Why A Carbon Tax Won’t Work in the Real World

By Phillip W. Magness

Writing in the Wall Street Journal, a group of distinguished economists including four former chairs of the Federal Reserve and 27 Nobel laureates issued a call to adopt a revenue-neutral carbon tax in order to wean the U.S. economy from fossil fuels. They offer this proposal as a way to address global warming, although one does not need to adhere to the premises of environmentalist political action to accept their narrow claim.

As the economists point out, a tax-based strategy for reining in carbon emissions is a less inefficient economic approach to this problem than attempting to attain the same objectives through top-down government regulations. So even if one disagrees with the need for government-imposed solutions to climate change, it is still true that the Pigouvian carbon-tax approach is an improvement over an alternative complex system of Environmental Protection Agency (EPA) mandates, fines, and administratively enforced directives, holding all else equal.

The economists’ letter has one fatal oversight though. They present their solution for an idealized public-minded government while paying no attention to the government we actually have.

To see how, we may turn to the work of the late Ronald Coase, who also won the Nobel Prize for his contributions to understanding the problem of economic externalities, precisely the area of policy today’s letter signatories purport to address.

While Coase’s work explored the conditions of economic efficiency in the presence of an externality, such as pollution, he offered an important caveat noting “the mere existence of ‘externalities’ does not, in itself, provide any reason for governmental intervention.”

Government action itself is a costly proposition, carrying no guarantee that even a well-designed and well-meaning policy will be implemented as intended. As Coase explained this problem,

The fact that governmental intervention also has its costs makes it very likely that most “externalities” should be allowed to continue if the value of production is to be maximized. This conclusion is strengthened if we assume that the government is not like Pigou’s ideal but is more like his normal public authority — ignorant, subject to pressure, and corrupt.

Returning to the economists’ carbon-tax letter, we find a complete neglect of this second condition. They offer an idealized solution for a non-ideal world, and simply assume it will be implemented as they intend it to be.

There are several reasons however that indicate carbon taxes will fail Coase’s test, and thus the optimal course of action is non-intervention.

The False Promise of Revenue Neutrality

First, even though the economists declare that their proposal will be revenue-neutral (i.e., it is offset by other tax and fee reductions so that it extracts no additional revenue from the public), they offer no guarantee but their word that politicians would adhere to this promise as opposed to treating carbon taxes as yet another lucrative revenue stream for public expenditures.

Indeed, several of the carbon tax’s most vocal proponents, such as the misnamed Niskanen Center, openly extol its promised ability to fill the government’s coffers with additional revenue for an assortment of spending projects.

While the Niskanen Center’s own carbon-tax proposal also touts a claim of revenue neutrality, a perusal of its many essays and public comments on the topic reveals a pronounced enthusiasm for tapping this new revenue stream for a multitude of other spending projects. The many goodies it’s already promised in connection with carbon-tax revenue include everything from additional increased highway and infrastructure funding, to federal debt retirement, to subsidizing an assortment of renewable-energy products, to providing a social safety net for displaced fossil fuel workers.

We need not take a position on the propriety of any of these spending proposals to note that the tax’s conversion into a revenue-generation tool belies the stated justification for a carbon tax in the first place. The entire claimed purpose of a Pigouvian tax is to draw the external costs of an activity into its market price by matching what is believed to be its social cost (whether we can even do so with any accuracy is another story). It is not to generate a stable and permanent revenue stream from the continuation of that externality.

The Threat of Political Capture

Second, carbon taxes are by their nature highly susceptible to political capture. Although the economists’ letter asserts the public-minded aims of carbon taxation and its efficiency benefits over regulatory alternatives, a tax is still a powerful tool of regulation unto itself. By altering the price of fossil fuels, carbon taxes quite consciously aim to shift energy consumers over to so-called clean-energy alternatives. The letter even touts this as a benefit.

Clean-energy providers, however, are not neutral parties to the political exchanges that must take place in order to implement a carbon tax. They’re financial beneficiaries of that tax precisely because it penalizes their fossil fuel competitors by raising their cost of doing business. The supposedly public-minded aim of shifting consumers over to clean energy through taxation also comes with the inescapable reality of lining the pockets of firms in the green-energy industry.

Many of those same firms, it turns out, are also willing to expend vast amounts of money lobbying in favor of the very same carbon taxes that penalize their competitors and steer business to their own products. Some of the more shameless examples of this behavior even espouse investment strategies based upon short-selling fossil fuel companies while simultaneously lobbying for carbon taxes that intentionally undermine their consumer base.

Economists refer to this practice of using political levers to manipulate market exchanges for the purpose of self-enrichment as rent-seeking. In the political world of environmental policy, where billion-dollar green-energy incentives are considered virtuous and large fortunes have been made off of federal and state subsidies to solar panel production and electric-vehicle manufacturing, we have every reason to believe that carbon taxes will also be susceptible to the same pressures.

The problem of rent-seeking, in turn, presents a further political complication to carbon taxation. It means that any carbon tax, once adopted, will attract vested stakeholders in maintaining it at a desired level and ensuring the continuity of their own private revenue streams from the resulting policy. This means that any carbon-tax system runs the risk of becoming captive to entrenched special interests. When that happens, the resulting tax can no longer be adjusted or “fine tuned,” as the economists’ letter necessitates, without also having to appease its political stakeholders.

The predictable result is yet another sclerotized regulatory tax program, beholden to special interests and incapable of being further reformed or adjusted through our current political process.

The Problems of a Regulatory Swap

Even though the economists’ letter neglected the political complications of carbon taxation that I have raised here, a signatory might respond with some validity that the same problems also afflict the alternative approach of using top-down regulations to address climate change. If carbon taxes attract rent-seeking interests, then surely this same problem affects the EPA and other regulatory bodies. And since carbon taxes are economically less inefficient than regulations, we should settle for that reality and accept the less bad alternative by swapping one for the other.

The problem with this argument is that it also assumes the swap can be effected through our existing political institutions. It assumes that the interest group beneficiaries of the current regulatory approach can be persuaded to forgo their rents and their political investments in maintaining those rents in exchange for the carbon tax. While not completely unheard of, such grand policy regime swaps are extremely rare and usually only occur when the rent extractions from the existing approach dissipate to a point below the expenses and energies needed to maintain them.

On the flip side comes a substantial risk. Carbon taxes, if adopted, will need to be phased in over time in place of regulatory approaches to the same externalities. That requires the interests behind both to agree to a scheduled and systematic transition over many years if not decades. But politicians habitually renege on promised future actions as the deadline actually approaches. The recurring debate over the debt ceiling, the kicking of the Social Security solvency can down the road, and the failure of past attempts at the execution of complex budget-constraining schedules all point to the dangers of this strategy.

Suppose, for example, that the United States adopted a carbon-tax pilot program in exchange for promised deregulation at a future date. As the date of the regulatory phase-out approaches, however, rent-seeking beneficiaries of the existing regulation begin to pressure the government for a delay to its repeal. Or environmentalist activists, believing that the carbon tax is desirable but insufficient on its own, switch their lobbying strategy to also retain the regulation that was scheduled to be phased out.

Barring some yet-to-be-devised mechanism for the swap, the carbon-tax proposal carries the substantial risk of becoming a cumbersome supplement to existing regulations rather than a replacement. While a carbon tax in itself may be economically preferable to existing top-down regulation, a carbon tax added on top of the existing regulatory system is demonstrably worse than the status quo.

In order to meaningfully advance the discussion on the policy proposed by the economists’ letter, its signatories will need to address the obstacles and pitfalls presented by its political execution. They will need to make a convincing case that they can mitigate and overcome these obstacles under the government that we actually have — “ignorant, subject to pressure, and corrupt” as Coase noted — rather than the government that they want to have. So far, they have not even broached that subject.

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Phillip W. Magness

Phil Magness is a Senior Research Fellow at the American Institute for Economic Research. He is the author of numerous works on economic history, taxation, economic inequality, the history of slavery, and education policy in the United States.