Harry Clarke » taxes

On carbon taxes vs. an ETS

hc — Mon, 21 Sep 2009 02:26:37 +0000

John Quiggin recently (i) attacked consumption-based bases for levying carbon charges and (ii) defended cap-and-trade schemes against ‘equivalent’ carbon tax schemes. On (ii) I don’t substantively disagree but on (i) I do. I responded on his blog. Here is an improved statement of my position.

John suggested firstly that endorsing a consumption-based set of charges was ‘defeatism’ since it amounted to assuming that other countries would not act to charge. My response is that other countries such as India and China – are not acting to charge and are unlikely to do so any time soon. Moreover, they have so far suggested that they will not act soon – in China’s case up until 2030 or 2050. Despite some noises, India, which has vastly lower energy consumption/head than China, will probably respond equivalently or with even greater delays in controlling its emissions.

Of course if all countries did act equivalently in levying production-based taxes then so should we. There are then no carbon leakage issues either directly from trade or from footloose polluters. In a world where a global emissions agreement based on production is endorsed I agree that a preference for production-based quotas is sensible.

But an advantage of a consumption-based charge in the world we live in can be transitional. If a consumption-based charge is levied then countries like China will face the price of their exports increasing by the amount of the border tax. But this tax will accrue to countries like Australia who import the goods. China would surely see the advantage of levying the tax itself.

Of course, as under the Waxman-Markey Bill, the border tax would be imposed whenever China did not levy internationally-comparable carbon charges on all its production not only the exported output so that incentives would be in place for China to tax all Chinese outputs.

Indeed the incentives are for China to tax production itself and to urge Australia to do the same. Then we get to John’s (and indeed my) preferred scenario. A production-based system is preferable longer-term since, in a uniformly-enforced consumption-based system, all carbon intensive imports would need to be taxed – no mean feat given differences in source country technologies and carbon intensities. I develop these arguments at greater length here.

A carbon-based tax would generate much less revenue than a production based tax because Australia exports goods with a great deal of carbon embodied. That is plausibly true but it would be interesting to do a calibration of the size of the discrepancy. Australia imports many carbon intensive final consumer and producer goods from China. Of course, at the global level there is no difference in the revenues between production and consumption based carbon taxes.

In my view we should urge all countries to shift to production based taxes eventually by levying consumption-based charges now. Countries such as China should be urged to levy charges on their own consumptions by providing compensations and finance to them (in income, technology transfer etc) from developed countries. In fact the offerings of technical assistance made under the Waxman-Markey bill and by the Europeans can be seen as a first step in this direction. Again see here.

On the issue of the choice between a cap-and-trade ETS and an ‘equivalent’ tax, like John I have been rather indifferent. It is obviously more important to get one of these operating than none. On balance I have gone for ETS for the standard reasons –a definite carbon emission outcome results. But I think concerns about carbon price instability are of concern.

John Quiggin has argued in earlier posts that variable carbon prices can act as an automatic tax stabilizer which bites when the economy is booming but impacts less during recessions. I think that is so. But carbon prices are also a signal for what amount to large sunk investment decisions for firms. A lot of noise in these prices might lead firms to delay investments in carbon friendly technologies for quasi-option values reasons. A power station thinking about an expensive carbon capture and storage retrofit that will be a huge burden if carbon prices wane might show increased reluctance to undertake the retrofit and may have incentives to delay action. That might be privately optimal but socially disadvantageous.

I worry too about the huge new created financial markets in carbon. Won’t these be subject to asymmetric information and insider trading issues from energy and power suppliers?

Finally, there are grounds for being somewhat pessimistic about the prospects for agreements at Copenhagen or soon thereafter. It may be that an internationally decentralized set of national taxes – with developed countries taxing most and developing countries taxing least – has greater chance of getting agreement among very different countries. This might be so even if the globally optimum is a global cap-and-trade with transfers.

Carbon taxes or cap-&-trade?

hc — Fri, 11 Sep 2009 05:11:50 +0000

I have not regarded the issue of choosing between a ‘cap-and-trade’ scheme and a ‘carbon tax’ for managing carbon emissions as one of first-order importance. Under certain conditions setting carbon quotas and auctioning them off at some equilibrium price has exactly the same effect as setting a tax on carbon equal to the equilibrium price. It results in the same emissions costs and the same transfer of revenue to the government.

This work has been translated into a set of studies that compare carbon taxes with carbon quotas – a seminal early study is due to Parry, Williams and Goulder.

In international trade theory the result amounts to claiming the equivalence of a tariff and quotas in restricting international transactions – in fact a vast literature has developed showing when in fact this equivalence breaks down. The main issue in the trade literature seems to be how the respective systems perform when demand changes.

Increasingly however the debate is hotting up on the issue. A survey is here and Joshua Gans discusses what seems to be a derived report for CEDA. European arguments are summarised here. Robert Shapiro of the Climate Task Force provides arguments favouring a tax (here and here). Both articles are reprinted in today’s AFR page 56 (subscription required).

The Shapiro piece interested me particularly.

One argument for a tax is that horse-trading for free-entitlements under the Waxman-Markey bill has weakened the cap on emissions. This horse-trading Shapiro argues was an endogenous consequence of the scheme’s complexity. Taxes are a more transparent instrument making it harder for sweetheart deals with polluters to be made.

Taxes can also be matched by transparent cuts in payroll tax or by lump-sum handouts to households. Revenues yielded by auctioned permits can do the same thing provided that horse trading does not eliminate most of the revenue gains through the distribution of free permits. In contrast a revenue neutral carbon tax looks appealing.

In addition the equilibrium price of carbon under an emissions trading scheme depends on unstable world energy markets. The macroeconomic destabilisation effects of volatile of energy prices would thus be compounded by the effects of volatile carbon prices. In the European Trading System’s first 3 years priced moved up and down by an average of 20% per month.

In a globalised cap-and-trade system the instability would be amplified.

The alternative argument – put by John Quiggin – is that the instability of carbon prices can operate as an automatic stabiliser of the economy.

At the international level cap-and-trade can be criticised because it creates the potential for horse-trading among countries. The Kyoto Protocol for example exempted all developing countries from the need to mitigate and hence, Shapiro claims, was ineffective in cutting global emissions. I’d question this argument – there are sound reasons for exempting a country like India from emission cutback requirements given that its energy consumption is 1/21^st that of the US.

From a microeconomic perspective ‘real option pricing’ literature suggests that firms would additionally have difficulty making long-term conservation investments given this volatility. In the face of such price uncertainty it would pay to be conservative in making irreversible sunk investments. A fixed carbon price time path would remove this difficulty.

This last advantage is tempered by Shapiro’s acknowledgement that fixed carbon taxes might need to be adjusted from time-to-time, for example to meet unexpected changes in energy demands.

Tradeable emission permits will become a huge market – a trillion dollars or so in new financial instruments. Given the attendant price instability this market would encourage speculation and would be vulnerable to insider trading and manipulation by large utilities and energy producers who will be the first to notice shifts in demand.

At the global level cap and trade may not be acceptable because, Shapiro argues, different countries have different emission goals. Developing countries were exempted under Kyoto which led to the non-ratification of this agreement by the US and Australia. Maybe developing countries would find a carbon tax more appealing given their needs for the revenue it would provide.

Finally, empirically, Shapiro argues that Europe’s cap-and-trade scheme has been a flop whereas Swedish carbon taxes have worked well. Since Sweden introduced its taxes in 1990 its emissions have fallen 8% while its economy has grown 48%. The French – among others – are now reconsidering the case for a tax.

My overall assessment of the case for a particular climate change policy format is strongly conditioned by the view that doing something is decidedly better than doing nothing. I might post again on this issue but my main interest is in which of the choices discussed above makes most sense in terms of the forthcoming negotiations in Copenhagen. I’ll almost certainly post again on this issue.

Taxes & Transfer Policy Conference

hc — Wed, 17 Jun 2009 08:08:23 +0000

My blogging activity has recently come to a standstill because of a myriad of work-related commitments. I am attending the Australia’s Future Tax and Transfer Policy Conference that has been organised by The Treasury over the next couple of days at the Melbourne Business School. The papers to be presented are uniformly excellent - I have even thought vaguely of trying to structure an advanced level unit at my university around them. It would be informative and fun.

The paper by Professor Alan Auerbach on tax theory I found particularly valuable. Worth reading along with the earlier piece I referred to by Professor Mankiw. Both are great papers if you (like me) want the ‘meat’ without the mathematics.

I have been given the task of commenting on an excellent paper by John Freebairn on ‘environmental taxes’ . I’ll post my comments on it eventually.

By about Saturday I might think again about some more ‘recreational’ blogging.

Update: My comments on John Freebairn’s paper are here. My points were that across the OECD environmental taxes were negligible – the 2-5% of GDP ‘environmental’ taxes observed were mainly fuel excises and vehicle registration charges which targeted the environment very imperfectly and should not be vregarded as kosher environmental taxes. These taxes should ideally be replaced or supplemented (if revenues were still sought) by user charges on roads which would provide a decent tax base that vould also be used to restructure road supply decisions. So too could the revenues from sales of permits to a comprehensive emmissions trading scheme which has a tax base between 300-576 million tons of Co2 equivalent and which under government plans might only be cut 5% by 2020. A sustainable tax base.

How to tax?

hc — Wed, 03 Jun 2009 13:20:30 +0000

If you are a bit hazy on how to levy income and excise taxes – and have not followed recent debates - I recommend this paper by Gregory Mankiw and others. It is a straightforward presentation of key ideas and is recommended. I posted earlier on some shockingly revolutionary work of Louis Kaplow that I found most interesting who treats things more formally. Kaplow’s stuff gets discussed in the Mankiw et al paper.