There is a new working paper out this month titled Five Myths About Carbon Pricing by Gilbert Metcalf, professor of economics at Tufts. The goal of the paper is to explain some of the common misunderstandings non-economists might have about carbon pricing.
Usually it is our job as analysts to translate the work of academics into a more accessible format for policymakers, so it is refreshing to see work like this. The paper is excellent and well worth a read for someone interested in better understanding carbon pricing.
Still, the paper proves its points by examining theories and formulas, so it is not necessarily an easy read. So if you want to understand carbon prices more but don’t have the background to take in lots of math, let's go over the five myths Metcalf talks about, trying to focus on the real world implications.
Myth 1: Carbon pricing will hurt economic growth
Policymaking is all about making tradeoffs, and of course there must be some economic tradeoff to carbon pricing. This tradeoff is the justification the Trump administration used in 2017 when they backed out of the Paris agreement.
Although some tradeoff does exist, we need to ask how big the potential economic loss is. Fortunately, some parts of the world have begun to implement carbon taxes, allowing researchers to compare how these areas perform against their peers.
Using methods such as differences-in-differences and panel regressions, researchers have found that the economic downsides of carbon pricing are likely very small, if they exist at all. With all new research, there should be healthy skepticism about how these results can be applied going forward. Still, the fact that their carbon pricing has not dramatically harmed the economies of any of the places that have implemented it makes it extremely unlikely that a carbon tax would cause much harm.
Myth 2: Carbon pricing is a job killer
If you accept the notion that carbon pricing does not harm economic growth, it should not be too surprising that it does not have a major impact on total employment either. In fact, some studies have found that there are slight increases in employment after a carbon tax.
The employment effect that is more important is the fact that there is a significant shifting between sectors. Carbon intensive jobs are being replaced by non-carbon intensive jobs.
While it is encouraging that carbon prices can be the catalyst for this shift without a net-loss in employment, Metcalf acknowledges that there hasn’t been any research done into the transitional costs of this shift. Even with transitional costs, it is good news for carbon taxes that new green jobs have the potential to replace old carbon intensive jobs.
Myth 3: Carbon taxes and cap and trade programs are equivalent
For those who are new to this topic, a carbon tax reduces pollution by making it more expensive while a cap and trade program defines the maximum amount of pollution and lets the market set a price by allowing producers to trade their allowances of pollution. From an economic theory perspective, these two instruments are two sides of the same coin.
However, the operation of these two systems in practice leads to many important differences. Metcalf talks about how carbon taxes might be preferred because the infrastructure to collect taxes already exists and taxes are easier to plan for than market fluctuations.
The most important advantage of carbon taxes is how they interact with other pollution reduction policies. Under a cap and trade program, new pollution reduction policies are unlikely to reduce the total pollution. This is because it allows the industries where the policy takes effect to simply sell their excess pollution allotment to other sectors.
Myth 4: Carbon taxes are incompatible with emission reduction targets
One major concern with carbon taxes is that they never actually require polluters to reduce their emissions. It just makes them pay more, and if polluters have the resources then they can just keep paying.
While this point is true, taxes can be adjusted to meet emission reduction standards. Metcalf proposes a tax schedule that is tied to emission reduction targets. This would make it clear to everyone when taxes would change and by how much, so firms could easily plan in advance.
Another point Metcalf makes is that emission reduction targets are often flawed. This is because greenhouse gas emissions are a stock pollutant rather than a flow pollutant, meaning they stick around for a long time.
For example, if the goal is to reduce emissions by 50% by 2050, then this could be accomplished by halving emissions in the first year and staying at that level or by slowly reducing emissions every year until 2050. The former would result in much lower total emissions than the latter.
Metcalf’s proposed tax schedule would be tied to cumulative emissions to counteract this. If emissions are too high in one year, that would lead to taxes being higher for a much longer period of time until the cumulative emissions were back in line with targets.
Myth 5: Carbon pricing is regressive
Regressive taxes are taxes that take a larger percentage of someone’s income the lower their income is. Think a flat tax of $100, that would be 1% of someone’s income who makes $10,000 but only 0.01% of a millionaire’s income.
We might expect carbon taxes to be regressive because they are a tax on energy consumption, and generally speaking low income households spend a larger portion of their income on energy usage. We call this part of the equation a “user side impact,” since it impacts the user of the taxed good.
What Metcalf goes into detail about is the “source side impacts” of a carbon tax, or how this policy could affect wages and transfer incomes.
The main point of this section is that despite the fact that this tax is on its surface regressive, it is still a tax which increases public revenue, which then often gets passed through to lower income individuals. The revenue generated by a carbon tax could be used to fund anti-poverty programs. Through good policymaking, we can offset the downsides of a carbon tax.