The Misguided Neoclassical Economic Thinking Behind a Carbon Tax

This week, the American Enterprise Institute (AEI), the Brookings Institution, the International Monetary Fund, and Resources for the Future co-hosted a daylong conference on designing a U.S. carbon tax. The event came on the heels of closed-door discussions of the topic at AEI and “a cascade of carbon-tax advocacy in recent days from the chattering classes and a slate of academic work over the summer,” as The Wall Street Journal noted, lending credence to the newspaper’s article title: “Carbon Tax Idea Gains Wonkish Energy.” Nevertheless, talk of a U.S. carbon tax – while a positive step forward – is not enough to address climate change if such a tax is not structured to support innovation. Ultimately, much of the enthusiasm over the idea of a carbon tax can be attributed to the misconception that it is a sort of climate change-silver bullet, as driven by neoclassical economics thinking.

According to the neoclassical economics doctrine, as detailed in the ITIF paper Economic Doctrines and Approaches to Climate Change Policy, the economy is a “large market of goods and services that is generally in equilibrium and usually best left to itself.” Climate change is viewed by doctrine adherents as a rare market failure, but one that can be addressed by simply implementing a market signal to control for the negative externality of greenhouse gas emissions. The paper thus concludes, “Neoclassical economists believe that setting a price on carbon—through a carbon tax or cap and trade—is the principal and often sole policy response needed to address climate change.” Case in point: Paul Krugman’s observation in his New York Times column that “If you seriously believe in markets, you should believe thatgiven the right incentives — namely, putting a price on emissions, through either a tax or a tradable permit scheme — the economy will find lots of ways to emit less.”

Nevertheless, a Brookings paper released last week by Mark Muro and Jonathan Rothwell throws yet another bucket of cold water on the idea that a carbon tax is a “one and done” climate change solution:

Numerous scholars have demonstrated that, while the scale of the needed carbon emissions reductions is extremely large, price-based systems by themselves are not likely to induce sufficient technology change to deliver the needed reductions, particularly given the “lock-in” of cheap, readily available dirty technologies and the modest pollution prices that are tolerable to politicians…A major problem with all carbon pricing solutions is the fact that the private sector will not (for recognized reasons) invest adequately on its own in low-carbon solutions and technology change – even in the presence of carbon pricing.

As such, a carbon tax can only be seen as effective climate change policy in the extent to which it funds clean energy innovation. In contrast to the neoclassical economics doctrine, innovation economics recognizes that the government can and should play a much more proactive role in supporting the clean energy innovation process. Fittingly, the Brookings scholars recommend setting aside at least $30 billion in carbon tax revenue annually for “an independently managed fund for supporting top-quality energy-system RD&D activity.” That policy proposal mirrors the “innovation carbon price” concept put forward by ITIF last year that called for a portion of revenue to go towards funding “a Clean Energy Innovation Trust Fund that would support clean energy innovation initiatives.” Establishing a dedicated revenue stream for clean energy innovation in this way would simultaneously reduce policy uncertainty and tackle climate change mitigation in a meaningful way. Nor would it be without precedent – gas tax revenue, for example, is dedicated to the Highway Trust Fund.

Of course, policymakers are currently looking at a carbon tax primarily as a possible revenue raiser as part of a grand bargain on deficit reduction. But ITIF and Brookings’ proposals would not preclude carbon tax revenue being directed towards that endeavor. The Brookings report goes on to call for the vast majority of the revenue to be spent on “tax cuts and deficit reduction as well as rebates to affected low-income households, as determined by Congress and the president,” while the ITIF report proposes that any remaining funding be “recycled back into the economy as growth and innovation inducing business tax incentives.” What the proposals do preclude is the idea – as informed by neoclassical economics doctrine – that a carbon tax is all that is needed to spur massive greenhouse gas emission reductions. As debate continues, Congress and the president would do well to more carefully consider all the products of the “wonkish energy” being expended on possible carbon tax designs.