Carbon Tax vs. Cap and Trade

Much has been written debating which is “better” — carbon tax or cap and trade.  The essential difference is simply whether government controls the price or the level of emissions as shown in the simple table.  CaT vs CT table

Cap and trade will assure that we reach our emissions target, which is a key objective to limit climate change.  But a carbon tax will also reduce emissions through the market.  As argued by Alice Lépissier and Owen Barder in a 2014 economic paper, “… we don’t necessarily know the right price to set on carbon. Setting it too high could have large economic costs and setting it too low would lead to potentially irreversible climate change. Given that our key underlying objective is to limit the volume of carbon emissions, then we should set the quantity and let the market take care of setting the price. That is the simplified case for cap-and-trade.”

Another point for discussion is the inefficiency and basic lack of fairness in either system of allocating allowances (free permits) to some companies in cap and trade, or similarly allowing tax breaks in administering a carbon tax.  The practice gives unfair advantage to those companies and their shareholders (which disadvantages poor folks who don’t usually invest) and skews the free market.  The over allocation of allowances at the beginning of the EU ETS is often pointed to as one reason the system initially floundered.  The many negative points surrounding free allocations are reviewed eloquently in 2009 testimony to the Senate Finance Committee by a number of experts.

Either system can return revenue to the households and businesses via other tax cuts or use the revenue to support government programs.  Either system can include all or only some emissions. Based on the evolution so far, both systems will be in place for some period of time.  Beyond which system is the best fit, we need to also consider what emissions are included and how the revenue is controlled and used.