How Climate Change Policy May Cause Economic Disruption

A little while ago, I wrote a post discussing why I didn't think that a tax on emissions of greenhouse gases would result in an overall decrease in buying power spread across the economy. In that post, I focused on how a policy might work out if it were slowly phased in; my intention was to set aside the possibility of certain problems that a climate policy may expect to face in order to focus only on a particular set of concerns about overall buying power in the light of increasing the cost of emissions. In this post, I want to address some of the issues I set aside in that earlier post. Particularly, I wanted to focus on the possibility that by implementing a new climate change policy, we could disrupt the existing economic order in a very significant way, and that this might be expected to produce some very worrisome impacts. (Again, this post will talk about carbon taxes; if the translation to cap-and-trade schemes is confusing, I can explain.)

So here's the deal. As I explained in the previous post, a good carbon tax is built on the idea that we make carbon-emissions-intensive goods more expensive with a tax. The proceeds are used to finance a tax cut elsewhere which has the effect of making non-emissions-intensive goods relatively less expensive by increasing consumers' buying power (stated in terms of nominal dollars). This would tend to have the effect of increasing the demand for non-emissions-intensive goods at pre-tax prices, and lowering demand for emissions-intensive goods at prices reflecting the pre-tax price and the carbon tax.

In the previous post, I discussed an example involving two consumers (Cynthia and Xavier) who were part of an economy including rocks (which do not take carbon emissions to produce) and rubber balls (which do take carbon emissions to produce). Before the tax, both rocks and rubber balls cost $5. After the tax, rubber balls cost $6 and the price of rocks is unchanged. The proceeds of the tax on the rubber balls, I said, was used to finance a tax cut so that the consumers each ended up having more buying power than they would have had otherwise (in dollar terms).

If such a policy were enacted, we would imagine that people would shift their consumption choices in the direction of rocks and away from rubber balls. If we held market prices fixed for the moment, we would expect people to demand more rocks and less rubber balls. This could create an incentive for suppliers to decrease the prices of rubber balls in order to avoid building up excessive inventories, and to increase the prices of rocks in order to avoid creating a shortage. Alternatively, it could create an incentive to decrease the production of rocks and to increase the production of rubber balls. In practice, it would more than likely be a combination of both.

So here's the problem: In our modern economy, there is a lot of capital invested in the production of emissions-intensive goods. In our example economy, we might imagine that many rubber balls are produced using a sophisticated ball-making machine. And it may be that at the new lower demand, some of the companies that invested in these ball-making machines would need to sell them or might even go out of business. The people who made the ball-making machines would see demand for their products drop, and perhaps they would be put out of work. The ripples would move outward.

Of course, on the flip side, the rock producers would experience some seriously good times, at least at first. Once the drop in rubber ball demand put some people out of work and decreased the salaries of others, it's conceivable that the decrease in those individuals' consumption would balance out the increase in demand for rocks created by the carbon tax, or even outweigh it.

It should be clear that the more drastic a tax is imposed, and the more quickly it is implemented, the more significant the impacts on the structure of the economy. In our example, we might imagine that the tax was imposed only with a five year warning. In the scenario, it seems rather likely that the impacts would be substantially less severe. Producers would have time to plan for the tax, and they would be far less likely to make investments that would turn out to be really awful. Or alternatively, we could imagine that the tax was relatively small, and so the shift in demand might be rather small.

But with a quickly implemented or severe tax (or both), it seems rather clear that the impacts would be very noticeable. A number of otherwise sound investments would be converted into misallocations of resources, and these would need to be liquidated. It seems important that we acknowledge this possibility when we think about our climate policy options. Of course, nothing said here shows that we should reject climate taxes; I just think this is a side of the picture that needs to be seen.