The Economist’s Favorite Tax

Economists love taxes. At least, we love the right kind of taxes, those that discourage bad actions and encourage good ones. Tobacco taxes, for example, make smoking a habit that hurts your pocketbook as well as your lungs. Evidence suggests that teens smoke less just because it has become so darned expensive. Hear, hear!

A “carbon tax” is one of the good taxes. If you accept any one of the following propositions – a)human activity has precipitated global warming, b)human activity hasn’t done so in the past, but it might in the future and this would be a bad thing, OR c) fossil fuel imports put money in the pockets of unstable nations and the world would be a safer place if we used less – then you should support a carbon tax. (If you don’t accept any of the above conditions, it is time to turn the page.)

The carbon tax is finally catching on—it no longer lives only in the gleam of an economist’s eye. British Columbia began to assess a tax on carbon in July, 2008. And it seems to be working as we would expect. Recent reports suggest that fuel consumption fell 4.5%, more than in the rest of Canada over the same period. Australia also joined the carbon tax party, imposing a carbon tax ($24/ton) on its 500 largest polluters (mostly power generators).

The model in British Colombia is designed to be “revenue neutral.” All taxes collected through the carbon tax will be converted into reductions in other taxes. Now set at $25/ton (on its way to leveling off at $30/ton in 2012), the tax adds about $.21/gallon to gasoline prices. The payback to taxpayers comes in the form of a 5% reduction in the bottom two income tax rates plus reductions in small business and corporate income taxes. BC politicians apparently know the value of symbolism, too: Every adult citizen receives an annual check for $100—a “Climate Action Credit”—and children received $30.

At this point, readers are likely divided into three camps: 1) “Good show, BC. We should do this here.” 2) “Sure, tax the bejeezus out of carbon. But don’t give the money BACK. Put it into supporting alternative fuels.” 3) “No tax is a good tax and no government has ever passed a measure that is revenue neutral. This is socialism masquerading as environmental policy.”

We economists like this sort of environmental policy because it is so much better than the alternative, i.e. subsidizing something that legislators, in their infinite wisdom, believe is a good thing. I offer two examples: Corn ethanol and solar power.

The scientific consensus on corn ethanol is clear: Growing the corn and converting it to fuel generates more carbon than we save when we use it to replace gasoline. It is an inefficient means of reducing either carbon emissions or our dependence on foreign oil. Earlier this summer the U.S. Senate finally saw fit to repeal the explicit $.45/gallon subsidy and $.54 tariff on imported ethanol, an action that doesn’t kill either measure but suggests that Congress is poised to do so. The Administration’s “renewable portfolio standard” still requires that 7.5 billion gallons of ethanol be mixed with gasoline next year, however, nearly double the total in 2006. Why? Because Corn Belt politics continue to defend this wasteful diversion of corn from food to fuel—4 of every 10 ears of corn, according to the New York Times.

And solar? Apparently it is not ready for prime time. I pass along an anecdote from my brother, now residing in Phoenix, Arizona. Barry’s employer, the charity Food for the Hungry, was offered a grant paying 100% of the cost of installing photovoltaic panels on its roof (51 panels generating 12 kilovolts of power, if you know about these things).

Unfortunately, the utility’s financial justification for this action is based on a slew of weak assumptions. First, the utility assumes that power prices will increase on average 6% per year. Second, it assumes no maintenance costs. Third, it assumes that the money invested in the project today has no alternative use, i.e. you can borrow it for free or, if you have the money, it would otherwise sit in a box under your mattress (no present-value discounting, for you finance geeks). Even with these rosy assumptions, the payback for the $52,000 installation is a lengthy 21 years. Assume you borrow for the project at 3% and prices rise at only 4% per year, and the payback stretches to 34 years. And this is in Phoenix, with 300 days of sun per year on a flat roof with nothing between the roof and the sky. I shudder to think what the payback would be in Rochester.

We’ve a long way to go before we run out of fossil fuels. Yet environmental concerns and worries about our dependence on Middle East oil suggest that we wean ourselves from fossil sources sooner than later. The critical policy question is, how? It is far better policy to drive up the cost of dirty fuels through taxation than to drive down the price of unripe technologies through subsidies, selected for us by federal and state legislators and regulators.

ORIGINALLY published in Rochester Business Journal 8/12/11