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The Pigou Club Goes to Washington

Wednesday, September 10, 2008

Higher pollution taxes make sense, provided the revenues are used to offset existing taxes that distort incentives.

Members of the “Pigou Club” should pay close attention now that energy policy has become a dominant issue in Washington. So named by Harvard economist Greg Mankiw, the club consists of economists and pundits who support an increase in taxes on pollution-generating activities. (I’ve been a member since 2006.) The economic rationale is simple: pollution imposes costs on society, so the taxes adjust market prices to account for these costs and thus improve general welfare.  

Yet advocates of higher pollution taxes rarely draw attention to another recommendation of the Pigou Club—that the revenues collected from the pollution tax should be used to offset existing taxes that distort economic incentives. A pollution tax that neglects this “revenue recycling” recommendation might do more harm than good. 

Again, the rationale is straightforward. Pollution taxes increase the prices of such things as transportation and energy. These price increases reduce the real wage rate, effectively amounting to a tax on earnings and a reduction in labor supply. Since work incentives are already distorted by the existing income tax, a pollution tax can worsen this inefficiency. So while a pollution tax promotes general welfare by reducing pollution, it also hinders general welfare by diminishing work incentives. The net effect is ambiguous. 

The harmful effect on labor supply can be at least partially offset by using the revenues collected from the pollution tax to reduce inefficient taxes. For example, the revenues can be used to lower marginal income tax rates, or perhaps to lower the deficit (which amounts to a future income tax reduction). Economists don’t like to see benefits go to waste, which is why Mankiw’s Pigou Club Manifesto highlights the pro-growth tax component of “an increased reliance on gas taxes over income taxes.” 

A pollution tax that neglects this ‘revenue recycling’ recommendation might do more harm than good.

To be sure, pollution taxes are not terribly popular. Though politicians frequently call for the regulation of carbon emissions, few will publicly endorse a direct tax on carbon. Instead, most prefer “cap-and-trade” programs, such as the legislation sponsored by Senators Joe Lieberman (I-CT) and John Warner (R-VA), or the bills proposed by both Senator Barack Obama and Senator John McCain. In a cap-and-trade system, a quota is placed on the amount of allowable pollution (the “cap”), and firms must either meet their quota or purchase pollution rights from other firms that are overcomplying with their quota (the “trade”). 

Yet a tax and a cap-and-trade program are essentially the same thing. With a tax, the polluter must pay a fee for each unit of pollution produced. With a cap-and-trade scheme, the polluter must buy a right for each unit of pollution produced. Both policies achieve the goal of raising the price of polluting to reflect the external costs to society. Not surprisingly, politicians overwhelming prefer the cap-and-trade approach because it allows them to dodge the negative publicity associated with a tax increase. Indeed, some politicians take this ruse a step further, such as when Senator Barbara Boxer (D-CA) falsely claims that a cap-and-trade system is “a huge tax cut” that “will not increase gas prices.” 

Unfortunately, the existing and proposed cap-and-trade systems ignore the Pigou Club’s advice to use the revenues to reduce economically harmful taxes. The first cap-and-trade regime was part of the 1990 Clean Air Act, and it gave all the revenues as lump-sum transfers to the polluting firms. More recent cap-and-trade programs for mercury and nitrogen oxides let individual states decide what to do with the revenues; all but one state opted to give the revenues as lump-sum transfers to the polluting firms. (The exception was Virginia, which collected only 5 percent of the revenues through an auction in 2004, but the following year changed the law to ban all future auctions.) 

Recent cap-and-trade proposals in Congress aren’t much better, since they link cap-and-trade revenues to potentially inefficient activities. The Lieberman-Warner bill, for example, would auction 25 percent of the pollution rights in the first year, gradually increasing the auction to 75 percent in 2032. While the greater reliance on auctions is good news, don’t be fooled—the revenues (amounting to hundreds of billions of dollars a year) are not dedicated to reducing economically harmful taxes, but instead go to a grab bag of government projects, such as climate-related research, worker training, job transition assistance, healthcare benefits, energy assistance, weatherization assistance, transfers to state and local governments, and so on. 

One could argue that these revenues are just paying for existing programs, thereby eliminating the need for higher taxes in the future. But proponents of Lieberman-Warner clearly aim to expand government activity. Senator Lieberman has proudly noted that the legislation will provide subsidies for “advanced energy technologies” that are worth more than “six times the investment America made in the Manhattan Project and the Apollo Project combined.” Likewise, Senator Obama’s energy plan boasts that subsidies from his cap-and-trade program will “create five million new jobs.” 

What’s a member of the Pigou Club to do? Mankiw correctly says that economists should not feel constrained by political contingencies. He quotes Milton Friedman as saying, “The role of the economist in discussions of public policy seems to me to be to prescribe what should be done in light of what can be done, politics aside, and not to predict what is ‘politically feasible’ and then to recommend it.” Agreed. But Milton Friedman also warns us that “History suggests that Washington spends whatever it receives in taxes plus as much more as it can get away with.”

Does this mean that I’ll burn my Pigou Club membership card? Certainly not. But unless Washington can overcome its urge to spend, members of the Pigou Club should withhold their support for any pollution tax or cap-and-trade program.

Ted Gayer is an associate professor at Georgetown University’s Public Policy Institute. From July 2007 to July 2008, he served as deputy assistant secretary of economic policy at the Treasury Department. 

Image by the Bergman Group/Dianna Ingram.

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