Thoughts on the Relative Merits of Cap-and-Trade versus Emission Taxes for Controlling Carbon Emissions.

Wednesday, May 27, 2009

By Bruce Yandle
Professor of Economics Emeritus,Clemson Univ.,
Distinguished Adjunct Professor of Economics, Mercatus Center, George Mason Univ.,
Senior Fellow, Property and Environment Research Center (PERC)


For decades, policy makers have debated the relative merits of alternate instruments for controlling unwanted stationary and mobile-source emissions. The instruments include 1) performance standards, 2) technology-based, command-and-control, 3) taxes and fees, and 4) cap-and-trade, market-like mechanisms. There is a strongly held conviction among economists and other analysts that technology-based, command-and-control regulation is the most costly and least effective instrument for reducing emissions. Even so, top-down command-and-control lies at the heart of basic U.S. statutes for controlling both air and water pollution.

In addition to being demonstrably the least cost-effective of all control instruments, command-and-control, which focuses on inputs instead of outcomes, has the additional disadvantage of eliminating the competitive spur for developing and implementing cost-effective methods for reducing emissions. U.S. style command-and-control, which sets stricter standards for new versus existing emission sources, also weakens the competitiveness of national industries and encourages cartelization through regulation.

Command-and-control has been shown to extend the life of older capital in polluting industries, thereby producing a dirtier rather than a cleaner environment. However, the opportunity for raising price through regulation attracts the support of some industries and firms for technology-based, command-and-control regulation. This support is buttressed by the support of some environmental organizations that favor the apparent certainty of centralized, top-down, command-and-control regulation. Those regulations that cartelize major polluting industries at the national level also cartelize national environmental organizations and support their economic success.

In recent decades, the U.S. has supplemented technology-based regulation by the addition of market mechanisms including cap-and-trade air pollution control. The use of cap-and-trade regulation for sulfur dioxide emission control and the requirement for air emission offsets in air quality in non-attainment regions are prominent examples of cap-and-trade air quality control. Recent emphasis on watershed institutions for managing water quality now encourages water quality trading within the limits set by technology-based regulation. The use of these incentive-based approaches for managing environmental quality has demonstrated their effectiveness in reducing both emissions and costs.

The Use of Taxes for Emission Control

Oddly enough, the United States has never adopted emission fees or taxes as a federal instrument for controlling emissions, although emission taxes have been used at the regional level of state government. Experience with emission taxes elsewhere demonstrates their effectiveness in reducing unwanted emissions. Unsuccessful U.S. efforts to control by taxation reach as far back as the Nixon administration and are as recent as the Clinton administration. However, every attempt to regulate by taxation has been rebuffed by an anti-tax objection that taxes raise costs, as though command-and-control regulation or cap-and-trade does not. Since any form of regulation will raise costs, the anti-tax objection apparently hides a real objection that may in fact be the preference for regulations that cartelize and raise profits, which is something taxes or fees cannot do. It is also possible that political preferences for command-and-control or even cap-and-trade rest on preferences for the possibilities that some sectors and industries will be treated advantageously when the controls are imposed and the permits for pollution caps are granted.

Controlling Carbon Emissions

When approaching the design of institutions for controlling carbon emissions, it is understandable that policy makers would be attracted to consider cap-and-trade as an appropriate mechanism for achieving the overall goal of reducing emissions, especially during times of fiscal stress when there is the possibility of auctioning off the rights to pollute. The political preference may be explained by the following reasons:

  • Cap-and-trade has been shown to work in the United States in the control of sulfur dioxide emissions from major sources of that pollutant.
  • Cap-and-trade, unlike command-and-control, induces cost-effective control thereby minimizing the technical cost for achieving a particular level of emission reduction.
  • The initial sale of emission permits when installing cap-and-trade can be the source of a large amount of one-time revenue.
  • Differential treatment of firms, industries, regions of the country and even interest groups is possible. Huge wealth grants can be provided to favored organizations by an initial free grant of permits that can then be sold.
  • The support of environmental organizations can be predicted, since the "cap" component of cap-and-trade means that the allowable level of emissions is fixed below the current level.

As indicated, the expected political support rests largely on the possibility of transferring wealth to favored groups, at the expense of the forgotten and disregarded groups.

Cap-and trade is an excellent example of my theory of Bootleggers and Baptists in action. Industrial groups and firms that are low carbon emitters, for example nuclear powered electricity producers as opposed to coal-fired producers, play the role of bootleggers who favor laws that limit carbon. The environmental groups are the obvious Baptists who take the moral high ground. Those who might object to the Bootlegger/Baptist political threat can be bought off by giving them an allocation of emission permits that can then be sold at auction.

Assessment of the relative merits of cap-and-trade for carbon control are based on critically important assumptions or no statement at all about the cost of determining the initial allowable level of carbon emissions for sources, the cost of monitoring outcomes, and the cost of enforcing and managing the standard. Put another way, the proponents of cap-and-trade generally behave as if there is no cost associated with the operating the trading institution. Attention paid to the sad European Union experience with cap-and-trade carbon control might lift the importance of assessing the prospects for successfully designing a trading institution that actually works.

Cap-and-Trade versus Taxation

Under a set of well specified conditions, it can be shown analytically that a properly designed carbon tax can induce the same level of carbon emission reductions as a cap-and-trade system and do so at the identical cost per ton of carbon emissions eliminated, assuming the cost of operating the two institutions is the same. Put another way, in a classroom setting with full information on production, production costs, and energy costs for all industries, an approach using either system can be shown to generate identical results, in a static situation.

Of course, when politicians speak of adopting one approach or another, they are not operating in a classroom environment. The world is full of unknowns, uncertainties and continuous change. When a tax approach is compared to cap-and-trade, the tax approach offers the following advantages:

  • Taxes can be raised and lowered with relative ease when market and environmental conditions change in ways that call for more or less carbon reduction from particular sources. Once allocated, it is politically and economically difficult to recall permits or to increase the number of permits in use.
  • Taxes allow for entry and exit of carbon emitters without resort to petition for emission rights. If emissions are expanded, the tax bill rises. If emissions fall, the bill goes down.
  • There is no Bootlegger/Baptist effect with emission taxes, although there can be political favor seeking for those who seek special tax treatment.
  • Taxation provides a readily available source of information on the annual cost of allowing carbon emissions, since the total taxes paid will be a proxy for that cost.

Just as in the case of cap-and-trade, the cost of operating an emission tax institution is unknown and unknowable.

Making Emission Taxes more Attractive

The fact that emission taxes are taxes is a major objection to the control instrument. Taxpayers almost instinctively prefer lower, never higher, taxes. As indicated earlier, there is also a tendency for many to believe that cap-and-trade is not costly, since the additional cost induced by the system is not seen each year as a tax.

In recent years, proponents of carbon and other emission taxes have softened the tax objection by placing a tax reducing dividend in the package with the emission tax. Reducing the marginal tax on labor so that the total amount of taxes reduced will equal the proposed emission taxes neutralizes the tax effect when examined at the level of the aggregate economy. A reduction in taxes on labor leads to increased labor supply and more output and income. A tax on carbon leads to higher priced consumer goods, lower consumption and lower carbon emissions. When combined, the two effects can lead to a net gain in carbon emission reductions and in total personal income. (I emphasize the word "can." Depending on the relative carbon and labor content of an economy and the design and application of the tax, other outcomes are possible, including a net decrease in total personal income, with lower carbon emissions.)

A No Regrets Policy

In recent years, I have published a no regrets policy for carbon emission control that contains the following features:


It is impossible to determine conclusively if there is a change in the long-run trend of earth temperature and climate conditions. The facts are unknowable. Models and forecasts based on them enable policy makers to consider options and actions.

It is impossible to know the extent to which the United States or any other country is or will be a net carbon emitter. That is, the effects of sequestration, discharging carbon emissions to oceans or into the earth have not been taken into account with precision.

Policy Proposal

When facing an unknowable risk but seeking to take an action that will reduce the risk, it is possible to develop a no regrets policy, which is to say that the policy will be beneficial even if the risk is found later to be trivial.

If there is a carbon emission problem, then the more rapidly capital is replaced with more energy efficient capital, the less carbon will be produced. Action: Reduce capital gains taxes to zero.

If prices of competing energy sources are not based on market-determined costs, then the use of energy will be distorted. This can lead to great carbon emissions. Action: Eliminate all taxes and subsidies currently applied to coal, gas, petroleum, ethanol, solar, wind, hydro, and every other energy source.

If there is climate change, changed migration patterns will follow. Action: Redesign immigration laws to facilitate the movement of people across borders and space.

Finally, only as a last resort adopt a carbon regulatory control instrument and only upon having assessments of the extent to which the country is a net carbon emitter. When considering instruments, let carbon taxes play the role of champion for comparison by all other instruments. Sweeten the carbon tax proposal by including equal reductions in taxes on wages as determined by marginal tax rates. 

Bruce Yandle is a consultant, writer and speaker on economics and political economy. He is Mercatus Center Distinguished Adjunct Professor of Economics at George Mason University and participates regulatory in the Center’s Capitol Hill lecture series. Yandle is Dean Emeritus of Clemson University’s College of Business & Behavioral Science and...
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