Friday, August 14, 2009

Tax interaction: the ultimate unintuitive, general equilibrium effect

Greg Mankiw and Brad DeLong differ on the effect of carbon pricing when the revenues are not used to cut income taxes.

Here's Mankiw:
But if most of those allowances are handed out rather than auctioned, the government won’t have the resources to cut other taxes and offset that price increase. The result is an increase in the effective tax rates facing most Americans, leading to lower real take-home wages, reduced work incentives and depressed economic activity...
I have been trying to think of a model of the economy in which Mankiw's claim is true. I am not having an easy time doing so...

We currently have a tax on carbon of zero. We don't think that a zero tax on carbon is where we should be right now, do we? It is good to raise the tax on carbon whether you use the revenues to reduce the tax rate on labor or whether you distribute them in some other way. Only if our tax on carbon were already equal to the pollution externality v, and we were thinking of raising it even higher, would it be a bad bet unless we used the revenues to reduce the tax on labor income--or if our tax on carbon was inescapably also a tax on labor income via joint production.

There are, I think, some very strong assumptions about the form of the production function and the demand for and supply of labor underlying Mankiw's claim: for his claim to be true, production has to be joint or nearly joing. Nearly every way of employing labor from playing Peruvian shepherd pipes in the public square to making aluminum via a Hall process powered by low-pressure steam generated by the combustion of lignite must involve nearly the same carbon footprint. And I can't figure out why he thinks that the production function takes that form...
I think Mankiw is actually right here, for a reason he drives at but never quite states explicitly (perhaps because it seems too technical for a general audience): the existence of tax interactions. The reasoning is simple but unintuitive. A tax on carbon lowers the returns to spending on consumption, and thus like any consumption tax acts implicitly as a tax on income, albeit without the intertemporal distortions. If our starting income tax rate was zero, this would be fine—one can work out the math and show that a carbon tax would discourage labor only to the extent that it was efficient to do so. Yet when we are starting with income taxes well above zero, the implicit labor taxation created by a carbon tax reduces work incentives far more than is warranted—rather than taking us from 0% to 2%, it pushes the rate from 28% to 30% (or 25% to 27%, or...), which is far more costly. If we recycle the revenues and lower income taxes, we relieve most of this negative effect, but otherwise the costs of the policy can increase by several hundred percent. Contra DeLong, you don't even need to consider the impact of carbon in manufacturing or services to get this effect (although it certainly increases the magnitude). It's enough to consider carbon—in the form of coal-fired electricity, or oil-powered transportation—as part of the consumption bundle.

This primer by Stanford professor Lawrence Goulder is a very good introduction to the topic.

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