The Environmental Defense Fund's Fred Krupp threw down the gauntlet to carbon taxers in the Wall Street Journal last month:

Environmental taxes have worked well to raise revenue, but without a cap they inevitably become a license to pollute in unlimited amounts. No air pollution problem has ever been solved except by imposing a legal limit on emissions. (emphasis added)

This is a little like the Pope complaining that sex isn't enough fun: how would he know? Pollution taxes have seldom been tried. But in the few cases where they've been tried, they've worked rather well.

One example is from the dawn of my own career, in early 1973, when I was a junior economist with the New York City EPA, and the City was almost entirely dependent on fuel oil to generate electricity and heat offices and apartments. A local law requiring a switch to low-sulfur oil had just gone into effect. Swearing that supplies of the cleaner fuel were drying up, the oil companies began jawboning city officials for variances to keep selling the dirtier (and cheaper) fuel.

The city was about to cave, until an EPA lawyer channeled Adam Smith and suggested granting the variances with a condition: that each barrel of dirty oil be "surcharged" at a rate slightly greater than the price premium for the clean fuel. After researching market conditions, the City settled on a surcharge of 75 cents to $2.00 a barrel of higher-sulfur oil, depending on the sulfur content.

Guess what? The Invisible Hand carried the day. With the surcharge canceling the profit from polluting, the oil companies discovered ways to get more clean fuel from their refineries and otherwise re-allocate supplies. For the rest of that year's heating season, the dirty stuff amounted to a tiny fraction of the total granted in the variances. A simple, market-correcting tax probably saved hundreds from succumbing to emphysema and other pulmonary diseases while keeping the lights on.

Another pollution-tax success story is the global phase-out of chlorofluorocarbons and other ozone-destroying chemicals. While this landmark achievement is often ascribed to the cap-and-trade system built into the 1987 Montreal Protocol, the fact is that emissions barely dropped until a U.S. tax on CFC's took effect on Jan. 1, 1990.

The rate of reduction in emissions in 1990, the first year with the tax, was at least five times greater than in the preceding period with the cap alone. While a more aggressive cap might have worked by itself, the fact is that, contrary to Krupp, a pollution tax did the job quite well.

Krupp's hostility to pollution taxes represents a retreat from good sense on the part of EDF, which used to be a conspicuous - and prescient - advocate of price incentives. For example, it was EDF that hired economist William Vickrey to testify for social-cost-based pricing in regulatory proceedings on electricity and rail transit in the mid-1970s - 20 years before Bill's work on peak-load pricing won him the Nobel Prize.

Back then, EDF understood the simple idea that when something becomes more expensive to do, people do less of it. Even granting the group's allegiance to cap-and-trade, is it really necessary for them to turn up the rhetorical heat against pollution taxes?

True, price internalization isn't the sole answer to everything, including slashing carbon emissions. Institutional barriers like split incentives and unequal access to capital need to be addressed by complementary policies. Regulatory standards, technology-forcing measures and pollution limits all have a part to play. But without fuel prices that clearly convey the real price of pollution to the purchaser, the transition from fossil fuels won't happen until most of the carbon still underground has moved into the atmosphere.

On the other hand, if human nature is anything like what it was in Adam Smith's day, then a phased-in, upward-adjustable and largely revenue-neutral carbon tax, such as proposed last month by Rep. John Larson (D-Conn.), is the best tool for the job.

The market insiders lined up at the cap-and-trade trough will gnash their teeth. But in some celestial think-tank, Mr. Smith will be smiling.

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Chris Hayes has a blockbuster scoop up on The Nation: "Pulp Nonfiction," about how the U.S. government will pay the paper industry up to $8 billion this year to emit more carbon dioxide.

Yeah, you read that right.

The horror begins, as it so often does, with well-meaning efforts by Congress to encourage biofuels. The $244 billion transportation bill signed into law in 2005 contains a $0.51/gallon tax credit for "mixed fuels" -- that is, "taxable fuel" like gasoline or diesel mixed with an "alternative fuel."

Funny story. See, for years the paper industry has relied on a biofuel derived from the process of removing fiber from wood. It's called "black liquor." The fuel runs the process -- a nice little closed loop.

But oops! It's not "mixed." So, since 2005, the industry has been adding diesel to the fuel in order to qualify for the tax credit.

So they're emitting more greenhouse gases and pulling down billions of dollars in taxpayer money.

Awesome.

Read Hayes' piece for the gory details.

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For an $80 billion program, President Barack Obama's cap-and-trade proposal is very short on specifics. His budget plan [PDF] provides only the briefest policy rationale for cap-and-trade, describing it as "a policy approach that dramatically reduced acid rain at much lower costs than the traditional government regulations and mandates of the past."

The acid-rain program's regulatory costs were indeed low, partly because emission allowances were freely allocated to industry. But Obama's plan calls for 100 percent auctioning of allowances, which erases the perceived cost advantage and puts cap-and-trade on par with carbon taxes in terms of political viability.

To ameliorate cost impacts, the plan would allocate most (80 percent) of the auction proceeds to a permanent $800 "Making Work Pay" tax cut for working families; but with cap-and-trade nothing is ever "permanent." Carbon trading prices in Europe have dropped from over $30 to $10 per ton CO2 over the last year, and in the U.S. northeastern states allowances are currently selling at a meager $3 per ton. Obama's plan is betting on $20 per ton, but linking the nation's tax system to an erratic revenue source would be imprudent.

The obvious, but unanswered, question is why a 100-percent auction would be preferable to a fixed-price sale of allowances, i.e. a carbon tax, which could simply be set at $20 per ton. There would be no price volatility.

Regarding the claim that cap-and-trade "dramatically reduced acid rain," the reduction was not sufficiently dramatic to actually solve the acid rain problem. Further reductions would yield an estimated societal return-on-investment of 2,500 percent from health and environmental benefits, and yet emission trading creates no incentive for such further reductions even when costs are far below initial expectations. The EPA has been trying for years to institute rules for more stringent acid rain regulations, but under the current cap-and-trade regime the rules cannot be strengthened without an Act of Congress -- or a very protracted court battle. The implications for global climate policy should be clear.

A carbon tax would create a stable price signal and a predictable investment climate that would be more conducive to long-term investments in clean-energy technology and infrastructure. Alternatively, a price floor applied to allowance auctions would avert the kind of price erosion and collapse that has characterized prior trading systems. Had a price floor been applied in the acid rain program, there may have been no need for the EPA's new rules.

Irrespective of whether carbon pricing revenue comes from an auction or from a fixed-price sale of allowances, the allocation of the revenue to a Making Work Pay tax cut would be problematic because consumers would not be equitably compensated for high energy costs. The tax burden would shift, not just onto wealthy taxpayers, but also onto low-income groups such as retirees on fixed incomes or people who expend a relatively large portion of their income on energy. The tax cut would have to somehow be linked to energy consumption to make it equitable.

A simpler and more direct way to mitigate energy costs -- one that is not discussed or considered in Obama's plan -- would be to apply most of the carbon pricing revenue to subsidize energy prices, e.g. at a uniform cents-per-kilowatt-hour rate for electricity. If the revenue is allocated to industry as an energy production subsidy it would have much the same cost-cutting effect as free allocation of allowances -- but with one crucial difference: Clean and renewable energy technologies would also qualify for the subsidy, and would therefore not be disadvantaged by the allocation method. Competition from subsidized clean energy would deter polluting industries from passing their costs onto consumers, and would make fossil-fuel energy progressively less economically viable as clean energy attains economies of scale and gains market share. (By contrast, free allocation is equivalent to giving all of the revenue to polluters.)

For example, if the electricity industry comprises 90 percent fossil-fuel energy and 10 percent renewable, then the subsidy would reduce the net tax on fossil fuels by a factor of ten while providing a per-kilowatt-hour subsidy of nearly ten times that amount to renewable energy. The same net tax could even support a much greater subsidy if the subsidy were focused on new renewables, excluding legacy hydroelectric and nuclear power. Eventually, as carbon is phased out of the electricity industry, the clean-energy subsidy would automatically diminish and the net tax on fossil-fuel energy would increase until the latter becomes uneconomical.

In essence, the subsidized-energy approach replaces the big "stick" of a high tax with a big "carrot" of high subsidies, which can be equally effective at incentivizing clean energy deployment. Carrots might succeed where sticks have so far failed to achieve political consensus on federal climate policy.

[Revised 3/22/2009]

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