At the Auction

Greg Mankiw writes in The New York Times on the Cap and Trade bill moving through Congress.

Mr. Obama understood these risks. When asked about a carbon tax in an interview in July 2007, he said: “I believe that, depending on how it is designed, a carbon tax accomplishes much of the same thing that a cap-and-trade program accomplishes. The danger in a cap-and-trade system is that the permits to emit greenhouse gases are given away for free as opposed to priced at auction. One of the mistakes the Europeans made in setting up a cap-and-trade system was to give too many of those permits away.”

The president clearly knows it is better to auction off the carbon permits but as has been so far characteristic of his presidency is letting the Democratic legislature lead on policy. Sadly, I can’t say I’m impressed with his leadership skills. Why he hasn’t converted his once soaring approval ratings (political capital) into legislative success is disappointing and confusing. He is letting an hugely improbable and historic presidency go to waste.
[update]: Mankiw links us to an interesting critique of his New York Times piece. Even despite his entirely reasonable criticisms it still makes more sense to me to auction the permits off in order to better be able to shift the tax burden from more distortionary areas (e.g payroll or income taxes). But really the obvious solution would be to set gradual carbon tax targets so firms aren’t punished for past behavior but can plan ahead to future increases.

The primary goal of cap-and-trade is to make firms behave better in the future, and as Professor Mankiw points out, that goal is served equally well whether we give the permits out for free or require firms to buy them. But the latter option not only creates an incentive for good future behavior; it simultaneously punishes bad past behavior. The firm that recently invested in a million-dollar machine that now can’t be operated without a half-million dollar permit is effectively paying a half-million dollar fine for behavior that was perfectly legal a year ago.

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