Multiple Approaches to a Carbon Tax

Tue, 25 Mar 2008 11:09:56 +0000

Monica Prasad, a sociology professor at Northwestern, holds forth on the successes and "failures" of carbon taxes in Europe in an op-ed in today's New York Times. She makes two key points about implementation in Denmark, the country where emissions actually fell after the tax was imposed. I think Prasad is mistaking sufficient conditions for necessary conditions. Here is the main part of her argument:

First, you prevent policy makers from turning the tax into a cash cow. Carbon tax discussions always seem to devolve into gleeful suggestions for ways to spend the revenue. Reduce the income tax? Give the money to low-income consumers? Use it to pay for health care? Everyone seems to forget that the amount of revenue is directly tied to the amount of pollution that is still going on.

Denmark avoids the temptation to maximize the tax revenue by giving the proceeds back to industry, earmarking much of it to subsidize environmental innovation. Danish firms are pushed away from carbon and pulled into environmental innovation, and the country’s economy isn’t put at a competitive disadvantage. So this is lesson No. 1 from Denmark.

The second lesson is that the carbon tax worked in Denmark because it was easy for Danish firms to switch to cleaner fuels. Danish policy makers made huge investments in renewable energy and subsidized environmental innovation. Denmark back then was more reliant on coal than the other three countries were (but not more so than the United States is today), so when the tax gave companies a reason to leave coal and the investments in renewable energy gave them an easy way to do so, they switched. The key was providing easy substitutes.

On the first point, if you raise tax rates and don't change behavior, you have an inelastically demanded (or supplied) activity. Optimal tax theory tells you that you should raise that tax rate and lower other tax rates, to collect the same amount of revenue with a smaller excess burden or deadweight loss of the whole tax system. This is true regardless of what you are taxing, but it may be tempered by concerns about the distribution of the tax burden.

On the second point, it is true that the availability of easy substitutes will increase the elasticity of demand for fossil fuels, encouraging more use of alternatives. Prasad's point seems to be that Denmark hit the sweet spot--the revenues from the tax at a particular level were large enough to fund public alternatives to the point where switching was feasible. So that's why I describe it as a sufficient arrangement.

But that's just one approach to reducing emissions, so it may not be necessary to follow the Danish approach. Another approach would be to raise the carbon tax rates even higher--using the proceeds to reduce all other distortionary taxes even further--until the firms and consumers in the economy make the switch to alternatives without public subsidies.

Read the whole thing, as well as the longer paper on which the op-ed is based.