Economics Explanation of Carbon Tax vs Cap and Trade

ECON 101: Carbon Tax vs. Cap-and-Trade

The purpose of this page is to describe the differences between a carbon tax and carbon cap-and-trade policies using the most basic of all environmental economic models.

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Conclusions

In terms of the market failure, the negative carbon externality, both a carbon tax and carbon cap-and-trade will achieve the same level of increased efficiency by achieving the optimal abatement level at the minimum cost. The only difference is the distributional implications. The cost to the firm is lower for carbon cap-and-trade. The government receives tax revenue with a carbon tax. Both policies are preferred over techological or output standards (i.e., command and control regulation).

Note the following extensions:

* Dynamic efficiency: firms have an incentive to adopt new technology to reduce their marginal abatement costs with both a carbon tax and carbon tax-and-trade.

* Double dividend: Carbon taxes and auctioned permits will generate revenue for government that can be used to reduce a budget deficit or reduce in distortionary taxes on labor and/or capital.

* Auctions, giveaways or both: The results of carbon cap-and-trade approach the results for a carbon tax as the extent to which permits are auctioned instead of given away to polluting firms increases. Auctions substitute for trading as high abatement cost firms have an incentive to bid higher.

One of the reasons that I have supported the carbon tax over the cap and trade is that the CAT does not provide revenue for the government. That revenue could make all the difference in the world for research into alternate energy sources, mitigation of global warming, reduction of the national debt, paying for the military supplementals or even provide for a big boost in paying for some of the measures that would provide cost savings for the health care industry (ie things that have an immediate 'hump' expensive, but would greatly reduce daily operations). Auctioning off permits though would work just as well.

However, whatever we spend it on, it must be for short term expenses. We cannot count on this revenue stream into the future. The whole point of a cap and trade or carbon tax would be to draw down emissions considerably and eliminate them as much as possible. That means the money eventually goes away. That's one reason why Al Gore's idea of swapping carbon taxes for payroll taxes isn't such a good idea: eliminate the payroll tax and then you lose that revenue stream. Reimplementing them after the carbon tax revenue has gone poof is going to be as popular as a skunk at a cocktail party.

Items that I'd aim to pay for would include our commitment to ITER that the Democratic Congress has hacked (idiots), a crash project on the renewal sources of energy (such as biohydrogen or cellulosic ethanol from switch grass), space related projects (of course!), etc.

At any rate, definitely do read the above article. It's interesting and a good, basic explanation.