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A few media outlets and blogs sympathetic to federal controls on carbon-based energy took quite some sport last week castigating some federal policymakers for promoting “outright lies” about a MIT study which shows that cap and trade legislation similar to the Waxman-Markey bill would cost roughly $3,100 per U.S. household.  The author of the MIT study strongly disputed this interpretation initially, but upon further scrutiny and persistent requests for clarification, he confirmed that households will in fact pay this amount because of higher prices. All of the revenues raised by selling emissions allowances to businesses will ultimately be paid by U.S. households, and simple arithmetic shows that each household will have to pony up $3,100 to finance the cap and trade style energy tax. 

 

Cap and Trade: A Stealth Tax on Carbon Dioxide Emissions 

As with most heated political disputes, folks on both sides of this policy debate feel perfectly justified in accusing the other of misleading the public about its impacts.  And like many debates that take place inside the Beltway, the accusations of those on the losing side are more often than not based upon their own set of self-defined, carefully chosen, “facts.” The DC discourse on the cost of cap and trade legislation is perhaps the most striking example in recent history. Despite the efforts of proponents of the Waxman-Markey legislation to discredit it, the figure of $3,100 in increased costs per household was derived in a candid, simple and straightforward manner:  The MIT study estimates that between 2015 and 2050, a cap and trade program similar to the carbon dioxide reductions called for in the Waxman-Markey proposal would raise an average of $366 billion annually. 

Remember, “cap and trade” means that the federal government sets an absolute limit or cap on how much carbon dioxide (and possibly other greenhouse gases) utilities and other targeted entities can emit in a given year.  In order to comply with the law, these firms would have to turn over the correct number of allowances based on how much they emitted that year. The government gets its revenue by creating and auctioning these allowances into the private market.  The “trade” aspect of “cap and trade” refers to the ability of firms to buy and sell these allowances, so that the total quantity of legally permissible carbon emissions gets allocated to those sectors of the economy that need them the most. 

Given the literally trillions of dollars in [taxpayer] revenue at stake and the inherent temptation for politicians to not only give “free” allowances to favored constituencies, but also design trading rules that steer business (and hence trading commissions) to particular brokers and organizers of “auction exchanges”, most economists believe that cap and trade is an inefficient process susceptible to unbridled political corruption.  In contrast to the shadowy arena of cap and trade, a straightforward tax on carbon dioxide emissions would actually achieve the alleged climate goals, minimize the opportunity for political mischief, and impose far less damage on the economy.   

There are still huge dangers of a carbon tax, to be sure, but the point is that most economists who think that the government should “do something” about global warming believe that an honest and explicit tax would provide the incentive to move away from fossil fuels, while reducing the scope for corruption that is far larger under a cap and trade scheme. 

If most economists agree that a carbon tax is more efficient and less prone to abuse than cap and trade, why are all the politicians discussing cap and trade to the almost complete exclusion of carbon taxes?  The answer, of course, has nothing to do with economics or climate change, but with pure politics.  It would be political suicide to propose to American voters a direct new tax on their energy that would raise $12.8 trillion in new government revenues from 2015 to 2050.  But if instead the government proposed to auction emissions allowances to “big business” that would raise the exact same revenue stream, and the public might not be as wary since most people don’t really understand what “cap and trade” even means.  And there you have it, folks… 

Cap and trade is, quite simply, Washington speak for what most hard-working Americans would rightly consider an unprecedented, unwarranted, unnecessary, and unacceptable TAX on their families, their livelihoods, their personal freedom, and their Nation’s economic prosperity. 

Like any other tax on American businesses and energy producers, this tax (the price they will have to pay for the emissions allowances they’ll need to stay in business) will ultimately be passed on to their customers in the form of higher prices.  And it amounts to the largest single tax hike in U.S. history.   

Given this fundamental and historic economic reality, a reasonable individual might understand why proponents of this tax are attempting to sell it to the American people under the misleading term “cap and trade”.  A reasonable individual, however, might also calculate the average cost of this “cap and trade” scheme on American households.  And based on the MIT study’s projection of $366 billion in auction [tax] revenues per year, divided by 117 million American households, a reasonable individual can calculate that this new scheme will cost American households an average of $3,100 per year.  

In the end, it won’t be “Big Oil” or the utilities who pay for the carbon dioxide permits, but motorists and just about everyone who uses a hair dryer or electric razor in the morning; a computer or a cell phone during the day; a radio, television, or night-light in the evening; or a furnace or air conditioner in the winter or summer. 

The Professor’s Retort: There Are Costs and Then There Are Costs 

John Reilly, the author of the MIT study which contained the $366 billion figure, strongly objected to the interpretation of cap and trading costing each household $3,100.  Reilly went so far as to say of the claim “It’s wrong in so many ways it’s hard to know where to begin.”  Rather than the scary figure of $3,100 per household, Reilly instead estimated the cost of cap and trade at around $800 per household. (He originally had pegged it at $215, but admitted this erroneous figure was due to a “boneheaded mistake in an excel spread sheet.”) 

What was Reilly’s objection to the estimate?  Did he think—as some bloggers do—that oil companies and electricity providers exercise strong market power, and that extracting auction revenues from them would simply reduce their unfair profits, rather than leading to higher gasoline and electricity prices?  Actually no, Reilly concedes that consumers will ultimately “pay for” the revenues flowing into government coffers because of cap and trade. 

Reilly’s objection has to do with a subtle distinction in formal economics between a “cost” as measured in out-of-pocket expenditures versus a “cost” as measured by forfeited opportunities.  This is a perfectly valid distinction, and it’s important for professional economists to keep these things straight.  However, in the present context, Reilly’s figure of only $800 will mislead most voters who are undoubtedly thinking of this issue – or wondering about it – in terms of what it will it will ultimately cost them, their families, and our economy as a whole.  

Before quoting Reilly’s explanation, let’s go through a quick example to understand the distinction between the two types of “cost.”  Suppose the government announces a new program in which everybody in America with red hair has to pay $100 a week to the person who lives across the street.  Economists are then asked to assess the “costs” of this strange new proposal. 

The redheads of course would go nuts, claiming that the plan would “cost” them $5,200 per year.  Ah, but that isn’t really a cost to the overall economy, the plan’s backers would say.  Because every time a redhead pays $100 out of pocket, it constitutes $100 of new money for the person across the street.  It’s a simple transfer from one American to another, and so the economy as a whole isn’t harmed. 

But actually, we can’t stop the analysis there.  The new program really would entail costs besides the transfer of $100 a week. For example, redheads would spend money on dyeing their hair or shaving their heads, and so more of the economy’s scarce resources would get channeled into the production of hair dye and barber visits than would otherwise have occurred.  That means fewer other goods and services could be produced—what the redheads would have purchased with that money before the new program made them reconsider and buy hair dye instead. 

In addition, the new “tax” on redheads would require government enforcement, and so real resources would be sucked out of the private sector to pay the bureaucrats who had to monitor the redheads and throw them in jail when they broke the rules.  That would be yet another hidden cost of the program, and it would truly reduce the amount of other goods and services that could be produced—because those bureaucrats could have done something truly productive with their time, rather than spending their days looking for noncompliant redheads. (For example, rather than working for the government enforcing the redhead transfer program, they could have waited tables at a restaurant and truly served their fellow Americans.) 

Our fanciful analogy of a transfer payment imposed on redheads is a good illustration of the distinction that MIT professor Reilly made when castigating proponents of the $3,100 figure.  According to Reilly, the figure is wrong because: 

It is not really a matter of returning [auction revenues to taxpayers] or not, no matter what happens this revenue gets recycled into the economy some way. In that regard, whether the money is specifically returned to households with a check that says "your share of [greenhouse gas] auction revenue", used to cut someone’s taxes, used to pay for some government services that provide benefit to the public, or simply used to offset the deficit (therefore meaning lower Government debt and lower taxes sometime in the future when that debt comes due) is largely irrelevant in the calculation of the "average" household. Each of those ways of using the revenue has different implications for specific households but the "average" affect is still the same. […] The only way that money does not get recycled to the "average" household is if it is spent on something that provides no useful service for anyone–that it is true government waste. 

So now we see where the professor is coming from, and why shrill critics call the figure a “lie.”  Because the government will turn around and spend that money on something, it doesn’t really count as a cost to the households who must pay higher gasoline and electricity prices after the Waxman-Markey plan is imposed.  Reilly’s own figure of $800 per household refers not to higher energy prices, but rather to the lost consumption possibilities, the forfeited goods and services that will not be produced because of the artificial constraint (i.e. the cap on emissions) imposed on the economy.  (That is why some groups argue that the number is too low and that the true cost to households should be $3,100+$800 = $3,900.) 

Which Cost Estimate Is Right? 

So which figure is right?  If the MIT study is a good approximation of the real-world impact of cap and trade, how much will it cost U.S. households–$800, $3,100, or $3,900? 

The answer depends on what the audience thinks you’re talking about. Opponents of cap and trade policies, such as the Waxman-Markey plan, make the point that the alleged “green recovery” program would be funded not by big businesses in the form of emissions allowance “revenues”, but rather by consumers who will ultimately shoulder the costs in the form of higher prices for everything those business produce. Professor Reilly doesn’t dispute that, and so for that reason the $3,100 figure is perfectly fine.  Americans need to recognize that trillions of dollars in new auction revenues won’t be coming from the Tooth Fairy.  Most voters won’t appreciate the subtle distinctions between an out-of-pocket expenditure versus a forfeited opportunity cost, and so Reilly’s own figure of $800, while defensible in a room of economists, would be very misleading in the political arena. 

Adding the two types of cost—funding the auction revenues to the tune of $3,100, plus the adjustment costs of $800 because of the artificial scarcity imposed by cap and trade—to yield a grand total of $3,900 is also defensible, if we assume that most U.S. households do not benefit from additional government spending. 

In other words, the $3,900 figure is an overestimate only to the extent that the government uses its auction revenues in truly productive ways. But surely a billion dollars spent by the federal government is not nearly as effective in promoting consumer welfare as a billion dollars spent by private households.  For example, if each household in a city is forced to pay $20 per month to maintain a park, which the residents would only pay $5 per month voluntarily to patronize, then $15 per month per household is truly flushed down the toilet.  It is money being siphoned away from taxpayers with no corresponding benefit to anybody.  Government operations are usually negative-sum games, which, on average, make everyone on poorer. 

Reilly is very naïve when he takes government spending as a fixed, “given” number, and then thinks auction revenues from cap and trade would lower the deficit.  On the contrary, the influx of trillions in new receipts will give the politicians the ability to fund all sorts of new spending programs that they otherwise would not have the luxury of funding. 

In a very real and economically correct sense, a federal cap and trade program will squander most of the resources that it puts at the disposal of federal politicians and bureaucrats.  Under quite conservative estimates, this will mean several thousand dollars per US household once the program is fully underway.  It is very misleading to tell voters that they will only shoulder $800 of the total economic cost, because this lowball figure assumes households enjoy their income to the same degree, whether they spend it themselves or politicians spend it for them.