Sunday, 14 July 2019

Why We Should Be Wary Of Carbon Tax

Being 6ft 7, I don’t have much leg room on planes. This was even more apparent on my night flight back from America in 2017, when the passenger in front of me wanted to recline his chair into a sleeping position, and I had to apologetically advise that this would not be possible as my leg room was already at full capacity. Most people would agree that having this discomfort imposed on me would be unfair to me, and that the passenger in front of me should save my discomfort, or else compensate me for it. This is what is known in economics as a ‘negative externality’ - costs imposed on somebody else that circumvents market signals without due compensation for the costs.

Pollution is another ‘negative externality’ in society - and one that many people want to see drastically reduced. To know if we should reduce pollution, we would need to know what the right amount of pollution is - and that is a complex analysis that we oversimplify at our peril. Consider a factory that emits sulfer oxides in the air. Obviously sulfer oxide emissions affect the pollution levels, but that's not the same as saying that they are bad. Technically, breathing pollutes the environment, but no one sensible suggests we should stop breathing. If a factory is turning a profit, it is creating value in society (because consumers prefer spending on the products to keeping their money), so the right question to ask is whether the pollution the factory emits has costs that outweigh the benefits of the consumer surplus the factory affords to society in total production (not to mention the jobs it creates too) or whether the benefits of the factory outweigh the cost of the pollution.

How can we tell which it is? Here's how; if the negative spillover effects of the pollution are less than the cost of preventing it, the pollution produces more gains than losses. If the negative spillover effects of the pollution are more than the cost of preventing it, the pollution probably should be penalised. The point so many people are missing is that sometimes pollution confers net gains on society (actually, my instinct is it usually does).

Returning to my night flight, here's an essential part of the story that is usually missed: it wasn’t just the case that the passenger in front of me was imposing a cost on me if he reclined, I too was imposing a cost on him by being 6ft 7 and sitting right behind him. This is what is meant by the notion that negative externalities are symmetrical. The passenger in front of me was inconvenienced by my height, just as I was inconvenienced by his desire to recline. And apart from a highly subjective recourse to Kamm’s Principle of Permissible Harm, which is the notion that one may endorse some forms of harm occurring but only if such harm is an effect or an aspect of the greater good itself, there isn’t really a sound way outside of market signals to established whose inconvenience should take precedence over the other’s. Naturally, the price system goes a long way towards solving these problems in advance - for example, by making more desirable things like seats with more leg room more expensive to match their increased demand. As my ticket had already been purchased, the way I rectified the problem was by asking if I could be moved to a seat with more leg room and no passengers in front of me - and the stewardess was happy to acquiesce, making all parties happy with the arrangement.

What I'm conveying here is the Coase theorem*, which basically says, we should never assume that the policy should be "Stop Fred from harming Bob" or "Stop Bob from harming Fred" - we need to work out whether we should allow Bob to harm Fred or Fred to harm Bob. Until we know more details, an abstract argument for preferring Bob over Fred is equally rational for preferring Fred over Bob - the devil is in the detail. Coase doesn't gainsay the value of carbon (Pigouvian) taxes per se, but he does teach us that we need to base the decision on evidence not on logic alone. Should we tax a polluter? Maybe, maybe not. Pollution causes harm to others, but so does taxation. The proper cost-benefit analysis is to consider the cost of failing to tax an emission (more pollution), against the cost of taxing an emission (the stuff we forgo because of the tax), and try to ascertain which is the bigger net cost.

To ensure a balanced enquiry, if I was steelmanning here, and trying to find the best argument for carbon taxes, this 5 point argument is about as good a case as I can make:

1) The main defining problem of climate change is that we are all part of the problem as well as part of the solution. We all rely on vehicles that clog up the road for others, pollute the air, and put the price of fuel up. We also use our central heating, wash our clothes and buy things that came from widespread transportation. Many of us even use aircraft to fly abroad, and run businesses that emit lots of carbon. The upshot is, we all contribute to greenhouse gas emissions, so what's needed is a collective effort to change things.

2) This kind of activity has indirect consequences for people who live near rainforests, people in hot countries, and it may well even have consequences for people who haven't been born yet. Even though both the problem and the solution is a shared one, it is difficult to get everyone to co-operate in shared solutions, which is where the state comes in.

3) The state imposes price increases on our transactions in the shape of carbon taxes, which incentivises us to be self-interested in being more responsible with our environmental activities. One problem I have with carbon tax is that due to lots of asymmetry of information the setting of a carbon tax rate is almost entirely arbitrary. Still, despite this, carbon tax might do some good for the following reason. People change their bad consumption behaviour to accord with differing incentives like price changes. So for example, a tax on carbon dioxide emissions of £50 or £60 a tonne would affect our consumption habits in relation to products and services associated with carbon dioxide emissions.

4) If this tax enabled the government to reduce taxes in other areas, then the carbon tax would help us change our habits and at the same time bring about selection pressure in the market for us to be more mindful of the environment. This is part of a general law of economics – when prices go up or down, people change their buying habits. If the price of red grapes goes up by 40% and green grapes stay the same, people will buy more green grapes and fewer red grapes. If the price of emitting carbon goes up, people will lower their CO2 emissions, which will place selection pressure on consumers and on eco-unfriendly businesses. This means that as carbon/pollution taxes endure, people will look for more ways to be greener, making us as humans more mindful of our environment.

5) The conclusion is that green taxes will do some good to bring about a phasing out of environmentally unfriendly activities.

Are they strong enough arguments to justify carbon taxes? My instincts tell me no - so let's explore those instincts more fully. The problem with carbon taxes in the present day is that if carbon taxes won't really do any overall good, they are probably a waste of time altogether. This may not seem obvious at first, but it should soon be fairly obvious when elucidated. In life, partial efforts are often good, particularly if the results are not impeded by others' non-involvement. Giving to charity is a case in point. If 30% of UK folk donate to Save The Children, then poor children still benefit because despite 70% not giving to that charity (some may be giving elsewhere) what they do collect still helps. Similarly if 90% of the country picks up litter then their efforts are not wasted simply because the other 10% did not. In the cases of charitable donations and litter picking, every little bit helps - and despite being simple on the surface, this is measured with rigorous economics (basically, if the Pareto efficiency or Kaldor-Hicks efficiencies are such that negative externalities are immeasurable or inconsequential to the positives then every little really does help).

But when it comes to reducing your own carbon footprint, things are different - because every little bit does not necessarily help - not in net terms. There are two reasons why this is the case: Firstly, reducing your own emissions is a solitary effort that probably has no real impact at the global level. Even if 50% of the UK's citizens made a concerted effort to reduce their carbon footprint, it would still be a drop in the ocean compared with the triune considerations of a) overall global consumption, b) the extent to which climates change outside of human involvement, and c) the comparative advancements of future generations.

And secondly, your reduced consumption will be offset by increased consumption elsewhere. As a hypothetical social experiment, suppose half the UK population were randomly drawn in a lottery and made to reduce their carbon footprint by 20%, with the other half free to carry on as normal. Here's what probably would happen. The reduction in consumption by half the people would reduce aggregate demand for ecologically unfriendly goods, which would see a drop in their price, which would increase consumption for others. What the 50% will actually be doing is helping out the other 50% in buying cheaper fossil fuels. Obviously that's too simplistic because there are global factors to consider, but they do not affect the truth of the statement that reduced consumption for some will mean increased consumption for others. If you can't get your head around it, imagine what would happen to the price of high heeled shoes if half the high-heeled shoe wearing women in the country stopped wearing them and reverted to flat shoes instead - the other half of the demographic would buy more pairs because they'd be getting them a lot cheaper.

Moreover, because politicians can only bring about the imposition of green taxes on their own citizens, not those of other countries (the EU aside), the same problem will apply at a global level - reduced consumption for some countries will mean increased consumption for those other counties that will be beneficiaries of cheaper fossil fuels. The cost incurred by those carbon-reducing countries will thus have a limited payoff in terms of overall global reduction. So it is literally the case that unless the vast majority of the world’s population are singing from the same ecological hymn sheet, environmental progress in some areas will be cancelled out by environmental regress in other areas.

In actual fact, the dialectic between 'If it makes no overall difference then small interventions will be too costly' plays out exactly this way with what’s called a 'cap and trade' policy, where a government issues annual permits that allow companies to emit the amount of carbon dioxide the cap allows. Companies are taxed if they exceed the permit’s level of emissions, and if they reduce their emissions they can trade unused permits to other companies. The rationale being that as the government lowers the number of permits each year, those permits become more expensive, incentivising companies over the years to invest in clean technology.

Alas, whoever devised this scheme isn’t very far-reaching when it comes to economics. Firstly, like every other state-fixed regulation, the government is bound to get the limit wrong, as it has no clue how much carbon businesses should emit. If their cap is too high it will do little good, and will probably even create an anchoring effect that artificially raises emissions. If the cap is too low it will destroy businesses and artificially raise energy prices to the detriment of the industry and consumers. Secondly, it can disadvantage small businesses who can’t afford to buy a permit, and stifle competition too. Thirdly, (for complex reasons we won’t elaborate on in this blog post) it is easier to calculate carbon tax based on per tonne emissions than it is calculating the optimum number of cap and trade permits.

Here's something else a lot of people get wrong about carbon tax - it is frequently assumed to be a method of reducing pollution, but that's not quite right. Even if there are conditions under which a carbon tax is not as bad as a cap and trade policy, a carbon tax is not a means of reducing emissions down to a nominal figure; it is supposed to be a tool for maximising utility. That is, carbon taxes help us incorporate negative externalities into the price system of a free market whereby polluters carry the costs of their negative externalities, but also whereby the price reaches equilibrium as the costs of pollution are measured accurately against the benefits. That way, those negative externalities are compensated for by the fact that they increase utility to a level greater than their costs. For example, a timber factory and a roadside diner on the outskirts of a city add some pollution to the environment, but they make up for those negative externalities by providing goods and services that people want.

Where they could be a benefit is when carbon taxes intervene in the price system to ensure that future costs of transactions are thought to be worth paying for present benefits. The rate of carbon tax is roughly commensurate with the future cost of pollution, incorporated into the price system to justify the benefits now – it should technically be a tax that attempts to ascertain the benefits of pollution, not the costs. Carbon taxes are far from simply being about lowering emissions, although they will likely change future behaviour as businesses innovate to be greener with improved technology.

Two other big problems with carbon taxes
The first problem is the way carbon taxes are used by politicians to make the state bigger at our expense and for their own gain. Here we can elicit a popular term coined by Bruce Yandle called Bootleggers and Baptists, which is about regulations that provide self-interested benefits for both the regulators and for those thought to be victims of the regulations. It is based on the notion that Baptists support Sunday closing hours, but so do Bootleggers, because if local bars and off-licenses are closed, Bootleggers gain too. Here's how it works. Sunday closing hours benefit both Bootleggers and Baptists, while at the same time purporting to serve the public interests - and the green regulations are of a similar nature, as well as being very short-sighted and hugely damaging. Climate change alarmists naturally support heavy green regulations - because it furthers their own agenda, and enables them to cream off crony capitalist subsidies - but so do some of the biggest polluters too because some of the regulations help shut out competition, which a crony capitalist misallocation of resources.

The second problem is that carbon tax does not really punish polluting companies very much; it tends to punish consumers, who are usually the poorest people in society. When a company is taxed - whether it is carbon tax, corporation tax, or labour tax (the minimum wage) - the cost of that tax cannot be borne by a company, because a company is made up of individuals, and only individuals can bear the cost of taxes. When companies are taxed, the cost either has to be borne by shareholders (with lower dividends), or employees (with decreased wages), or by customers (with increased prices of goods or services). Like with corporation tax and tax on labour, the cost of carbon taxes are primarily borne by customers or employees to avoid being borne by shareholders, because a company will always do its best to pass additional tax costs on to employees or consumers. If the cost of taxes ultimately falls on individuals in the form of higher prices of consumption and lower wages (or in some cases increased unemployment) then a carbon tax policy that tries to hurt corporations who pollute is simply a tax policy that harms the people who are most struggling to get by. You may still support carbon taxes on the basis that consumers are contributing to high-pollution goods and services, and that they are paying their fair share - but it’s a bad argument for saying that carbon taxes make companies greener, because what they mostly do is make poor people poorer.

The right amount of carbon tax is this and only this: it is a tax that imposes prohibitive costs on low-utility activities while still allowing for high-utility activities. The trouble is, due to the complexity and inability to see into the future with any degree of rigour, the level of utility is hard to distil, leaving us only with ambiguous probability. The probability estimate is roughly this; if activity A has significant emissions and few offsetting benefits to make it a low-utility activity then carbon taxes on it could be encouraged. If not, carbon taxes should be discouraged. If activity B has significant emission but enough offsetting benefits to make it a high-utility activity then carbon taxes on it should be discouraged. Where the future costs outweigh the present benefits we should make the activity price prohibitive. Where the present benefits outweigh future costs we should make the activity price conducive. If under a system of high or maximum utility we can't go on to produce an alternative to our carbon taxing system then we know we are doing the best and most practical things; if we can go on to produce a better, higher utility alternative, all the better.

Let me give you a simple illustration to show this: take cars. Either the future technology will or won't turn our car industry from a high emissions petrol/diesel generated industry to a low emissions electric/solar powered industry. All the evidence thus far suggests that it will (there are electric car prototypes in place, even as we speak). Give it a few decades and there'll probably be very few if any petrol or diesel driven cars. So, then, using our utility measurement above, the right kinds of car will be produced in the future if it's efficient to do so - and this will happen irrespective of whether the state influences the market or not. It's true that carbon taxes swing the incentive towards more environmentally friendly industries, but as I've shown, that doesn't mean it's a good thing. Taxes on foreign charity may well swing more donations towards the British Heart Foundation, but that doesn't mean this swing is a good thing either.

Here's an example of how not to undertake this analysis. In October 2018, many MPs wanted to ban all of the standard petrol or diesel driven cars by 2040 and allow only vanishingly low emission vehicles on the roads (presumably electric and solar vehicles). A simple understanding of the cost-benefit analysis above would show that such a ban is irresponsible and unnecessary. Here's why. If the present benefits of petrol or diesel driven cars outweigh future costs, we should carry on supporting them, and taxes imposed upon them are more harmful than good. If on the other hand future costs of petrol or diesel driven cars outweigh present benefits then taxes imposed upon them are still more good than harmful. Translated in terms of what the future will hold, what we are saying is: if future technology brings about electric or solar vehicles with greater utility than petrol or diesel vehicles then we'll see a natural switch driven by voluntary market choices, rendering the ban entirely unnecessary. But equally, if future technology brings about electric or solar vehicles with less utility than petrol or diesel ones then we won't see a natural switch driven by voluntary market choices, which means that banning such vehicles (or even heavily taxing them) will make us all much worse off. Either way, a ban is a foolish thing to impose.

Closing thought
The upshot of all this is that when the state intervenes to mitigate the extent to which humans pollute, the intervention will only be beneficial if it outweighs the costs of intervention - and my instinct is, it usually does not. With carbon tax, politicians are trying to prevent future damage by minimising present benefits. But if present and future benefits of pollution outweigh present and future costs - and it seems pretty certain that they do (by a long way) - we should carry on enjoying them, and taxes and regulations imposed upon industrial activity are more harmful than good. This is what is meant by maximising utility - net benefits outweigh net costs. Greens believe that things like carbon taxes maximise utility. Sceptics like myself believe that carbon taxes impede utility - and I have never had a reason to change my mind.  

The scientific and technological capabilities we have acquired in the past few hundred years will almost certainly make a better job of tackling externalities than carbon taxes, especially if humans are given the freedom to cooperate in problem-solving. Our science, technology and market activity are already making huge differences, and they are the progression trinity that will ultimately bring about the future changes needed. The entire nexus of the global economy is a physical system which is all the time tending towards the principle of maximum efficiency. Although carbon taxes bring in revenue for politicians short-term (for a few decades maybe), the long-term indicators are that the market left to run by itself will naturally make us greener anyway. The reason being: businesses are already looking for the most efficient means of supplying customers using as little energy as possible, because in a highly competitive market it is in their interest to do so to remain profitable. The goal to reduce energy output has already come in various ways: replacement of human energy for machines, replacement of metal-based technology for higher intensity resources or carbon-cased materials, replacement of paper for digital devices, and so forth – and these are improvements in production that naturally improve business’s cost-effectiveness.

The transition from the paper revolution to the digital one required lots of burning of fossil fuels, equivalent to energy being driven into the system from outside, but all the time that external energy is helping the global economy tend towards a path to least resistance very similar to how thermodynamics operates in the natural world. As the old saying goes, you can't make an omelette without breaking a few eggs - and the eggs we've cracked since the Industrial Revolution, while not without some externalities, have done more to improve global standards of living than anything else in human history. Carbon taxes may lead to fewer emissions, but with carbon taxes, energy prices rise, resources are misallocated, innovation is impeded (including innovation that actually helps solve climate change), and many of the world's poorest people suffer as a consequence.

My instinct is that because prices have been changed to account for the increased emissions, the only investment that is needed is investment that is more economically viable than the current prices. The imminent effect of those price changes will tell us the best course of action. If, for example, our ability to augment our solar capacity enables that venture to be price competitive against our current carbon industries then consumers will respond to it. If it doesn't, they won't (that point alone illustrates how state interference will probably impede the process). The costs (present and future) of staying with our current carbon trends have already been factored into the increased prices of our externalities. We don't need to throw much taxpayers' money at it at all - because people's preferences for economic viability will drive this, as already happens in virtually every other market process. Consequently, compared with how the market engenders continually increased efficiency, I'm pretty sure that carbon taxes probably will turn out to have had only a much more negligible effect on lower energy output and more efficient use of resources than the free market, because the market is driven by efficiency far more than politicians with political interest. If there is a race to make us greener, politicians are more like the tortoise and the market is more like the hare.

* Externalities are based on incentives, as was most famously written about by English economist Arthur Cecil Pigou with his standard textbook examples of nineteenth century trains that threw off sparks that frequently ignited the crops on neighbouring farms, and of rabbits that would frequently eat the neighbouring lettuce farmers’ goods. Quite naturally, or so Pigou (and just about everyone else) thought, the railroad owners and farmers with rabbits had to feel the effects of their actions, so recompense was owed to the farmers with the ignited crops and the diminished lettuce supplies. But things aren’t quite so straightforward, because outside of economic expertise, most negative externalities are only narrowly considered from one person’s perspective and not the other. It’s here we need to elicit the Coase theorem – which was conceived by Nobel Prize winner Ronald Coase in 1960. The idea behind the Coase theorem is that negative externalities are not usually asymmetrically one-sided, they are symmetrical. This is what Ronald Coase theorised:
"Where there are complete competitive markets with no transactions costs, an efficient set of inputs and outputs to and from production-optimal distribution will be selected, regardless of how property rights are divided."
In other words, the Coase theorem asserts that when rights are involved, parties naturally gravitate towards the most efficient and mutually beneficial outcome, with no prior blame or discrimination being automatically assumed. This dramatically changes the situations above, because Coase was smart enough to enquire as to why the railroad owners and farmers with rabbits were the ones causing inconvenience – why not the farmers with the ignited crops and the diminished lettuce supplies? If your trains set fire to my crops, then you have imposed a cost on me, but at the same time I have imposed a cost on you by having my crops near your railroad (which may be in the optimal location for transporting commuters from A to B). Moreover, I may very well use the train myself. Your rabbits are annoying me by eating my lettuce; but equally my lettuce is annoying you because it is causing your rabbits to eat them, which incurs the cost you are forced to pay me as compensation. Your nearby power plant burns fossil fuels and pollutes the air I breathe, but you shouldn’t bear all the pollution costs because you supply electricity to many of the places whose products I buy.
Remember, Coase wasn't looking to play the blame game; he was looking for an efficient set of inputs and outputs, regardless of how property rights are divided. In the case of the railroad and the fires, he was looking for a solution that benefits both, not who should reimburse who. If the farmer plants his crops at an optimal distance from the railtrack, then both may enjoy the most efficient outcome. The town has crops and train journeys, and no one is paying financial restitution or looking for ways to sue. Similarly the rabbit farmer can keep his rabbits in cages or secure ring-fences, the lettuce farmer could grow other things the rabbits won’t eat, or they could split the costs and build an impenetrable fence between their farms. The railroad/crops example showed a new way of looking at the situation; yes, if there were no railroad tracks there would be no crop fires, but equally if there were no crops that were so close to the tracks there would be no crop fires either.