Monday, July 2, 2007

Global Warming - Tax or Standards?

As global warming becomes an increasingly urgent issue, there are many calls for action. Many call for standards to be set, to achieve a reduction in pollution. In some cases, it seems to make sense to set a standard or to simply prohibit a product or service that causes too much pollution. However, there are several arguments that make tax more attractive compared to standards and outright prohibition. Taxing supply of energy that was generated by burning fossil fuel can often be a better alternative to achieve reductions in pollution. As such taxes make pollution more expensive, markets could work out what was the least polluting alternative.

How well do standards work? The inevitable practicalities of standards are that some rather polluting behavior will be permitted, while other behavior that was far less polluting will be prohibited. Standards are often popular as they seem to come at no direct cost for consumers, whereas taxes only seems to cost us money. But in reality, the cost of compliance with standards can be huge and it may not always make sense, i.e. people do not often see how a standard helps reducing pollution. A tax has a direct relationship with the pollution and therefore makes more sense, especially if the proceeds of tax are used to subsidize local supply of clean and renewable energy.

There is popular support for outlawing cars that are too polluting, but does that justify standards rather than tax? Perhaps someone only drives a rather polluting car for a very small distance once in a while, producing far less pollution than someone who drives a clean car for long distances daily. With tax there's no such judgement call to be made. Taxing emissions constitutes a straitforward and effective instrument to reduce global warming, whereas standards could lead to all kinds of complications.

There's not just an economic argument in there, it's also a moral issue. The reality of global warming urges us to reduce all pollution, rather than to prohibit only some forms of pollution while legalizing and protecting other forms of pollution, as if some were justified in polluting since they complied with an arbitrary standard or were exempt from complying. Indeed, will the army be expected to comply, will police in persuit of subject stick to the limit or will the burglars, for that matter? Tax can simply apply across the board, to all supply of energy resulting from burning fossil fuel. All users pay the tax and they will pay more, the more they use such energy. Such a tax makes sense and is also fair - it penalises all pollution and it penalises the bigger polluter more than the smaller polluter, at a flat rate or under a scale that can be gliding or exponential and that is under control of the legislator and can be adjusted as needed. Standards, by contrast, set arbitrary limits - rather than to prohibit all pollution, they approve some pollution and prohibit other pollution. Standards operate in a framework that only allows one option, i.e. one has to comply with the standard.

Standards put legislators in charge of running the economy. Where standards produce only one correct outcome (i.e. one has to comply with the prescriptions), tax is much more flexible and leaves more choice in the hands of suppliers to come up with products that respond to market demand. These market mechanisms make tax a much more effective instrument, both economically and in terms of reducing global warming. Standards lead to a single product, designed by legislators and administrators, with all the associated risks of bureaucratic waste, little innovation, favoratism and collusion.

Standards give suppliers an economic incentive to operate on the edges of what the standard permits, seeking loopholes and ways to slip through the mazes. A standard forces all suppliers to produce a product that is just as polluting as their competitors, thus maximising (permittable) pollution. By contrast, tax doesn't prescribe product details other than that the more one pollutes, the more tax is paid. Tax thus leaves it up to suppliers to design a product, while creating incentives to produce a product that reduces pollution more than their competitors.

Also, standards can come not only with a high cost of compliance, but also a high cost of administering the standard. Who pays for the cost of setting the standard, administering it, the technical testing and the testing of the dicisions in court? Who pays for the cost of enforcement? What will happen if one does not comply? Who pays for imprisonment of offenders?

By contrast, tax raises money in a rather simple and straitforward manner, without the need for a battery of trained technical staff and experts to test things. As said, the proceeds of tax could be used to subsidize local supply of clean and renewable energy, making the policy more effective, whereas there's less clarity what the impact will be of the cost of standards.

Standards cost a lot of money. Should penalties paid by offenders perhaps pay for that cost? Designing a policy on that basis would only lead to administrators becoming dependent on revenue from fines and give them an incentive to chase fines instead of reducing global warming. It's often hard to get rid of such administrators. Tax, by contrast, will simply go away by itself. If no more energy is sold that resulted from burning of fossil fuel, then no tax will be levied on the supply of such energy.

In conclusion, taxes work better to combat global warming than standards. Mind you, I'm not arguing to abolish all standards. There's a place for standards and I surely wouldn't want to abolish safety standards for vehicles. But what we need to look at here is what is the most effective framework. Note that we have progressive income taxes (i.e. the more you earn, the higher the scale at which you're taxed). Yet, Warren Buffett, the world's third-richest, was last year taxed at 17.7 percent on his taxable income of more than $46 million, while his receptionist was taxed at about 30 percent.
This because there are so many deductions and loopholes in the tax system. If we're to introduce a progressive tax on fossil fuel (one that increases as one pollutes more), then we have to be very cautious about possible exemptions and deductions. Also, taxes run the risk of being consumed by administrators who seek to perpetuate their bureauracy.

The framework I propose is a combination of tax and subsidies. The proceeds of the proposed tax on fossil fuel should be spent to subsidize local supply of clean and renewable energy, rather than end up in the consolidated government funds. If we taxed the rich polluters and spent the money to help the poor polluters (as in the old socialist motto), then pollution will only increase, as the rich can afford to continue to pollute, while the poor will pollute even more if they get paid to do so. the rich can afford the higher energy prices (being rich) while the poor get compensated (either directly from the proceeds of the carbon tax or because the proceeds will be used to lower income and payroll taxes), then there will be little or no change to people's patterns of energy use. As said, the rich can afford to continue with their current lifestyle while the poor get financial support, so there's little or no incentive for either to change.

I don't want to see the proceeds of emissions tax added to the consolidated government funds, because of the risk that it will then be used to assist people buying fossil fuel or simply to feed a wasteful bureaucracy. Instead, I want all proceeds to be used directly to subsidize clean and renewable energy. It should be a local dollar for dollar exchange, to assure people that their money will be used to lower the price of clean energy in their area. That way, the combined policy will be most effective and most easily accepted.

I propose a new emissions tax to be introduced and the proceeds to be used to subsidize local supply of clean and renewable energy. An emissions tax introduced as a new tax doesn't require budget changes and makes it easier to raise extra money to subsidize alternative energy, which will reduce the local price of alternative energy and which in turn will help people cope with higher energy prices. A new tax could be justified on those grounds, and also on the need to become energy independent and since the urgency of global warming warrents compensation for cost to be more directly included in the price of fossil fuel.

My feeling is that a new tax at a mere 10% would be acceptable to the public and (given the proportion of energy now generated from fossil fuel) such a tax would result in a huge amount of money. If (as I propose) all that money was used to subsidize clean and renewable energy, it would probably be more than the alternative energy industry could handle at this time. Instead, we need a framework of policies that work together to establish a shift away from burning fossil fuel. We need to subsidize local supply of clean and renewable energy, but where should we get the money for such subsidies? Doesn't it make a lot of sense to get those who pollute most to pay for it?