How Induced Innovation Lowers the Cost of a Carbon Tax

A growing number of nations are turning to a carbon tax to reduce carbon dioxide emissions. One effect of such a tax will be to induce innovation in less carbon-intensive technology. Such innovation will reduce the cost of lowering emissions. If the tax revenues are used to provide tax incentives for research and investment, they are likely to lead to higher, not lower, GDP growth, while at the same time making progress against global warming.

Carbon emissions can be reduced by focusing on either the supply side or the demand side. The supply side involves either subsidizing existing low-carbon technologies or spurring innovation in better technology (including through R&D funding), and the market then naturally adopting the technologies because they cost less or perform better than conventional fossil fuels. The demand side involves enacting policies that limit the consumption of carbon-intensive energy and products. There are two main kinds of demand side policies: carbon taxes and regulatory limits such as cap-and-trade programs. A carbon tax would work by putting a tax on upstream fuels containing carbon. This cost is then passed on to downstream users of products derived from burning those fuels. Most economists prefer a carbon tax because it is more efficient (achieving a given level of reduction at a lower cost) and uses the existing price system. The tax forces both firms and consumers to incorporate the social cost of higher carbon emissions into their economic decisions.

Putting a price on carbon will also have a secondary effect. Firms constantly face pressure to invent or adopt innovations that reduce costs or increase quality. Raising the cost of carbon-intensive activity will give firms stronger incentives to develop more carbon-efficient technologies. Because they will be cheaper than existing technologies, these carbon-efficient technologies should ultimately be more widely adopted, thereby reducing the cost of achieving a given amount of emission reductions. Over the last two decades, a growing body of research has focused on the nature and size of this “induced innovation.” This research shows that a carbon tax would lead to more investment in clean technology innovation beyond what would otherwise occur. And this induced innovation would lower the cost of achieving a given level of emission reductions.

One complaint about a carbon tax (or cap and trade) is that it artificially raises the price of inputs and thereby reduces economic welfare. But a carbon tax doesn't only reduce the cost of compliance through innovation; if the tax revenues are dedicated to reducing the after-tax cost of research and capital investment, the net economic effect is likely to be positive. Using carbon tax revenues to encourage private investment would address a second market failure: the social benefit from research and capital goods investment is much greater than the private benefit companies receive. Society would be much better off if companies conducted more R&D and invested in more machinery and equipment than is strictly profitable for them to do. Global warming aside, such a policy would be strongly beneficial for productivity and economic growth.

Both logic and scholarly research point in a clear direction: A carbon tax at reasonable levels, with the revenues dedicated to reducing the after-tax cost of research and capital investment, is likely to not only reduce carbon emissions but do it in a way that grows the overall economy.