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October 17, 2013

The Rest of the Story Part 2: McKitrick on the Elusive “Double Dividend”

October 17, 2013
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Over the summer, the Institute for Energy Research (IER) hosted a conference entitled, “A U.S. Carbon Tax: The Rest of the Story.” We picked experts from both academia and policy analysis to demonstrate that the American public has been getting a very biased perspective on the case for a carbon tax. Even if we accept at face value the official position of the IPCC on the natural physical science of greenhouse gas emissions and climate change, the economic science doesn’t automatically point to a U.S. carbon tax the way its proponents would have us believe.

I have already posted about my own presentation on the panel (concerning some surprising facts about the “social cost of carbon”). In this post, I’ll walk through the talk given by Dr. Ross McKitrick, a world expert and graduate-level textbook author on the economics of environmental policy. For our panel, McKitrick discussed the alleged “double dividend,” in which advocates of a carbon tax claim that it is a “win-win” because it will help the environment and allow for faster economic growth due to tax cuts elsewhere in the code.

Yet as McKitrick shows, such claims ignore the bulk of the peer-reviewed economics literature on the subject: even a theoretically perfectly designed “carbon tax swap” would likely harm the economy. The advocates of a carbon tax need to educate themselves and stop claiming, matter-of-factly, that a carbon tax would allow for “pro-growth” tax reform.

The Elusive “Double Dividend”: Some Background

Realizing that Americans do not want to pay higher taxes, even for alleged mitigation of future climate change damages, the proponents of restrictions on carbon dioxide emissions in recent years have emphasized the argument that a carbon tax’s receipts could be used to finance tax cuts elsewhere in the code. A few prominent conservative intellectuals and former policymakers have made this point in particular, arguing that a revenue-neutral carbon tax would be good for the economy, regardless of the impact on the environment. The basic idea is to “tax bads, not goods.” Surely if the government is going to discourage behavior with a tax, we want to tax odious emissions rather than labor and saving, right?

As it turns out, this simple intuition is just plain wrong. The published literature is somewhat mixed, but comes down in favor of the view that there is not a double dividend. In other words, the economists specializing in this line of research think that if the government imposes a carbon tax—even if every dollar of revenue is used to give a corresponding income tax cut—then conventional economic growth will suffer.

Obviously, in the real world, even this scenario is absurd; of course the government would increase its spending in light of a new carbon tax, bringing in billions of extra dollars. In my study for IER, I walked through several lines of argument to show just how dubious the notion of a “carbon tax swap” really is.

Yet in his talk, McKitrick focuses on the pure economics, to show that the bulk of the research concludes that even in principle, a revenue-neutral carbon tax would harm the economy. McKitrick’s presentation at times is a bit technical, so I refer non-economists to my article on the “tax interaction effect” to assist in understanding it. The basic idea is that in the presence of a pre-existing tax code, levying a new carbon tax exacerbates the original inefficiency. So it’s true that using carbon tax receipts for income tax reductions is better than simply spending the new money, but that doesn’t mean the whole thing is a wash (let alone a gain, as the “double dividend” people claim).

McKitrick’s Presentation With Highlights

Below is the video for McKitrick’s presentation, or the YouTube link is here. Underneath the video I highlight key moments from his talk.

  • 1:00 – 2:00 McKitrick explains the “Pigovian” (named after the economist Pigou) analysis in which a tax on a “negative externality” is supposed to help, by reducing the behavior, such as emissions, toward the “socially optimal” level. But nobody really looked at how the tax revenue was used.
  • Around the 3:00 mark, McKitrick explains that in the 1990s, economists began studying the effects of a completely revenue-neutral tax on a negative externality. This is where the “double dividend” idea comes into play, since—in theory—it should be good to (a) levy a tax on the behavior causing the negative externality and (b) raise revenue that will allow taxes on socially useful things (like labor and saving) to be reduced. Some economists became excited that “revenue recycling” (where the revenue from an emissions tax, say, is devoted to income tax or capital gains tax cuts) provided a painless way for the government to help both the economy and the environment.
  • At 4:05 McKitrick raises the issue of the “tax interaction effect,” which caused researchers to pause in their tracks. The new tax—even if it’s levied on a negative externality—will still interact with the pre-existing tax code, exacerbating the original inefficiency in the code (or raising the “excess burden” of those original taxes). Thus the benefits of “revenue recycling” must be contrasted with the harms of the tax interaction effect. Is there a double dividend? Only if the former outweighs the latter.
  • At 4:30 McKitrick says the “overly strong” claim was clearly false: We can’t say that any emissions tax that is coupled with 100 percent revenue recycling is always better than the status quo, even though that’s what some economists had originally thought. Thus, the people today who say matter-of-factly that the government should “tax bads not goods” are decades out of date, with respect to the actual published literature on the topic.
  • At 4:45 McKitrick discusses a weaker version of the double dividend claim, which says that once we consider the possibility of revenue recycling, the government ought to set the emissions tax higher than the level that reflecting the negative externality. So for example, if the “social cost of carbon” is $35 per ton, then this weaker version of the double dividend hypothesis says that the government should set the actual carbon tax at higher than that, perhaps $40 per ton, since the carbon tax receipts not only help mitigate global warming, but also allow for pro-growth income tax cuts. Yet, McKitrick says that researchers in the field quickly concluded that even this weaker claim was probably false.
  • Starting around 6:45 McKitrick explains that the first economists to develop models with enough detail to show the possibility of a revenue recycling effect, discovered that in fact the government should set a carbon tax much lower than the “social cost of carbon.” In fact, with plausible estimates of the actual “social cost of carbon,” the optimal carbon tax could be $0 per ton. This shows the tremendous importance of the tax interaction effect.
  • Starting at 8:00 McKitrick tries to explain why the pre-existing tax code matters so much in these analyses. Part of the explanation is that the emissions tax has a smaller “base” than broader taxes such as income taxes. There is a general rule in the tax literature that a tax should be applied on as large a base as possible; this is one reason that a “revenue neutral carbon tax” can harm the economy.
  • Around the 12:00 mark, McKitrick showed that actually Sandmo in 1975 had provided the general framework for thinking about these issues. These remarks will probably only help professional economists make sense of the seemingly counterintuitive result that the government should set an “optimal” carbon tax less than the “social cost of carbon.”

Conclusion

The pro-carbon tax camp needs to stop matter-of-factly claiming that a revenue-neutral carbon tax will be good for economic growth. As Ross McKitrick’s presentation shows, the peer-reviewed published literature shows that the exact opposite is the case. And of course, in practice the government would not reduce other taxes dollar for dollar, making the “conservative” case for a carbon tax even more dubious

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