Monday, 14 September 2015

Pigouvian taxes: the century-old idea in need of an overhaul

A highly simplified model of environmental taxation still holds sway despite some profound questions over its applicability to the carbon problem.

The idea of using a tax to correct an environmental problem, or 'externality', was first described by the economist Arthur Pigou in 1920. This is the basic model that students of environmental economics are still taught today. It suggests that, for any environmental pollutant, there is a socially optimal level of emissions, a balance between the benefit associated with reducing it, and the cost of doing so. This can be reached by applying a tax to the pollutant to disincentivise its release.

All very sensible. So what's the problem? The most urgent environmental problem today, and the one most likely to require the application of environmental taxes, is climate change. The original Pigouvian model was just not designed to tackle an externality so fundamentally and inextricably linked to almost every kind of economic activity.

To illustrate, I will refer to a recent IMF working paper, How Large are Global Energy Subsidies? This paper uses a Pigouvian approach to estimate the scale of global fossil fuel subsidies, and the potential welfare gains of scaling them back. It estimates them at $5.3 trillion, a truly alarming sum.

There are three main reasons I would take issue with this analysis. One is to do with communication to non-economists, one relates to the actual economics, and the other concerns the political 'sellability' of environmental taxation.

Communication: subsidies and missing taxes are not really the same thing
Firstly, if you said "fossil fuel subsidy" to most non-economists, they would probably envisage some kind of fiscal transfer between government and fossil fuel producers, like the subsidy which the German government gives to coal mining. Or they might imagine breaks on existing taxes, R&D grants, or controls on the prices paid by consumers, as with India's kerosene subsidies.

However, 87% of the fossil fuel subsidies outlined in the IMF paper are "underpriced externalities" – they represent the social cost of not imposing environmental taxes on fossil fuel emissions, in terms of health and environmental impacts, at the Pigouvian socially optimal level. 

Whatever the arguments for and against environmental taxes, it is certainly not the norm to price externalities with any kind of exhaustive consistency even in the developed world; so it's a bit of a stretch to say that Honduras or Botswana are subsidising fossil fuels by not taxing them fully. Economists describe subsidies and missing taxes as conceptually identical, but for a policy-maker or member of the public, they have very different political, fiscal and social implications, and the conflation is misleading. The $5.3 trn figure gives the impression that there is a ready money stream in national budgets to divert away from fossil fuels towards clean technologies. Not so.

Economics: when it comes to fossil fuels, we can't ignore the rest of the economy
Next, the economic reasons. There are two of these. The traditional Pigouvian framework:
  1. uses partial equilibrium analysis, in other words, looks at the effect that increasing the price of fossil fuels has on their demand, but not on the knock-on effects on prices and demand for other goods and services. 
  2. is unable to tell us anything about macroeconomic impacts, even if very large.
The upshot is that the Pigouvian approach need not linger on what would happen to a national economy if it applied across the board fossil fuel taxes to fully reflect their social cost. This starkly highlights its limits in the context of climate change. In the current era, fossil fuels are all-pervasive in economic activity. As past oil price shocks and slumps have shown, we cannot assume away the economy-wide impacts of changes to their prices. A partial equilibrium framework which ignores these does not provide policy-makers with the overall picture which they need to guide decisions.

The IMF paper is not remiss in this respect – the profession as a whole lacks better tools, at least, ones which you don't need a relevant PhD to apply. The macroeconomic impacts of environmental taxes specifically seem to have received little attention. A quick web search reveals a splurge of papers in the 1990s. Since then, the macroeconomics of climate change has been dominated by models which tend to focus on the economic impacts of climate change itself rather than on policy instruments, and which have been largely driven by academic rather than policy questions (see this review by Vivid Economics for more info).

The question of whether economists can come up with better, more policy-relevant workhorse models and frameworks, which are both more comprehensive but not prohibitively complex, is one we should consider.

Politics: what would you think if you were a finance minister?
Economists need to articulate how emissions can be cut to acceptable levels at lowest cost and with least social disruption.

While I can't speak for developing world politicians, I can imagine that on hearing a proposal to tax fossil fuels, their reaction might be to think of the child who can't get to school, the farmer who can't get produce to market, and the rural mother who can't earn extra cash from sewing without lighting; at least in the short term until clean alternatives are cheap and widespread. I would be looking for some sensitivity to these concerns in any policy proposal.

The IMF paper states that "energy subsidy reform [i.e., for the main part, raising taxes] is clearly beneficial from the view of the entire society" and that, because many of the external costs relate to local air pollution "unilateral price reform is in countries' own interests". If this is the case, perhaps we should ask ourselves why it hasn't already happened. Proposals which would lead to reductions in transport fuel use of 20-50% in some regions are drastic. A Pigouvian framework can't say anything about the availability, affordability and take-up of substitutes, or the appropriate timeframe, or the overall impact on the economy of such far-reaching reductions.

If I were a finance minister reading a proposal containing these statements I would be fairly disinclined to give it serious consideration. People who are not already in the climate community will be sceptical towards, and will misread, the case for carbon taxes if political difficulties are brushed aside.

What needs to happen?
We need a new approach to assessing the potential overall economic impact and advisability of environmental taxes specifically

The UK Chancellor of the Exchequer (finance minister) recently announced a review of UK energy taxes and subsidies. It would be fantastic if this review were to put some thought into how we can build an improved framework for the economic analysis of environmental taxes. How can we better communicate with policy-makers? What do politicians need to know, and how should economists respond?

We need to be clearer and more precise in our language. The $0.5 trn or so real fossil fuel subsidies are significant enough – let's make what that means clearer to non-specialists without getting into a conceptual muddle.

Above all, economists need to be more open about the shortcomings of the Pigouvian model whenever it is brought out of the textbooks into the real world.

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