Wonky Talk about Carbon Taxes

I appreciate David Leonhardt’s kind words about my recent Times column on the problems with giving away, rather than auctioning, carbon allowances. I thought it might be useful to explain a bit more some of the economics behind what he calls my Rorschach test. Here is the more wonky way of putting some of the arguments.

We can think of the typical household as having to make two decisions. First, the household decides how much to work and consume. This is the standard consumption-leisure tradeoff. Second, the household decides how to allocate consumption between carbon-intensive products and less carbon-intensive products.

Mathematically, we might write utility as

U = u(C) + v(L)

where C is consumption and L is leisure. Consumption is a composite of carbon-intensive consumption C1 and less carbon-intensive consumption C2, which we can write as

C=F(C1,C2).

There are two margins of adjustment: between C and L, and between C1 and C2.

We start in a situation in which each of these margins of adjustment is distorted. Because earnings are taxed via income and payroll taxes, people have too little incentive to work and consume. In addition, because there is a negative externality associated with carbon, people have too little incentive to move their consumption basket toward less carbon-intensive products. In other words, the relative price of consumption compared to leisure is too high, and the relative price of carbon consumption compared to noncarbon consumption is too low.

The trick is how to fix the second distortion without making the first one worse. A tax on carbon with the revenues used to cut income taxes does that. Everyone who thinks there are negative carbon externalities should agree that is the efficient policy.

A tax on carbon with the revenue squandered via lump-sum handouts to powerful special interests, however, fixes the second distortion but makes the first one worse. The good thing about this policy is that it raises the price of carbon-intensive consumption relative to less carbon-intensive consumption. The bad thing about it is that it also raises the price of consumption relative to leisure—that is, it depresses the real wage. The basic problem is that a new tax on carbon-intensive products C1 is also an additional tax on consumption C, unless there is some other offsetting tax change.

This is where the Rorschach test comes in. A carbon tax without a compensating income tax cut makes one problem better and one worse. The question then is which problem is bigger. I don’t think there is a consensus among economists on this last question. That is why reasonable people can disagree about the bill being debated in Congress.

But there is a consensus, more or less, that we could fix one margin of adjustment without distorting the other margin more. That requires a cut in income or payroll taxes to be a key part of the environmental policy.