On free-riders and externalities

By Matt Nolan 04/06/2014

Today I wrote a brief post on the Green announcement of a carbon tax.  I do support the carbon tax, but just wanted to raise some specific issues to think about.

However, a number of people on twitter were unhappy with me saying that, without Kyoto, we didn’t have an externality here – and I think their point is worth discussing.  I think a key issue here is the “group” involved and how we think of policy.  Hopefully by having a brief discussion here I can help to clarify what I was talking about in the prior post.

If this brief rundown isn’t sufficient, I don’t have anything more to say unless you add a comment here with a new framework – I’ve been as clear about my framework as I can be and really need to get back to work ;)

The externality and the policy transfer

In the policy document the Greens discuss a carbon tax with a corresponding cut in other taxes (it is a tax free threshold, but I am going to discuss it as a general tax cut – as the details of this are not too important :) ).  The carbon tax is to pay for an externality from the production of pollution.

This tax and transfer program within a nation corresponds to common tax policy, it is a Pigovian tax.  However, in order to justify the tax we need to estimate the size of the externality.

The external cost of pollution here stems from the fact that rising carbon (and related) emissions increase the probabilty (and intensity) of a global warming event (GWE) – where a GWE will negatively impact upon everyone.  By reducing our emissions, we lower both of these, and as a result this fits our definition of an externality nicely.

However, New Zealand is very small (producing in the range of 0.1-0.2% of global emissions).  As a result, the impact of a NZ carbon tax on the probability and intensity of a GWE is also very small.  This implies that the benefit from introducing this tax is tiny, and as a result the optimal externality tax is also very small!

Free-riders and the “positive externality” from our choice

The thing with a GWE is that it doesn’t just impact upon New Zealand – it causes damage right across the world.  In that way, if New Zealand was to reduce its emissions it not only has some small benefit for New Zealand, but it also has a benefit for everyone else on earth.  As Julie Anne Genter says:

In this way, there is a “positive externality” from New Zealand cutting its emissions for the rest of the world – but as we pay the full cost of emissions reduction and only receive a tiny amount of the benefit it is not in our strict national interest to do so.  The rest of the world is “free-riding” off our emissions cuts!

In fact, a lot of nations will feel this way – and this is the reason why there was a push for the Kyoto agreement.  By having a supra-national authority that priced emissions in a way consistent with the externality, and then made individual countries liable for this cost, it is possible to align countries incentives for what is in the global interest.

Here the Kyoto agreement is forcing individual nation states to “internalise” a global externality that exists between countries!

Without such an agreement, we end up in a “prisoner’s dilemma” situation – where it would be best for all nations if we could introduce a carbon tax, but it is in each nations individual interest not to.

With regards to my prior post

When I was writing about externalities in the previous post, I was sticking to the definition used to provide the justification for policy in the report – there was a fixed lump of income that was being transferred via a change in the national tax system, and that producers were subsidised “by households” in some way.  Without Kyoto, or associated Kyoto payments (which Sam points out may be zero if the adjustment is strong enough), the externality associated with such a transfer from producers to households would be very small.

Note: Sam pointed out I should clarify this something here.  Even if net liabilities and the given payment is zero, with and without a Kyoto type agreement are still entirely different situations.  With a Kyoto agreement the “marginal price” for each carbon unit is higher, as you either make a payment for creating an extra unit or sacrifice revenue associated with your net credit position – in this way there is an “opportunity cost” associated with carbon consumption.  With no agreement, this marginal price for carbon units does not exist.  It is this agreement that makes the price per unit faced by nations equivalent to the full “social price” – which then implies it is in individual nations best interest to set that price domestically.

I suspect the frustration on twitter came from people presuming that I meant the global externality was small.  But this is an entirely different issue.

If we are taking into account the global externality, then yes we may well need a larger GLOBAL tax to change incentives.  Imposing the tax only in New Zealand would both do very little, and would set the national cost to be larger than the national benefit of doing so – essentially if we fully modeled what happened to the NZ economy here, we would be transferring resources overseas.  And we would be doing so without doing terribly much with regards to global warming.  From a NZ only view taxing carbon and transfer is certainly NOT the “best response” policy if we strictly looked at economic costs and benefits with a fixed response from overseas.

However, it is in this context that I actually support a tax on carbon in New Zealand.  We can’t expect to solve a prisoner’s dilemma by having everyone sit back and not try to cooperate.  A free-rider problem doesn’t get solved by having everyone continue free-riding.

But there is also no need for me to mix these two definitions of externalities just to justify a tax – the push for global coordination, taking into account the benefit for other nations, and being a responsible global citizen, are all good things that justify it for me ;)

Sidenote:  The interest in “doing the right thing” for people around the world through our policies around global warming is something I applaud.  It is something I would also keep in mind when looking at any other types of policy program though!

Sidenote 2:  Just because I support the tax does not mean society has to – society can decide it doesn’t give two hoots about this global stuff, and that they don’t want to pay.  I realise this.

Sidenote 3:  I also stick to my comments that, if we are now working on the basis that global agreement is unlikely, we need to start planning for the expected outcomes.  I certainly hope that other political parties start thinking about these issues as well, now that the Greens have had a good crack at highlighting them.