of product, and so no reasonable way to impose a carbon tax on that item.

Without the ability to tax based on the carbon input to a particular item, which is the whole point of a carbon tax, we are left with the idea of taxing everything from a foreign supplier based on some conceptual level of carbon used in their manufacturing processes. We could then try to distinguish between the energy inputs on various categories of products, and tax them based on that concept. But at the end you are left with what is essentially a tariff on products from that country. Presumably you would be willing to negotiate the tariff lower based on your conclusion about their progress on carbon intensity, but this is much more political than economic.

In the end what you are trying to do is to get them to implement a carbon tax so that you will remove a burdensome import tariff. Trying to change the political and economic decisions in other countries using tariffs is essentially economic warfare. The long run outcome is very uncertain, and in the short run is likely to cause tariffs to be imposed in response with negative consequences.

I also comment that the VAT on imports doesn't have the same effect as a tariff politically because it is seen as creating a level playing field between imported and domestic products. As long as the same VAT is applied to domestic products of a similar type, then the foreign country is unlikely to feel the need to retaliate. This is a different response to a tariff where the foreign products are put at a disadvantage to domestic products.

One commenter brought up something like the Green Dot system which started in Germany. Again the difference is that at the time of importation it is easy to monitor compliance. Whether something is packaged, and has paid a tax or fee based on that packaging is quite obvious. There would be no equivalent way to know that amount of carbon used to produce and transport the same product.

There are many taxes and regulations on imported products in many countries. On automobiles The US has certain smog regulations which don't exist other places as well safety regulations. Again this are possible to impose because the item being imported can be inspected to determine whether it meets the regulation.

So then in summary we are extremely unlikely to impose a tax high enough to achieve the eighty percent goal in any useful time frame. Even if we do this will achieve nothing unless it is coordinated globally which is even less likely. A carbon tax is a good idea to achieve small reductions in the US output of CO2. As a policy for stopping dangerous greenhouse warming it will not be effective.

So what should we do? Try to minimize how much we put in while we achieve the crucial task of finding a way to get the CO2 out of the atmosphere. I will write more about that in my next post.


  1. IMO the answer is a combined approach of a rising carbon tax and declining subsidies on all non-(fossil)carbon energy. The idea would be to set up a 20-year plan with a carbon tax that starts out somewhat inconvenient and rises to almost prohibitive over the 20-year time frame. All the proceeds would be allocated to subsidies on non-(fossil)carbon energy, allocated according to the amount of carbon tax collected and the current amount of non-fossil energy being generated. Administrative costs would either come from other sources, or be limited to some small fraction (e.g.5%) of the carbon tax receipts.

    For subsidies on fixed power generation, the actual energy should come from non-fossil sources, no exceptions. For vehicles and other mobile applications, the energy must not come from immediate burning of fossil carbon, but systems like batteries and fuel cells whose original energy came from fossil carbon would be allowed (although the carbon tax would be added into the cost of that recharging energy).

    This would provide a double incentive: the prospect of immediate high subsidies would spur investment in short term development, while the prospect of replacing the increasingly expensive carbon would provide for on-going investment in the more promising technologies. Note that the subsidies on rechargeable mobile systems, even if recharged by fossil-sourced energy, would spur the development of technologies that could later be used with non-fossil fixed energy sources.

    The major difficulty, of course, is creating a reliable 20-year commitment, avoiding major corruption or modification for local political agendas. I'm not sure this would be possible, but if it could, IMO it's a workable solution.

  2. Art,

    Thanks for commenting. It depends what you are trying to accomplish, but if the goal is global reduction in CO2 output, then your plan ignores the objections that I raised in my post.

    In many areas the CO2 output from a country imposing this tax would be exported to countries not imposing the tax, with no net gain and perhaps even a loss from shipping.

    It isn't possible to tax imports based on CO2 content because there is no meaningful way to calculate the CO2 content of an import.

  3. Obviously you have not read Eli Rabett's simple plan to save the world. To deal with the issue of how to tax imports Imports from countries that do not have an emissions levy would have the full levy imposed at the time of import. The base rate would be generic ones based on worst previous practices in the countries that do have carbon taxes, which would be reduced on presenting proof that the actual emissions were lower.

    This is similar in spirit to what the Germans did with their packaging levy (Green Point) which has the additional interesting point that it is not a tax as such, but no one will buy anything that does not display the "optional" symbol saying the packaging levy has been paid.

  4. ER,

    Thank you for making a specific comment. I did read your proposal some time ago and unfortunately consider it simplistic.

    The fundamental difference between VAT type taxes and carbon taxes is that the VAT tax is based on the type of item at each point of the process. The Carbon tax is based on an input that is no longer apparent at the time of importation.

    I will update my post to comment on this.

  5. A key component of your argument is the price elasticity of energy demand, and the fact that if US goes it alone without the rest of the world then action will be pointless.

    But surely the argument applies exactly the same to both tax and cap and trade? How can cap and trade achieve a given reduction in carbon emmission without raising prices exactly the same as a tax?

    The only difference you have pointed out in this post between cap/trade and tax is that a tax is easier to understand and less subject to political meddling (until they try and apply as many exceptions as apply to Australia's income tax code...)

  6. Thanks Michael,

    Cap and Trade is just a clumsier form of tax, so I agree it won't work either. They can each cause modest amounts of changes in a particular country, which might be useful. But neither one is any kind of practical solution to the large scale CO2 problem.