The Basic Economics of Carbon Permits versus Carbon Taxes

Maybe a few simple diagrams will penetrate the fog of confusion that enshrouds discussion of carbon caps
and taxes. Maybe not, but here goes.

The starting point is this, a highly simplified demand curve for carbon inputs (primarily fossil fuels), drawn as
if we actually knew what it looks like.

We start out at a high quantity of carbon use, Q1, and a low price, P1. Our goal is to reduce carbon use to the
much lower target Q2. There are two ways we can do this. We could introduce a permit system, and cap the
number of permits at Q2. The shortage of permits, in conjunction with the demand D, will drive the carbon price
up to P2. This is true whether the permits are sold or given away; their scarcity makes them valuable.

The second approach would be to introduce a carbon tax. When the tax is set high enough to make the total
price of carbon equal to P2 we once again arrive at a total use of Q2.

In this very simple world there is no difference between the price and quantity effects of either a carbon cap
or a carbon tax. Which you choose is a matter of convenience.

Now introduce uncertainty. We really don’t know very much about what the demand curve for carbon inputs
in all their shapes and uses looks like, especially as we travel further from our initial starting point at Q1 and P1.
There is an enormous empirical literature on this question, and the uncertainty is large. The next diagram
illustrates this.
The shaded purple area represents the range of possible demand curves; it gets wider the further we go from
where we are today. If we set a carbon cap at Q2 we don’t know just how low or high the carbon price will turn
out to be.

If we use a tax, we are facing a situation like this:

If we set the tax so that the carbon price is P2, we don’t know exactly how much carbon will be used.

In an uncertain world, the choice between a tax and a cap depends on which kind of uncertainty worries you
more. Many economists are terrified that we may impose too large an economic burden by underestimating
how high prices have to go to reduce consumption. If this is your main fear, you should support a tax, since
this nails down the price with near certainty. (A price ceiling combined with a cap is almost the same, since
a ceiling functions like a tax when it is triggered.)

On the other hand, suppose your greatest fear is that we will not take stringent enough measures to reduce
our carbon consumption, and that catastrophic, uncontrollable climate change awaits our children and
grandchildren. In that case, you would support a tight cap that guarantees we will meet our carbon targets and
allows prices to find their own level.

This distinction ought to be clear in the minds of everyone who debates carbon policy.

Then there is another wrinkle: suppose we face interaction effects among consumers that produce multiple
equilibria. As someone who thinks a lot of economic behavior is driven by social norms, I expect to see this
wherever I look. For example, take the case of flying to business meetings versus videoconferencing. At the
present time the norm is to meet in person. Videoconferencing seems “cheap”, “limited”, a compromise. If you
are the only firm or conference organizer who switches to video, your reputation will likely suffer. Once enough
organizers make the switch, however, and videoconferencing becomes the new normal, asking people to fly
in to a meeting will seem extravagant, spendthrift, and suitable for only the most special occasions. This is a
“tipping point” story, characteristic of interactive behavioral models.

Suppose we depict just one sort of interaction in a fully certain world. If we use a carbon cap to change
behavior, the diagram looks like this:

As the cap is lowered, the price rises until a tipping point is reached. After this the price collapses, then rises
again as demand is lowered along the left portion of the curve, coming to a stop at P2. (Technical note: this
is called a multiple equilibrium model, since a supply curve drawn through both halves of the demand curve
will intersect it twice.)

Now let’s tell the same story, but with a rising carbon tax.
The tax is cranked up until the tipping point is reached, then demand falls even beyond the ultimate target. The
final step is to lower the tax until we get back up to Q2. There are two big differences between taxes and caps
in this simple story. First, taxes in the context of multiple equilibria lead to overshooting—higher economic
costs than necessary. Second, the final reduction in taxes has to be undertaken deliberately, as a matter of
policy, unlike the price responses to a cap, which emerge from the ordinary workings of a market. In my mind
this is a big disadvantage: the risk is that taxes, once they really start to bite, will be reduced too soon. Bear
in mind that the world is both interactive (with multiple equilibria) and uncertain. No one will know for sure when
taxes need to come down, and there will be powerful interests lobbying from day one to minimize or reverse
any carbon taxes we manage to put in place.

One final word about the interpretation of the multiple equilibrium diagram: this also describes the effect of
infrastructure investments on demand, if you “endogenize” the willingness of voters to support such
investments. That is, if you think carbon prices have to rise significantly before projects to invest large amounts
of money in mass transit and similar demand-shifters will be adopted, the diagram looks essentially the same.

This means that we have a handy visual way to interpret the argument (e.g. Schellenberger and Nordhaus) that
we don’t really need either a cap or a tax, that the policy objective should be to make the investments
themselves. This argument is correct to the extent that the shift from the right-side to the left-side demand
segment is fundamental. It rests on two further assumptions, however: that we will get these investments
without a prior rise in carbon prices, and that getting to Q2 does not require any movement up the new demand
segment. (This is equivalent to saying that all the adjustment we need is collective, via investments in
infrastructure and R&D; no additional behavioral change is required.) How credible are these assumptions?