Reasons for liking a carbon tax

By Paul Walker 25/01/2013

This article from the National Journal argues in favour of a carbon tax:

To paraphrase Ronald Reagan paraphrasing Will Rogers, some people around here never met a tax they didn’t dislike. Others have met just one: a carbon tax.

A number of the nation’s leading conservative economists, who as a rule do not like taxes, are touting some benefits to a federal carbon tax. That group includes Gregory Mankiw, a former Romney adviser and George W. Bush-era chairman of the Council of Economic Advisors; Douglas Holtz-Eakin, Sen. John McCain’s 2008 chief economic adviser; and Art Laffer, progenitor of Reagan’s treasured Laffer Curve.

Such a tax could raise an estimated $1.5 trillion over 10 years and help wean the country from carbon-intensive fuels. And with Congress set for a season of budget fights and a possible effort to overhaul the tax code, the carbon tax is likely to reenter the conversation about getting America’s fiscal house in order.

So, it’s worth understanding why the economics of a carbon tax might make it appealing to some conservative economists, and why many political arguments about taxes don’t apply to it.

The reasons that some economists like a carbon are outlined here.

The basic reasoning is,

A carbon tax is a special kind of tax called a Pigovian tax, named after 20th-century British economist Arthur Pigou.

Normally, a competitive market produces just the right amount of a good. If there are not enough people selling glue, its price will rise and people will cash in by selling more glue. If too many people are selling glue, the price will go down, and some people will find it’s not worth their while to sell glue anymore. Either way, the market should settle at the point where the cost of producing more glue is equal to the value people place on that additional glue.

But Pigou realized that if a producer wasn’t paying for the full cost of producing a good, they would produce too much of it anyway and everyone else would foot the bill. Imagine that making glue is expensive because it costs a lot to cart away all the horse carcasses used in its production. There’s not going to be a lot of glue because only people who really like glue will be willing to pay to produce it.

Now imagine that instead of carting away the dead horses, glue factories realize they can dump them in nearby rivers for free. All of a sudden, it becomes a lot cheaper to make glue, so the price goes down. At a price like this, you can’t afford not to buy glue, so people consume more of it, and new glue factories pop up.

It all looks like economic growth, until the dead horses start piling up, and people start getting sick. Then they get a bunch of medical bills and the government has to spend money cleaning up the river. The sticky-fingered glue barons don’t mind much, because they can afford to buy the expensive houses upriver, and when the cost of cleanup gets spread to everyone, the cost to them is a pittance compared to their newfound glue fortunes.

Meanwhile, the tape users are fuming. They’re getting sick from glue they don’t even use, and the horse-dredgings are driving up their tax bill. And because a bunch of the former tape-makers have jumped on the glue bandwagon, there’s now a tape shortage. It’s a mess.

When you account for the costs of sickness and cleanup, each tub of glue costs $20 to produce. But the glue factories don’t pay for this, so they can sell glue at a going rate of $12. Glue that’s only worth $12 is being made at a cost of $20, so $8 is being wasted on each new tub of glue.

In this case, Pigou would prescribe an $8 tax on glue. Now, it costs glue factories $20 to produce glue, and only people willing to pay that much for glue will buy it. Less glue is produced, so fewer dead horses end up in the river, and the revenue raised from the tax can be used deal with the problems caused by the ones that do.

Coase in his famous 1960 article, The Problem of Social Cost, points out some problems with Pigou’s approach.