Assuming carbon emissions damage the environment, should they be discouraged through taxation? And if so, should the tax revenue be earmarked for damage abatement, or should it be paid into general funds?
Elizabeth Kolbert, writing in the New Yorker, suggests that economic theory decides this question in favor of a carbon tax. As I pointed out last week, she’s plain wrong. As a followup to some of the discussion on that post, here’s a simple example to illustrate that no policy can be infallible:
A steel mill pollutes the air, causing $24 worth of damage to the business of a laundromat next door. (Or if you prefer, read $24 worth of expected damage to the owners of oceanfront property or farmers in currently temperate zones.)
If the steel mill is forced to bear the consequences of this damage, it reduces its output. This cuts the pollution damage by $12, and cuts the profits of the steel mill by $17.
Question: Which is the best policy?
- The steel mill incurs no penalty for polluting.
- The steel mill pays a tax (or fine) equal to the damage it causes; the revenue is used to reduce the national debt.
- The steel mill is required to reimburse the laundromat for all damage.
Answer: It depends. Consider the following scenarios:
Scenario I. The laundromat can fully alleviate the damage (say by moving to another location) at a cost of $6. Under scenario A or B, the laundry chooses to move rather than bear $24 or $12 in pollution damage. Net cost of scenario A or B: the $6 moving cost. Under scenario C, the laundry remains. Net cost of scenario C: the $17 reduction in the steel mill’s profit. Best policies: A or B.
Scenario II. The laundromat can fully alleviate the damage at a cost of $15. Then under scenario A, the laundromat chooses to move rather than bear $24 in pollution costs. Net cost of scenario A: the $15 moving cost. Under policy B or C, the pollution damage is reduced to $12, so the laundromat chooses to stay. Net cost of policy B or C: the $17 reduction in profit. (There is also $12 worth of pollution damage, but this is offset by $12 in tax collections or reimbursement to the laundry.) Best policy: A.
Scenario III. The laundromat can fully alleviate the damage at a cost of $20. Under policy A, the laundromat moves for a net cost of $20. Under policy B or C, the laundromat reamins, for a net cost (in reduced profit to the steel mill) of $17. Best policy: B or C.
Scenario IV. The laundromat can fully alleviate the damage at a cost of $25. Now the laundromat surely never moves. Net cost of Policy A: $24 in pollution damage. Net cost of policy B or C: $17 in lost profit. Best policy: B or C, though for slightly different reasons than in Scenario III.
Moral: Policy A is suboptimal in scenarios III and IV. Policy B is suboptimal in Scenario II. Policy C is suboptimal in scenarios I and II.
Larger moral: You name a policy; I’ll find a scenario in which it’s suboptimal.
Larger moral, restated: You can’t use pure theory to settle this kind of question. Not even if you use fancy words like “Pigovian”.