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Thursday, April 26, 2007

Cap and Trade v. Carbon Taxes - Definitive

Previously discussed benefits of Cap and Trade (CAT) over tax hikes include:

1. Politically feasible due to the fact that the tax incidence on consumers is less
apparent than under a tax system.

2. Revenues generated from taxes must go to whatever the politicos want them to be. There is no guarantee money will flow back to the best place (to compensate consumers who now pay a higher price via the tax). (Sold) Cap and trade of course can have that same problem, and while “freely given” cap and trade permits can get around that problem, there is of course a lost revenue in doing so. So in some sense, this “benefit” is not a net benefit over a tax system

3. A large benefit of CAT over tax hikes is that it incents polluters directly to find alternatives AND it rewards low polluters because they can receive payment by trading their cap permits. Depending on how the tax revenue is distributed, this may not be the case with a tax system.

4. The most important is of course, simply put: CAT sets the quantity of pollution and varies the price (unknown), taxes set the price and vary the quantity (unknown). This is a benefit of CAT in some sense since under a tax, we don’t really know what, if any, benefit we are getting from a given tax increase. Under CAT, we may not know the full cost, but we know we are reducing emissions by X.

Another benefit of CAT not talked about is the psychology differences between that and taxation:

With a gas tax hike, consumers KNOW their gas price is being manipulated by a government that is taking their revenue and doing who knows what with it. This is problematic because people FEEL less wealthy in this case because their price increase is tangible. This may mean consumers fail to internalize this cost as much thinking that the price is mandated by the government. Consumption may hold more constant relative to a CAT system because consumers may think “the gas price hasn’t reason more than other substitutes, it’s just that the gov’t has intervened, so either way I go I’m screwed – I guess I’ll stick with gas.”

With a CAT, all prices (increase) fluctuate with the market for the permits, so any increase in price is not artificial to consumers. It seems more likely then that consumers can internalize this increase in price easier – perhaps leading to a greater reduction in carbon consumption than under a tax policy for any given price hike. Consumers may think in this case, “Wow, the carbon market prices are skyrocketing. I better substitute to something else.

Of course, this whole idea of relative elasticities based on psychology of the SOURCE of price changes is not found in economics anywhere. Economics says the source doesn’t matter….but it just might in this case.

I don’t know if this means CAT is a good policy overall – I’m still concerned about its regressivity and the inability to compensate the losers. But it seems a better system than tax hikes.

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