Dear Greg, Why Waxman-Markey is minimally distortionary

Greg Mankiw, whose style and wonkiness I love, posts a simple model of how he sees a cap-and-trade bill or carbon tax functioning.

The trick is how to fix the second distortion [inefficiently high carbon intensity of consumption baskets] without making the first one [work/consumption decision distortions via taxes] worse.

This is a fair way of framing the problem.

The basic problem is that a new tax on carbon-intensive products C1 is also an additional tax on consumption C, unless there is some other offsetting tax change.

This is where the Rorschach test comes in. A carbon tax without a compensating income tax cut makes one problem better and one worse. The question then is which problem is bigger.

Stop there - what I think the crucial point he is missing is that Waxman-Markey will effectively function as an income tax cut for the most part. Let's review the Waxman-Markey allowance allocations and split them into those which will effectively function as consumer rebates, and those which will not.

- 46% to electricity generators and local natural gas distribution companies, "which they must use to protect consumers from price increases" (REBATE)
- 15% to low- and moderate-income households to "protect them from other energy cost increases" (REBATE, although implicitly redistributionary)
- 17% to domestic energy-intensive, trade-exposed industries and refining (REBATE unless there is some collusion in pricing to increase prices beyond the cost increase)
- 11-16% to energy efficiency and clean energy technology (NOT A REBATE)
- ~10% to other public purposes like avoiding deforestation, adaptation and international clean tech transfer (NOT A REBATE)

So almost 80% of the "giveaway permits" are effectively consumer rebates, and the remaining ones, which will be largely purchased by oil refiners, amount to a gasoline tax whose proceeds will be used for energy efficiency, clean tech and other public purposes.

So in addition to Robert Stavins' conclusion that “the appropriate characterization of the Waxman-Markey allocation is that more than 80% of the value of allowances go to consumers and public purposes, and less than 20% to private industry,” I would add that ~80% are effectively rebated to the consumers, mitigating the majority of the distortion which Mankiw laments in his post. Waxman-Markey is in fact, for the most part, a carbon tax with a compensating income tax cut.