There are further problems with cap and trade regulations. For instance, these regulations create significant price volatility. The experience of Europe’s carbon emissions market is a classic example of the natural consequences of regulations that impose caps or constraints on the market. In fact, the Congressional Budget Office, citing the price volatility issue, concluded that cap-and-trade regulations are not a sound policy alternative for addressing global warming issues.
While cap and trade policies are undesirable, there is a better path if we are going to address global warming concerns. In a recent paper I co-authored with Arthur Laffer, we examined the implications of alternative global warming policies.
According to the scientific consensus that man-made carbon emissions are causing global warming, there is a consumption problem. Whether or not one believes this scientific consensus is correct, man-made global warming is a possible risk. With respect to the appropriate policy response, the question is whether good government policies can create a less risky scenario. The answer is yes.
When consumers use energy, or products created from energy, the prices do not reflect the costs from the carbon emissions on the environment; consequently consumption is higher than optimal. The appropriate policy response is a tax on consumption, the source of the market distortion, but not on trade or production.
But, the catch is that carbon taxes impose a giant negative incentive on both producers and consumers through the higher costs the tax creates. Furthermore, if the carbon tax were implemented as a means to expand government, then the amount of inefficiencies in the economy would increase even further.
However, if the carbon tax increase were offset, dollar for dollar, with an across the board marginal income tax reduction, many of the adverse impacts from the carbon tax increase would be mitigated. A marginal tax rate cut—ideally to a flat rate with strong taxpayer protections against future tax increases—has two types of effects. Because the decrease in marginal tax rates lowers the cost to the employer in the form of lower wages paid, firms will employ more workers. On the supply side, a reduction in marginal tax rates raises net wages received. Again, more work effort will be supplied. Therefore, tax cuts increase the demand for, and the supply of, factors of production. In dynamic formulations, as tax rates fall, output growth increases and vice versa.
The rewards for incremental work by labor, the employment of additional capital and the more efficient combination of the two will all be higher. As a result, more employment, output and production is expected. Economic growth rates will accelerate until these effects are fully incorporated into the workings of the economy. All of the aforementioned positive incentive effects help offset the impact of the carbon tax on production.
From the global warming perspective, the lower marginal tax rates do not impact the reduced incentive to consume carbon emissions because carbon tax increase has raised the relative price of carbon emissions.
Thus, the higher taxes on carbon emissions provides incentives for people to reduce the amount of greenhouse gas emitted while the lower marginal income tax rates provides incentives for people to increase the amount of economic activity. The result is a policy that reduces the risks associated with both the environmental and economic concerns.