If we impose carbon taxes and use the revenue to cut taxes elsewhere (e.g., corporate income taxes, capital gains taxes, or personal income taxes), does the economy improve on balance? Some economists think so, which is why carbon tax promoters often talk about a “double dividend” (one dividend from a carbon tax comes from reduced climate risks, the other, from increased wealth creation).
But some economists disagree. They maintain that “the tax interaction effect” will negate any gains that follow from such a tax switch. Stanford economist Lawrence Goulder explains:
Like all taxes on goods and services, a tax on coal is an implicit tax on factors of production. This is because the coal tax increases the prices of goods and services generally, which lowers the real wage and real return to capital. For a given nominal wage, for example, the increase in the overall price of goods and services constitutes a reduction in the real wage. Through this mechanism, the environmental tax is an implicit tax on labor.
Why should this matter for the overall costs of the coal tax? It wouldn’t matter much if there were no pre-existing taxes on labor or capital. But in the presence of such taxes (such as income, payroll, or sales taxes), it does matter … Existing taxes such as income, payroll, or sales taxes create a wedge between the marginal value of labor supplied and private marginal cost of labor supply … Now suppose that, in this situation, a carbon tax is introduced. This implicit tax on labor raises the labor supply curve further … This leads to a further reduction in labor supply … Associated with this further reduction is an additional excess burden or efficiency loss … This additional efficiency loss is termed the tax-interaction effect. It is the efficiency cost that stems from the carbon tax’s functioning as an implicit tax on labor (or, more generally, on factors of production). It may be noted that the tax-interaction effect is more pronounced the higher are the pre-existing taxes on factors (or, in the diagram, the more distorted the labor market is initially).
So would the tax interaction effect negate the wealth gains that would otherwise be associated with a tax switch? Who knows? Until we have more information about the efficiency losses associated with the existing taxes at issue, we have no way of knowing for sure.
The case for a well-designed carbon tax, however, remains strong even if Goulder is correct. If the tax cuts that accompany a carbon tax do not fully offset the economic cost of the carbon tax (producing the double dividend), they will still offset a not insubstantial chunk of those costs. A carbon tax is already a less costly means of securing greenhouse gas emission reductions than the command-and-control alternative. Carbon taxes will be even less costly than command-and-control once we figure in the gains from the tax swap (whatever they may be).
Why is command-and-control a more costly means of reducing greenhouse gas emissions than carbon taxes? Harvard economist Robert Stavins explains:
Conventional approaches to regulating the environment are often referred to as “command-and-control” regulations, since they allow relatively little flexibility in the means of achieving goals. Such regulations tend to force firms to take on similar shares of the pollution-control burden, regardless of the cost. Command-and-control regulations do this by setting uniform standards for firms, the most prevalent of which are technology-based and performance-based standards. Technology-based standards specify the method, and sometimes the actual equipment, that firms must use to comply with a particular regulation. A performance standard sets a uniform control target for firms, while allowing some latitude in how this target is met.
Holding all firms to the same target can be expensive and, in some circumstances, counterproductive. While standards may effectively limit emissions of pollutants, they typically exact relatively high costs in the process, by forcing some firms to resort to unduly expensive means of controlling pollution. Because the costs of controlling emissions may vary greatly among firms, and even among sources within the same firm, the appropriate technology in one situation may not be appropriate (costeffective) in another. Thus, control costs can vary enormously due to a firm’s production design, physical configuration, age of its assets, or other factors. One survey of eight empirical studies of air pollution control found that the ratio of actual, aggregate costs of the conventional, commandand- control approach to the aggregate costs of least-cost benchmarks ranged from 1.07 for sulfate emissions in the Los Angeles area to 22.0 for hydrocarbon emissions at all domestic DuPont plants.
Furthermore, command-and-control regulations tend to freeze the development of technologies that might otherwise result in greater levels of control. Little or no financial incentive exists for businesses to exceed their control targets, and both technology-based and performance-based standards discourage adoption of new technologies. A business that adopts a new technology may be “rewarded” by being held to a higher standard of performance and not given the opportunity to benefit financially from its investment, except to the extent that its competitors have even more difficulty reaching the new standard.
Carbon taxes remedy those problems. Again, Stavins:
In theory, if properly designed and implemented, market-based instruments allow any desired level of pollution cleanup to be realized at the lowest overall cost to society, by providing incentives for the greatest reductions in pollution by those firms that can achieve these reductions most cheaply. Rather than equalizing pollution levels among firms (as with uniform emission standards), market-based instruments equalize the incremental amount that firms spend to reduce pollution – their marginal cost. Command-and-control approaches could – in theory – achieve this cost-effective solution, but this would require that different standards be set for each pollution source, and, consequently, that policy makers obtain detailed information about the compliance costs each firm faces. Such information is simply not available to government. By contrast, market-based instruments provide for a cost-effective allocation of the pollution control burden among sources without requiring the government to have this information.
In contrast to command-and-control regulations, market-based instruments have the potential to provide powerful incentives for companies to adopt cheaper and better pollution-control technologies. This is because with market-based instruments, particularly emission taxes, it always pays firms to clean up a bit more if a sufficiently low-cost method (technology or process) of doing so can be identified and adopted.
Double dividend or not, the case for trading EPA regulations for carbon taxes is very strong.