Carbon tax medicine is a better Rx than green subsidy sugar

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Mary Poppins taught us that a spoon full of sugar helps the medicine go down. But for politicians advocating a transition to green energy, the temptation is to hand out the sugar of subsidies without the medicine of imposing a tax on carbon emissions.

With subsidies, after all, consumers, companies and research institutions receive checks and tax breaks. Ribbon-cutting publicity opportunities begin immediately. Even if only one project out of every five or 10 is clearly successful, there still will be plenty of locations for self-congratulatory political events a few years down the road.

Meanwhile, the costs of such subsidies — the other priorities that don't get funded, along with higher budget deficits and/or taxes in the future — are largely invisible.

With carbon taxes, on the other hand, consumers/voters everywhere pay higher gasoline and home energy prices. The costs are upfront.

Meanwhile, the altered incentives from a carbon tax that lead to conservation of fossil fuels and innovative efforts to produce green energy are less visible than subsidized enterprises, because they happen in a decentralized way across the economy. The opportunities for ribbon-cutting ceremonies and political favoritism are few.

What's more, the additional public revenue that could come from a carbon tax — but are forgone when subsidies are the chosen policy — are invisible, too. Yet such revenue could be used for (choose your priority here) a permanent child tax credit, rebuilding defense stocks after what has been sent to help Ukraine, cutting other taxes in an offsetting way, bolstering Social Security and Medicare, or reducing the budget deficit.

In short, when the goal is to reduce carbon emissions, the sweet and easy political choice is to focus on subsidies. John Bistline of the Electric Power Research Institute, Neil Mehrotra of the Federal Reserve Bank of Minneapolis, and Catherine Wolfram of Harvard University discuss the results in the "Economic Implications of the Climate Provisions of the Inflation Reduction Act" in the Spring 2023 issue of the Brookings Papers on Economic Activity.

Despite its name, the Inflation Reduction Act that President Joe Biden signed into law in August 2022 is actually focused on clean energy subsidies. Bistline, Mehrotra and Wolfram walk through the law in some detail: provisions, costs and mathematical modeling of distributional and macroeconomic effects.

Here, I'll focus on one issue. Say that you view reducing carbon emissions by a specific amount as a policy goal of central importance. The social costs of achieving that goal are much lower with a carbon tax rather than with a grab-bag of subsidies in the style of the Inflation Reduction Act.

Both carbon taxes and green energy subsidies provide an incentive for a shift from carbon-heavy to lower-carbon or non-carbon sources. However, carbon taxes also encourage conservation of fossil fuels by raising their price. Subsidies for green energy will not have this added conservation effect.

In addition, the tax credits and subsidies of the Inflation Reduction Act are based on production of new technologies, not on how they are used. For example, subsidies to buy electric vehicles are based on buying the car, not on how much it is driven. Subsidies for facilities to produce non-carbon energy are not based on how much energy is actually generated by these facilities. In contrast, a carbon tax is higher or lower based on the actual carbon emitted.

Thus, when Bistline, Mehrotra and Wolfram run their model of energy, carbon emissions and the economy, the cost of reducing carbon emissions through the green subsidies approach of the Inflation Reduction Act runs $83 per metric ton of reduced carbon emissions.

An identical reduction in carbon emissions through a carbon tax would cost about $12-15 per metric ton of reduced carbon emissions.

But even this 6 to 1 gap in cost-effectiveness underestimates the virtues of the carbon tax medicine. As the authors point out, their model focuses on differences in incentives for energy conservation and the efficiency of subsidized green energy investment, but it doesn't include some other relevant factors.

For example, their model doesn't take into account that a carbon tax raises revenue, while green subsidies require higher government taxes or borrowing.

Their model also doesn't take into account the inflexibility of government subsidies and tax credits for green energy. For example, subsidies for non-carbon energy will sometimes displace higher-polluting coal, sometimes displace lower-polluting natural gas and sometimes displace non-carbon hydropower or nuclear power. A subsidy strategy can even create a situation where subsidies for new solar and wind power are displacing old solar and wind.

In contrast, when households and businesses react to a carbon tax, the incentives are focused on actual reductions in carbon emissions.

Finally, the researchers' estimated costs don't take into account how a political process starts with a goal of reducing carbon emissions, but then can't resist add-ons. For example, the qualification rules for the green energy subsidies include "domestic content" rules that producers are required to buy certain inputs from American suppliers, along with various required labor practices. Whether you favor or oppose these kinds of additional rules, they push up the costs of a subsidy-based approach to reducing carbon emissions.

I'm fully aware that taking the carbon tax medicine isn't easy for the U.S. political system. Also, government subsidies to support research and investments in carbon-reducing technologies have their role to play. But an all-subsidy approach, rather than also putting a price on carbon, is a far less cost-effective approach to reducing carbon emissions.

Timothy Taylor is managing editor of the Journal of Economic Perspectives, published by the American Economic Association and based at Macalester College. He blogs at conversableeconomist.com.