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Understating the Economic Cost of a Carbon Tax

Politics / Climate Change Feb 03, 2011 - 11:29 AM GMT

By: Robert_Murphy

Politics

Best Financial Markets Analysis ArticleIn a recent article in the Wall Street Journal, Alan Blinder listed numerous alleged benefits of a phased-in carbon tax. Out of his entire column, he devoted a single sentence to the possible downside of his plan when he wrote, "No one likes to pay higher taxes." A more balanced assessment shows that a carbon tax presents very real dangers, even if we rely on the same economic analysis that so enthralled Blinder.


Spurring Innovation through Higher Taxes?
Here's Blinder explaining the economic benefits of a carbon tax that starts out low, but will eventually become quite steep:

Once America's entrepreneurs and corporate executives see lucrative opportunities from carbon-saving devices and technologies, they will start investing right away — and in ways that make the most economic sense. I don't know whether all this innovation will lead to 80% of our electricity being generated by clean energy sources in 2035, which is the president's goal. But I can hardly wait to witness the outpouring of ideas it would unleash. The next Steve Jobs, Bill Gates and Mark Zuckerberg are waiting in the wings to make themselves rich by helping the environment.

We should also be clear that Blinder's argument for job creation does not rely on the "negative externalities" of carbon emissions. Earlier in the piece, he made a list of the "few nice side effects" that would result from a carbon tax: "reducing our trade deficit, making our economy more efficient, ameliorating global warming …" Because he puts global warming at third in the list, we see that there is nothing peculiar to greenhouse gases behind his main argument for job creation.

No, Blinder is making the simple observation that if the government imposes artificial costs on the current way businesses operate, then the market will respond to the new handicap and end up generating new products and techniques along the way.

This analysis is true, as far it goes. But the same could be said for any new government policy that made it illegal for businesses to continue operating in the ways that they currently find the most efficient. For example, if the government promised to impose stiff taxes on nails and screws over the next few decades, that would certainly cause entrepreneurs to see "lucrative opportunities" in developing do-it-yourself furniture that used only wooden pegs and glue. But obviously consumers would be worse off because of the less convenient and/or more expensive products.

This is basic economics: you don't make the country richer by taxing it, or by taking options away from industry. If investors pour money into carbon-reducing technologies under the threat of a future carbon tax, there is correspondingly less investment available for other technologies.

Dealing with Negative Externalities
Of course, advocates of a carbon tax claim that there is a special reason to penalize carbon emissions, as opposed to nails and screws. They argue that because emissions of carbon dioxide (and other greenhouse gases) may eventually lead to significant damages from climate change, entrepreneurs currently are not taking all of the costs of their actions into account.

Even if we concede this framing of the issue, it still does not follow that economists should favor a new carbon tax. Ironically, we can use the same researcher — William Nordhaus — upon whom Blinder based his own case.

It is true that Nordhaus himself favors a carbon tax. In the 2007 calibration of his "DICE" model of the global economy and climate system, Nordhaus estimated that the theoretically optimal carbon-tax regime would reduce (the present value of) climate damages by about $5 trillion, at the cost of about $2 trillion in lost economic output. This is why Nordhaus favors such a policy — its theoretical benefits exceed the costs by up to $3 trillion.

However, this figure assumes all governments around the world implement the tax. If some governments cheat, then the alleged benefits shrink, as some of the emissions simply migrate from the high-tax to the low-tax areas.

Nordhaus's calculation also assumes that governments implement the economically optimal carbon tax. If the tax is set too high, however, Nordhaus's results demonstrate that the cure can be much worse than the disease. For example, when Nordhaus simulated the impact of limiting atmospheric concentrations of CO2 to 1.5 times their preindustrial level, he found that it would make the world more than $14 trillion poorer than if governments did absolutely nothing to regulate emissions. This is because the simulated $13 trillion in benefits from avoided climate damage were swamped by $27 trillion in reduced economic output.[1]

A Carbon Tax Involves Economics, Not Just Natural Science
The proponents of a carbon tax (or "cap and trade") continuously point out that there is a "consensus" on the natural science linking human activity to rising global temperatures. But the economic arguments, needed to show that the benefits of a carbon tax outweigh its costs, are far less conclusive.

For example, in the spring of 2009, Richard Tol published a survey of comprehensive studies of the global "welfare impacts" of climate change.[2] His list of these impacts included, not just appraisals of direct economic harms, but also attempts to value (in dollar terms) intangibles such as human health and mortality. Of the 13 studies Tol surveyed, the best-guess estimate of global GDP impacts ranged from a loss of 4.8 percent to a gain of 2.5 percent. Most of these impacts were calibrated for temperature increases of 2.5 to 3.0 degrees Celsius, which are not expected to occur until the second half of the 21st century. (Currently the globe is about 0.8 degrees Celsius warmer than the preindustrial benchmark.)

Tol found that, of the 11 studies that had been published since the year 1995, the most grim estimate was a global GDP loss of 1.9 percent. To put that number in context, in a 2009 report the Congressional Budget Office estimated that an 83 percent cut in emissions — the long-run cap proposed under the Kerry-Boxer bill — would reduce US GDP in 2050 from 1.1 to 3.4 percent.[3]

To repeat, the damages in Tol's survey were calibrated for a particular range of temperature increases, and in reality it's always possible that global warming could be worse by, say, 2085.

But using reasonable projections of what is likely to occur, the economic case for a carbon tax is not nearly the slam dunk that Blinder implied in his article. To reiterate my argument, I am conceding the basic framework of "negative externalities" and peer-reviewed models of the harms from climate change. And still, once we factor in the obvious possibility that governments will not uniformly implement the "optimal" tax, the case for intervention falls apart.

Conclusion
Alan Blinder is right that this country could use a burst of entrepreneurship and investment. But there are much more productive policies to stimulate investment than threatening future tax hikes.

Robert Murphy, an adjunct scholar of the Mises Institute and a faculty member of the Mises University, runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. Send him mail. See Robert P. Murphy's article archives. Comment on the blog.

© 2011 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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