Sunday, March 08, 2009

Cap & Trade-The Worst Kind Of Carbon Tax

Obama will now implement various measures to fight what he believes is the threat of "climate change". Among those are his "Cap and trade scheme" that he for example explicitly mentioned in is remarks to the joint session of Congress.

An alternative approach to "cap and trade" is a straightforward carbon tax. As I've already pointed out, "cap and trade" is simply a euphemism for an alternative form of carbon tax. What is then the real difference between "cap and trade" and a straightforward carbon tax? The difference lies in what element is fixed and what is variable (what will fluctuate).

It is a basic truth within macroeconomics that monetary policy makers can only fix one target at the time. If they try to fix exchange rates, then they'll have to let consumer price inflation and money supply growth fluctuate. If they try to target consumer price inflation, they'll have to let money supply growth and the exchange rate fluctuate. If they target money supply growth, they'll have to let the exchange rate and consumer price inflation fluctuate.

This conflict also exists for politicians that try to reduce carbon dioxide emissions through economic incentives (taxation). Either they'll have to fix the amount that emissions will be reduced and let the incentive fluctuate. Or they'll have to fix the incentive abnd let the emission reduction fluctuate.

In a "cap and trade" scheme the emission reduction is fixed, so fluctuations in demand for emissions will result in fluctuations in the tax on emissions. In a straightforward carbon tax, the tax rate will be fixed so fluctuations in demand for emissions will result in fluctuations in actual emissions.

Which scheme is preferable, or which scheme is the lesser evil? "Cap and trade" is the worst of the two because they create an unnecessary (artificial) economic cost. Leaving aside the issue of whether really emission reductions are a worthwhile goal, we have to ask which scheme produces the greatest economic cost. While uncertainty about prices is necessary in many cases in order to avoid excess surpluses or shortages of goods and services, it is nevertheless always a bad thing in itself, which is why artificial uncertainty (that do not fill any function) is a bad thing, period.

"Cap and trade" creates such an artificial uncertainty for market participants. Remember, the difference between "cap and trade" and straightforward carbon taxes lies in what is uncertain, the price (tax) or the amount of emission reductions. While short-term fluctuations in emissions shouldn't be a problem for the politicians, short-term fluctuations in price is an example of the kind of artificial uncertainty that produces an economic cost as companies can't be sure of how much the tax will cost them, and they will therefore refrain from investments which will likely but not certainly be profitable.

So, while "cap and trade" and a straightforward carbon tax will not (need not) create any difference in the level of emissions, "cap and trade" will for any given level of average emissions impose a greater economic cost.

But if "cap and trade" produces a greater economic cost, why do Obama and many other politicians push for it? The most likely explanation is that "cap and trade" sounds better from a political point of view. Obama frequently claims that he will not raise taxes for anyone with a family income of less than $250,000 a year, an assertion that is false for several reasons, including his planned "cap and trade" scheme". But since "cap and trade" doesn't sound like a tax, Obama thinks he can get away with that lie, while he knows that anyone would recognize a straightforward carbon tax as a tax.

But make no mistake-"cap and trade" is a tax that you will all have to pay, and it is a tax that will damage the economy even more than most other taxes.


Blogger earth that was said...

A timely comment. The Australian government is just about to introduce a Cap and Trade system. Here is climate minister Penny Wong arguing Cap and Trade is better than Carbon Tax. She argues that C&T is more "predictable" and can "guarantee" reductions. Whether C&T is ultimately more effective than Carbon Taxes is not clear.

Of course, C&T as you point out is more effective at obscuring the source of the pain. Always a political bonus that.

11:35 AM  
Blogger Ke said...

Stefan, besides the Cap and Trade tax, what other forms of tax hikes is Obama planning?

6:08 PM  
Blogger stefankarlsson said...

Ke, he has already signed an increase in the tobacco tax.

And he proposes a repeal of all of the Bush tax cuts, plus limiting deductions for high income earners, which will in effect raise the marginal rate of taxation.

Plus he proposes various changes to the corporate income tax which in effect raises it, by for example not permitting LIFO (Last In First Out) inventory value accounting anymore. Oil companies will get additional tax increases on top of that. The latter will pf course further reduce U.S. oil production, but in light of their environmentalism, they likely think that is a good thing.

11:15 PM  

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