Mankiw On Cap-And-Trade

Greg Mankiw has a highly readable and quite balanced editorial in the Sunday Times about cap-and-trade.

Mankiw makes the point that the economists’ preferred solution to the problem of climate change would be a carbon tax. He notes that it allows the revenues collected from carbon emissions to be used by the government as offsets against other taxes in order to mitigate the negative economic effect of an extra tax while encouraging consumers to ramp up their efforts to limit their carbon output.

A cap-and-trade system in which the permits are auctioned provides the same opportunity, however, once you decide to pass out permits for free the scheme begins to fall apart.

From The Times:

The numbers involved are not trivial. From Congressional Budget Office estimates, one can calculate that if all the allowances were auctioned, the government could raise $989 billion in proceeds over 10 years. But in the bill as written, the auction proceeds are only $276 billion.

Mr. Obama understood these risks. When asked about a carbon tax in an interview in July 2007, he said: “I believe that, depending on how it is designed, a carbon tax accomplishes much of the same thing that a cap-and-trade program accomplishes. The danger in a cap-and-trade system is that the permits to emit greenhouse gases are given away for free as opposed to priced at auction. One of the mistakes the Europeans made in setting up a cap-and-trade system was to give too many of those permits away.”

Congress is now in the process of sending President Obama a bill that makes exactly this mistake.

How much does it matter? For the purpose of efficiently allocating the carbon rights, it doesn’t. Even if these rights are handed out on political rather than economic grounds, the “trade” part of “cap and trade” will take care of the rest. Those companies with the most need to emit carbon will buy carbon allowances on newly formed exchanges. Those without such pressing needs will sell whatever allowances they are given and enjoy the profits that resulted from Congress’s largess.

The problem arises in how the climate policy interacts with the overall tax system. As the president pointed out, a cap-and-trade system is like a carbon tax. The price of carbon allowances will eventually be passed on to consumers in the form of higher prices for carbon-intensive products. But if most of those allowances are handed out rather than auctioned, the government won’t have the resources to cut other taxes and offset that price increase. The result is an increase in the effective tax rates facing most Americans, leading to lower real take-home wages, reduced work incentives and depressed economic activity.

It appears as if cap-and-trade’s passage is problematical at best. As it’s currently drafted it is, in my opinion, a mediocre effort of addressing the problem. In good economic times it would be suspect, in these times it is simply unconscionable. Better to put it on the shelf and tackle the problem when the economy is better able to withstand the shock that the current legislation would entail or redraft it to make those tax effects more neutral.

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