Why Cap-and-Trade is the Best Route to a Carbon Tax

Greg Mankiw has a simple equation:

Cap-and-trade = Carbon tax + Corporate welfare

There's a kernel of truth here, but it ignores two big issues. The first is that cap-and-trade caps emissions, while a carbon tax doesn't. In other words, even if the fiscal sides of the equation balance, the carbon output might not.

The second issue is that cap-and-trade both can and should allocate quotas not by right but by auction. Most cap-and-trade schemes, indeed, include some kind of partial auction mechanism. And it's here where I'm much more optimistic than Mankiw. He would agree, on the level of his "fundamental theorem", that a fully auctioned cap-and-trade system has no corporate-welfare component and is tantamount to a carbon tax. So then the only question is how do we get there from here.

One option is to try to impose a carbon tax, which is politically very difficult, and which in any case would not be high enough, certainly at the beginning, to significantly reduce carbon emissions.

The other option is to build a cap-and-trade system, which would, by definition, cap carbon emissions. You could then, by accident or by design, slowly increase the amount of quota which was auctioned each year. (This would happen almost automatically, in that it's an obvious place for any government to increase its revenue without raising taxes.)

You end up with a de facto large carbon tax, but without ever passing a bill where your opponents can accuse you of raising taxes. Smart, no?