The Magazine

The Exploding Carbon Tax

The costs imposed by the cap and trade system are equivalent to raising a family of four's income tax by 50 percent.

Jun 22, 2009, Vol. 14, No. 38 • By MARTIN FELDSTEIN
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The combination of permit giveaways to selected firms, separate administrative regulations aimed at CO2 reduction, and a market for offset credits means that the Waxman-Markey bill lacks the efficiency virtues of the classic cap and trade system. Some of its supporters may not care that it reduces U.S. emissions inefficiently and does little to reduce global warming as long as it produces a large future source of government revenue. If cap and trade legislation is passed, it should be for a relatively limited period of time like five or ten years rather than the 40-plus year horizon in the Waxman-Markey bill. We need to see how the system works in practice. In particular, it is not clear how CO2 monitoring and compliance will work in all of the participating countries.

Scientific knowledge in this field is changing rapidly, and our approach to global warming should be flexible as we learn more. One important approach being explored by scientists, geo-engineering, is not even recognized in the Waxman-Markey legislation or in the administration's original proposal. (Geo-engineering uses a variety of technologies to offset the warming effects of the level of CO2 in the atmosphere.) If one or more of the geo-engineering methods is successful, it will be possible to have higher levels of CO2 emissions without the adverse environmental effects. And the higher level of CO2 will allow a higher level of economic activity and a higher standard of living. Governments around the world should be devoting more research funds to promising ideas.

If there is to be a U.S. cap and trade plan to reduce CO2 emissions, it would be best to avoid the big revenue creation of permit auctions and the arbitrary congressional granting of free permits to favored industries and firms. Tradable electronic permits should instead be distributed directly to all households. This distribution could reflect the average spending on CO2-intensive goods in different income groups and geographic areas. Individuals could then sell the permits through an organized auction exchange. The payments that they received would offset most of the adverse effects on their standard of living of the higher prices that they would have to pay for CO2-intensive goods and services. Such a system of individual permit distribution would reduce CO2 with all of the efficiency advantages of a pure cap and trade system but without increasing taxes and enlarging government.

Martin Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard University.