Economic Distortions And Carbon Tax Receipts

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An explicit assumption of the general equilibrium models is that deviations from the base run entail 'distortions' which incur costs. Thus Gaskins and Weyant write of 'the distortions to the economy caused by the imposition of the carbon tax' (Gaskins and Weyant 1993:320). Jorgenson and Wilcoxen write of the 'introduction of distortions resulting from fossil-fuel taxes' (Jorgenson and Wilcoxen 1993:518).

On the revenue side, a common procedure is to recycle the revenues by means of lump sum rebates to households. This is the procedure followed by Jorgenson and Wilcoxen (1992:88; 1993) and in the models participating in the comparative study co-ordinated by the Energy Modelling Forum at Stanford University. Gaskins and Weyant, reporting on the study, say that under this procedure the GDP losses caused by the carbon tax can be calculated 'without adding a credit or subtracting a penalty for the way the revenues are used' (Gaskins and Weyant 1993:320). Jorgenson and Wilcoxen note that this procedure 'is essentially the replacement of a lump-sum tax (the rebated labor tax) by a distorting one (the carbon tax)' (Jorgenson and Wilcoxen 1992:96, note 53). This way of proceeding can therefore be summarised as follows:

• The economy is presumed to start from and finish in a position of equilibrium with no unemployed resources.

• The carbon tax introduces distortions while raising revenue.

• The revenue is recycled through the economy by reducing non-distortionary taxes (even where it could replace distortionary taxes).

Such a procedure would not appear to accord with economic reality or optimal policy-making possibilities. For example, it is clear that there are considerable unemployed resources in the economy (i.e. labour) and substantial distortions are likely to be present in the base run from the existing tax regime, which bears heavily on labour and capital. Moreover, the phenomenon of global warming itself is a classic example of a negative distorting externality. Ballard et al. calculate the marginal excess burden (MEB) of taxation in the United States to be in the range 17-56 cents per dollar of extra revenue (Ballard et al. 1985:128). Jorgenson and Yun (1990) find that the MEB of the US tax system as a whole, even after the tax reform of 1986 which was widely held to have reduced the excess burden, is 38 cents per dollar of revenue raised. Some components of the tax system had far higher costs, e.g. the MEB for individual capital taxes was 95 cents per dollar (Jorgenson and Yun 1990:20). Jorgenson and Yun acknowledge that their MEB estimates 'are considerably higher than previous estimates. This can be attributed primarily to the greater precision we employ in representing the US tax structure' (Jorgenson and Yun 1990:6). Nordhaus notes that 'some have estimated [the marginal deadweight loss of taxes in the United States] as high as $0.50 per $1.00 of revenue' (Nordhaus 1993:316). However, in his simulation using carbon tax revenues to replace burdensome taxes, he uses the value $0.30. Cline uses the value $0.33 (Cline 1992:294).

Jorgenson and Wilcoxen argue against their own earlier practice of lumpsum recycling of revenues thus: 'This is probably not the most likely use of the revenue Using the revenue to reduce a distortionary tax would lower the net cost of a carbon tax by removing inefficiency elsewhere in the economy' (Jorgenson and Wilcoxen 1993:20).

This is precisely the effect that is obtained in all models that do in fact reduce distortionary taxes to offset a carbon tax. Jorgenson and Wilcoxen (1993:22, Table 5) themselves find that a 1.7 per cent GDP loss under lumpsum redistribution is converted to a 0.69 per cent loss and a 1.1 per cent gain by reducing labour and capital taxes respectively.

This effect has also been shown in the work of Nordhaus. Nordhaus (1991a), on the basis of an abatement-cost curve derived from his survey of extant models in Nordhaus (1991b) and his own calculation of a global warming damage function, arrived at an efficient level of a carbon tax of $7.33 per ton CO2 equivalent (Nordhaus 1991a:934). By 1993, using his own DICE model, the optimum carbon tax had fallen to $5.24 per ton CO2 equivalent. Using a carbon tax of $56 per ton to cut emissions in 1995 by 20 per cent from 1990 levels caused an annualized global GDP loss of $762 billion (Nordhaus 1993:315). However, these DICE results came from recycling the carbon tax revenues through lump-sum rebates. When instead carbon taxes are used to reduce other burdensome taxes, then the optimal tax rate becomes $59 per ton, emissions go below the 20 per cent cut and annualized GDP rises by $206 billion. Nordhaus notes: 'The importance of revenue recycling is surprising and striking. These findings emphasize the critical nature of designing the instruments and use of revenues in a careful manner. The tail of revenue recycling would seem to wag the dog of climate-change policy' (Nordhaus 1993:317).

Barker has consistently argued against lump-sum rebates to offset revenues: 'An alternative treatment would be to find which existing tax creates the largest distortions in the economy and the highest loss of welfare and then to use the carbon tax revenues.. .to reduce the marginal rates of this tax' (Barker 1992:9). Boero et al. agree: 'Economically we should seek to reduce the most distortionary (tax)' (Boero et al. 1991: 93). On Jorgenson and Yun's figures this would mean initially offsetting taxes with an MEB of 95 cents per dollar. Because of interaction effects between the taxes, it is not possible to argue that, for this tranche of offset, each dollar of carbon tax revenue raised would generate a 95 cent increase in welfare because of distortionary reductions elsewhere; but it may be noted that this rate of offset is more than three times that used by Nordhaus in his 'tail-wagging' calculation discussed earlier, and could thus be expected to yield a substantially higher optimal tax rate than his $59 per ton CO2 equivalent.

While they do not report the MEB figure they used, Gaskins and Weyant confirm the importance of this approach to revenue recycling: 'Simulation with four models of the US economy indicate that from 35 per cent to more than 100 per cent of the GDP losses could ultimately be offset by recycling revenues through

Greenhouse gas emissions ffrom fossit fuel use)

Figure 12.4 Marginal costs and benefits of greenhouse gas emissions: MC, marginal cost curve of damages from global warming; MNPB, marginal net private benefit of emitting greenhouse gases

Greenhouse gas emissions ffrom fossit fuel use)

Figure 12.4 Marginal costs and benefits of greenhouse gas emissions: MC, marginal cost curve of damages from global warming; MNPB, marginal net private benefit of emitting greenhouse gases cuts in existing taxes' (Gaskins and Weyant 1993:320). This means that the figures of GDP loss as surveyed by Boero et al. (reproduced here as Figure 12.3) and Gaskins and Weyant (1993:321) indicate possibly excessive costs, because they are based on suboptimal policy-making.

With regard to the supposed 'distortions' introduced by the carbon tax, this too would appear to be a misstatement of the situation. Global warming is likely to entail substantial external costs imposed by high emitters of greenhouse gases on low emitters of greenhouse gases and future generations. It is an economic distortion caused by the use of the atmosphere as a free good for the disposal of greenhouse gases. The carbon tax is intended to rectify this distortion by bringing the marginal costs and benefits of GG emissions back into balance, thereby internalizing some of the costs of global warming into the activities which cause it. As Pearce says: 'While most taxes distort incentives, an environmental tax corrects a distortion, namely the externalities arising from the excessive use of environmental services' (Pearce 1991:940).

The situation is as set out in Figure 12.4. With no carbon tax, GGs will be emitted at a level Q. With the imposition of an optimal carbon tax t*, emissions will fall to Q*, which must be regarded as the undistorted position of economic activity. The imposition of the tax has removed the distortionary loss equivalent to the area abc.

It should be noted that, even at the optimal position Q*, society is subject to an external cost burden equal to the area under the MECj curve between the origin and Q*. This cost is borne because, below Q*, the marginal private benefits are greater than the marginal external costs, and the private benefits are assumed to add to the social benefit overall. However, it is clear that there are many people in the world (low GG emitters) who may be expected to incur damage from global warming but who derive practically no benefits from GG emissions, because, perhaps, they and the societies in which they live use little fossil fuel. To be fully inclusive, the MEC curve must include, in addition to a comprehensive and correct valuation of the damage costs, appropriate weightings that take account of both distributional issues and uncertainty.

The intergenerational issues will be dealt with directly through the discount rate that is chosen. The intragenerational distributional issue is normally ignored in damage cost calculations, i.e. no extra weight is given to damage suffered by low GG emitters than to that suffered by high GG emitters. In fact, a negative weight is often implicitly implied, because high GG emitters, being richer, have a higher willingness to pay to avoid damage, so the damage incident on them is valued more highly than that incident on poorer low GG emitters. If the damages facing low GG emitters were given higher weight, this would have the effect of shifting the MEC curve to the left, perhaps to MEC2, yielding a new optimum tax rate t** (>t*) and lower GG emissions Q**. In effect, the external cost aefg would have been revalued at hdfg.

A similar result would occur if a weight was given to risk aversion by policy-makers against the possibility of higher than expected damage. Q** could again become the optimal position, with the excess lost private benefit over external cost saved, aed, being regarded as an insurance payment in case the expected damage given by MEQ is underestimated. The incorporation of risk aversion into a benefit-cost analysis in this way can make a substantial difference to its outcome. In Cline's study, the application of risk-aversion weights of 0.125 to his low damage estimate, 0.5 to his central estimate and 0.375 to his high damage estimate converts the central estimate's benefit-cost ratio of 0.74, with no adjustment for risk, to a ratio of 1.26, thus justifying a programme of 'aggressive abatement action' (Cline 1992:300).

The conclusion of this analysis is that, where external costs are important and their valuation is complex, the incorporation of considerations of distribution, equity, uncertainty and risk can make a significant difference to where the 'undistorted' position of economic activity is taken to be.

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