Energy and Environment

Debate: The pros and cons of carbon taxes

Should a carbon tax, levied on the carbon content of fuels, be part of plans to combat global warming?

Philip Booth, the IEA’s Senior Academic Fellow, says YES

Almost every economics undergraduate is taught that if the marginal social cost of an economic activity exceeds the marginal private cost there should be a Pigouvian tax imposed. The market, after considering the tax, will maximise welfare.

Unfortunately, the world is not that simple. In practice, we need market exchange to determine the social cost of said activity. If we did know the value people placed on goods and services, central planning would work – but it is a catastrophe. So why would we know the ‘right’ value of the Pigouvian tax?

Secondly, there are issues of justice. Granted, a Pigouvian tax might move the market towards a better position from an economic welfare perspective, but will the people who have the social costs imposed on them benefit from the tax? Economists tend to assume away this problem and put it in a separate box, but we cannot easily do so. Of course, those affected will benefit from having less of the damaging activity, but it is unlikely they will be compensated.

Despite this, I would support a carbon tax – with strong conditions. The impact of carbon emissions is such that we cannot imagine a market dealing with the problem and their effects so dispersed that the transactions costs of market bargaining are simply impossible. This is not like my next-door neighbour building a factory and making a noise at 5am. My carbon emissions may be harming people in Bangladesh in 30 years’ time.

The problems caused by carbon emissions are potentially so great that if we have to choose between the binaries of no tax or some kind of carbon tax (however imperfect), I would choose the latter. True, a carbon tax could be set at the wrong level, might not work properly because it is not internationalised, might come with heaps of institutional baggage and so on, but faced with a binary choice between two sets of risks, I would rather choose to be exposed to the institutional risks of getting things wrong in the hope that it will reduce the impact of climate change.

But my conditions would be strict. It obviously should not apply to industries to which cap-and-trade already applies. Secondly, it should be proposed in a single bill which abolishes a range of other expensive (often counter-productive) interventions and reduces existing taxes. One advantage of a carbon tax would be higher emission reductions than from other policies at the same price. A carbon tax might lead me to insulate my home or refrain from heating under-occupied rooms, thus reducing emissions at a lower cost than by using expensive electricity generated from green sources.

The bill would also remove deliberate interventions designed to increase energy use and carbon emissions such as the reduced rate VAT on domestic energy. Domestic energy consumption is implicitly subsidised to the tune of almost 15 per cent. This is very bad economics even if you are not concerned about climate change.

Finally, we should consider exercising influence through international institutions and other channels to reduce the huge level of energy subsidy that exists elsewhere in the world. The total value of fossil fuel subsidies in the world is estimated at $300bn (and rising).

This fact alone demonstrates why some of us are so sceptical of government intervention. In response to perhaps the world’s most pressing public policy issue, appallingly-designed policies pull in opposite directions. I don’t hold out that much hope that things will improve. However, perhaps by putting everything in one big bill there might be a fighting chance.

NO, argues the IEA’s Director of Research Dr Jamie Whyte

The emission of greenhouse gases – CO2 from burning fossil fuels and methane from flatulent livestock – is warming the global climate. Let’s not quibble about this scientific consensus, even if there are grounds for scepticism. The question for economists is the proper policy response.

The standard view is that greenhouse emissions are a classic negative externality, and that a Pigouvian tax should be applied. For example, farmers should pay a “fart tax” for each cow they own. This would internalise the external cost of the farts, and cows would be farmed only when the total benefits of doing so exceeded the total cost.

This is preferable to a cap-and-trade system, because the cap is arbitrary. If the price of emitting CO2 under such a scheme were to exceed the external cost (the Pigouvian tax), then too little CO2 would be emitted.

Ronald Coase’s insights about managing external costs through private bargaining are irrelevant here because no one owns the climate and, even if such rights were assigned, the owners would be so numerous and dispersed that the costs of bargaining would be prohibitive.

But does anthropogenic global warming warrant a Pigouvian tax on the emission of greenhouse gases?

The first difficulty is estimating the external cost of greenhouse gas emissions and, hence, the size of the tax. Begin by noting that global warming will have benefits. Increased CO2 emissions have caused a great greening of the planet over the last 20 years. If the climate warms as predicted, vast tracts of land in Russia and Canada, now too cold for agriculture, will become arable. We should expect food to become more abundant and cheaper. More generally, the costs created by cold weather – heating, delays in construction work, etc – should decline. Many people like warm weather. They pay good money to travel to it. I would willingly pay £2,000 a year to make London five degrees warmer.

Of course, there will be costs too. Sea levels may rise, swamping some now inhabited areas. Some places may become too hot for comfortable habitation or agriculture (though these are sure to be smaller than the cold areas made usable). The number of storms may increase, destroying property and interrupting economic activity.

So what is the net cost? No one knows. They don’t even know if it is negative or positive. So they don’t know if greenhouse gas emissions should be taxed or subsidised.

This not an anti-science position. Scientists can predict physical outcomes (with varying degrees of certainty, which, in the case of climate science, is low). But they cannot predict economic outcomes. They cannot tell you the value of those physical outcomes. Global warming will have many effects – some positive, some negative – on a vast number of people with very different environmental circumstances, incomes and preferences. Anyone who claims to know the net aggregate value of global warming displays amazing overconfidence.

Some will say that ignorance itself gives us reason to impose the Pigouvian tax (at some arbitrarily chosen level, as is unavoidable given our ignorance). We should think of it as an insurance policy. The dire warnings may be true and, just in case they are, we should take measures to reduce emissions. Think of the tax as an insurance premium paid against the risk of global warming being net negative.

Yet this logic fails by simply reversing the argument. Global warming might benefit mankind. It would be a tragedy if we didn’t take the opportunity this presents. To avoid this risk, we should tax people to subsidise greenhouse gas emissions. Think of the tax as an insurance premium paid against the risk of missing out on global warming.

This ignorance argument against taxing or subsidising greenhouse gas emissions applies to many things with spill-over effects. Revealing clothes, for example. They affect people besides those who choose to wear them. Are these external effects positive or negative? The answer differs from beholder to beholder and context to context.

There is also a political problem to applying Pigouvian taxes to greenhouse gas emissions – namely, that it is likely to simply relocate emissions rather than cut them. A carbon tax applied in the US will shift (marginal) industrial production to places that don’t apply it. Carbon taxes are one of those cases where there is no point doing something unless (almost) everyone else does it too. Those who advocate applying one in their own country are implicitly committed to the idea that all other relevant countries will also apply one. But that is implausible. The gains from breaking ranks are too great.

Given our ignorance and the implausibility of a globally enforced Pigouvian tax, we should just wait and see. We can adapt to the ill-effects of global warming – relocating activities if need be or building sea defences – while taking advantage of the gains. And we can do this without incurring any immediate cost. Let future people, who will be richer than us, pay for the costs that may arise.

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

Former Director of Research

Jamie Whyte is the former Research Director at the Institute of Economic Affairs. Prior to joining the IEA, Jamie was the leader of ACT New Zealand as well as the Head of Research and Publishing at Oliver Wyman Financial Services. He has previously worked as a management consultant for the Boston Consulting Group, as a philosophy lecturer at Cambridge University and as a foreign currency trader.

4 thoughts on “Debate: The pros and cons of carbon taxes”

  1. Posted 12/11/2018 at 09:15 | Permalink

    A carbon tax set initially at a modest level and incrementally increased as experience of its effects become clearer is the way to go. But don’t underestimate the difficulties of implementation. The ‘carbon content’ of all products and services (including imports) would need to be estimated. In a similar way to VAT, carbon-added could be assessed and taxed but this is not an easy or simple job.

  2. Posted 14/11/2018 at 20:27 | Permalink

    Regarding who gets the compensation, a fee is being charged for the right to pollute a common resource. As such, that fee should be equally divided among society. If costs are being internalised, there is no need to pick out one group as recipients for that compensation.

    Jamie Whyte isn’t playing by the rules of fair debate. In the main, he is not arguing about the pro/cons of the mechanism of the Carbon Tax, but whether or not it is necessary. He says economists don’t know the net cost, but surely doesn’t mean they couldn’t give it a try? Indeed, lots of them have and published a large body of work on the matter.

    The most substantive point he makes is one of carbon leakage. However, it has to be put into the context that all governments need to raise taxes, and most do so from damaging taxes on output. So the worse that could happen it appears to me is a straight swap.

    As it happens, most countries, like China want to reduce fossil fuel consumption for many reasons, not just global warming. I really don’t think getting a competitive advantage from carbon leakage is a policy goal. Why else are they looking at carbon taxes/cap and trade themselves?

    Easy win for Prof Booth.

  3. Posted 07/03/2021 at 19:08 | Permalink

    Apart from the fact that this article does not actually provide an economic debate on the mechanism of the carbon tax, it seems that the author wishes to employ the victim-blaming phenomenon as an example of an economic transaction incurring an externality. The attempt to justify his misogynistic views only serves to discredit this article as an economic debate. The suggestion that nobody really knows the net costs of climate change and therefore we should ‘just wait and see’, is really a regressive and pointless conclusion from an economist. The suggestion that we can simply adapt to a warmer climate incurring no immediate costs exposes a clear disregard for those already disproportionately affected by rising temperatures in developing countries.

  4. Posted 07/09/2021 at 23:18 | Permalink

    The carbon tax is the most equitable method for carbon use to pay for its pollution.
    The system needs to be employed by law similar to other sin taxes on alcohol, tobaccos, and even sales taxes.
    The tax rate on carbon products should be attaches to objective CO2 tonnage contributed to the atmosphere. An Objective authority “EPA” would establish the standards and the measurement. The taxes would be implemented gradually, in order for the economic adjustments can be gradual, progressively increasing over time .

    The eventual increases, would cause competitive advantage for alternative energy sources and conservation measures.

    With this process carbon emissions would be financialized on the balance sheet and income statements. Conservation and renewable sources would become competitive with the true cost of carbon emissions, which have had a free ride to alter the atmosphere. Intangible carbon emissions will become accountable. Money talks.

    John Cockerill

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