A Deeper Look at Tradable Allowances
Since the passage of the Clean Air Act, SO2 emissions have decreased by 35%. Part of this is due to tradable allowances, which created a market solution to the
Since the passage of the Clean Air Act, SO2 emissions have decreased by 35%. Part of this is due to tradable allowances, which created a market solution to the external costs of SO2 emissions. In this video, we look at the lessons of tradable allowances for SO2 and see if a similar market-based solution could work to decrease other pollutants, such as CO2.
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The comparison between a pollution tax and pollution trading needs to consider a few other issues:
* I think you are partly right about the difference in political incentives, but you have missed an important implication. It will be relatively easier for the government to introduce a trading scheme and harder to introduce the tax… conversely it will be harder to remove the trading scheme later if/when it becomes unnecessary but much easier to remove the tax. For a dramatic example of this, consider the taxi licensing schemes that exist in many countries around the world, where the government can create some fiat property in the form of taxi licences (similar to pollution licences) and this fiat property can be traded. It is now abundantly clear that these taxi licensing schemes are a bad idea, but politicians have struggled to remove them because there is an embedded lobby group who have a vested interest group in ensuring the fiat property continues to exist. If we had a taxi tax (or pollution tax) instead, then the politics of the system would be vastly improved and it would be much easier to remove the policy if/when it is no longer necessary.
* A second reason to prefer a tax over a trading scheme is to consider the dynamics of the situation. This argument mirrors the argument from international economics in why economists generally prefer a tariff to a quota system (even a tradable quota system)… a tax allows the underlying behaviour to change if the situation changes, which is normally a good thing. If we know that the social cost of pollution is $10/tonne which would result in 100 tonnes of pollution then in a static sense we could set the tax at $10 or the quota at 100 tonnes and the situation would be the same (as you mention in the video)… but now consider what we should do if it turns out that the pollution is much easier/harder to address. With a quota system, pollution would continue being 100 tonnes regardless of whether it is hugely expensive to achieve that outcome (e.g. $50/tonne) or much easier to reduce the pollution (e.g. $1/tonne) and so it's easy to imagine the quota system resulting in an inefficient low or high level of pollution. When using a tax, the producers are able to adjust their behaviour in response to changing underlying conditions. So if it turns out that pollution costs $50/tonne to remove but only creates a $10/tonne social cost… with a tax they would continue emitting the pollution, which is the socially optimal action. And if it turns out that all pollution can be reduced for $1/tonne then under a tax system the producers could entirely stop polluting, which also would be a socially optimal solution. In short (echoing the trade argument) having a tax allows the producers to still respond to price signals created by changing circumstances; a quota (even a traded quota) does not allow that same flexibility.
* Also, in a further echo of the international trade arguments, a tax creates greater transparency and predictability, thereby reducing market risk for producers.
* A tax provides a more certain stream of revenue for the government, which can (at least in theory) be used to reduce other taxes. Since most taxes create a deadweight loss, replacing those taxes with a carbon tax has the potential to be good tax reform even if we ignore the environmental part of the argument. Since unilateral action on climate is unlikely to create much benefit (given it is a global problem) then efficient tax reform is one of the few ways the government can achieve a net benefit from climate policy. (There are a few other options, but they aren't relevant to the current discussion.) One particularly cheeky option here (that has been previously suggested for Australia) is to reframe the current fuel tax as a more general "climate tax" and then note that it is currently very high on petrol but non-existent on coal burned for electricity… and then follow the time-honoured economic tradition of calling for a broader base (fuel & coal) and a lower rate. The elasticities of demand are roughly equal for both petrol and electricity, but since the efficiency cost of a tax grows exponentially with regards to the level of the tax, having two lower taxes on petrol and coal electricity (instead of one high tax only on petrol) would be more efficient. Not only would this create environmental and economic benefits, but it would also be politically hilarious since it would turn the political argument on its head. And we could all use a good laugh now and then. :)
For all of these reasons, economists should have a preference for taxes over trading. The only virtue of trading is that they lack transparency and allow politicians to trick people into supporting something they don't want to support… and that is a very dubious benefit that rests on a huge amount of faith in the political system. The is no reason to have that level of faith.
Here's a monograph I wrote on the issue a long time ago. I would write it quite differently now, with some changes, but many of the core ideas are here:
BTW, this was published by a free-market organisation in Australia, which confused a lot of people. :)