The Wine, The Widgets and The Wardrobe
The blogging medium generally operates in reverse-chronological order. The reader encounters the most recent post first. If anyone has not already read my previous post outlining the Man in a Wardrobe Fallacy, then I suggest now would be a good time to do so. Otherwise the following will likely make no sense whatsoever.
Previously I glossed over what are in fact two distinct cases:
1. When the product for which it is proposed to use taxes to reduce consumption is produced internally to the economy – alcoholic drink for example.
2. When the product has to be imported, e.g. oil or other fossil fuel.
Case 1: Internally produced products
I assumed last time that all income over the 50 units p.a. needed for essentials would be spent on drink. I’d now like to consider a refined example where there is a limit to how much can be drunk – 60 units worth p.a. say, at the untaxed price. Any income over that amount is spent on massages, say, as suggested in the comment by Dr Adrian Wrigley.
I suppose I should address Adrian’s point directly. He argues that the higher the price of drink, the less will be consumed relative to massages. I seriously doubt it. This may well be “classical economics”, but in real life value is determined socially, not just in terms of utility. In this case, the social consideration is paramount. People will only spend on massages what they have left after peer-pressure has forced them to drink with their mates until they fall over.
Now let’s do the math. Remember our population of 100 people earn from 50 to 149 units per year. Necessities in this economy cost 50 units/year and the most that can be spent on drink is 60 units. As before, the guy earning 50 can afford no drink. Those earning 110 or over can afford to imbibe the full 60 units worth. So the total amount spent on drink is 40*60 + 60*(0+59)/2 = 2400 + 1770 = 4170 units.
Only the top 39% (earning from 111 to 149) can afford massage. So 39*(1+39)/2 = 780 units are spent on massage.
Now let’s impose our tax on drink at (say) 100%, redistributing the revenue to the whole population. We can only approximate by simple arithmetic (we have to use a more sophisticated technique such as iteration to find an exact solution), but let’s assume roughly the same amount of drink is consumed as before – around 4200 units worth, before tax, so 8400 units in total with the 100% tax.
The 4200 units raised by the taxman are distributed evenly, so that now the population has from 92 to 191 units to spend each year. But drink costs twice as much, so only those earning 170 units or more can afford to spend the maximum 120 units a year. The rest can spend from 42 to 119 units. The total amount now spent on drink is therefore 22*120 + 78*(42+119)/2 = 2640 + 6279 = 8910 units. But this buys only half as much drink as without the tax. Nevertheless the total amount of drink bought is equivalent to 4455 units, a significant increase over the 4170 units drunk prior to the introduction of the tax regime. (Really we should iterate by feeding the tax revenue of 4455 back into the calculation but this clearly won’t affect the result massively…).
As a sanity check, note that only the top 21% (earning 171 or more units) can now afford massage, so a mere 21*(1+21)/2 = 231 units is spent on that activity. Massage professionals change career to start wineries all over the country.
Of course, if we believe so much in our drink tax policy that we respond by raising the tax to (say) 500%, and redistributing the approximate 25000 units of tax raised (there are just under 5000 units available to be spent on all except essentials, before tax), then the population will have from 300 to 399 units to spend. But with the maximum intake of drink now costing 360 units, no-one will be able to afford a massage. The maximum salary of 399 units is only enough to spend 50 units on essentials and 349 units on drink. Everyone will spend all their disposable income down the boozer!
In real life, of course, the situation would be considerably worse, because there are far more people on low wages than high ones, not equal numbers on each unit of salary as I’ve modelled.
I fear that the implication extends beyond the vice taxes. For example, policies such as increasing taxes on heating fuel and distributing the money directly or indirectly (i.e. by just adding it to the general pool of money raised by taxation) to the poor and elderly would be socially just, but ineffective in reducing carbon emissions. The effect of such policies is to reduce the constraint on consumption for those who were constrained by price, whilst failing to limit consumption of the targeted product by the majority of those who weren’t previously constrained. Dear, oh dear!
An even bigger point is that surely we want everyone to become better off in the future. Productivity is increasing all the time, so this should be the natural outcome. Policies to restrict consumption of products unhealthy to individuals or the environment simply by taxing them should therefore be considered suspect at the outset. It doesn’t really make a lot of sense to keep the majority of the population poor just so that their consumption of harmful products can be limited by taxing said products! Such policies only make sense if the goal is to increase the price of a harmful option above that of a desirable option. If no desirable substitute exists (as for drink) then this result suggests that perhaps we should be thinking more about alternatives to taxation policies to reduce consumption – public education initiatives, for example.
Case 2: Imported products
This is the true Man in the Wardrobe Fallacy. The point is that taxation is a change internal to the economy, but the amount we can afford to import is an external parameter, independent of internal taxes.
It’s not entirely clear to its inhabitants how the UK pays its way in the world these days. But we must be selling something in order to fund our imports. Possibly our main export is now financial services snake-oil, but let’s pretend we make widgets and export £10bn of these a year. We can therefore afford £10bn worth of imports a year, and let’s say we spend the dosh on oil and products that contain “embodied” emissions. [See an interesting recent piece by Monbiot on embodied emissions, and note the comment by SteelyGlint].
Let’s say we impose an import tax on these nasties making them more expensive to the consumer. Why might this be ineffective?
1. Remember we will still be able to import £10bn worth of goods because nothing has changed on the export side – the world still wants £10bn worth of our widgets. And practically everything we might import has at least “embodied” carbon. If we use (say) less oil, because the tax encourages us to use it more efficiently, but import manufactures produced using coal-based power from (say) China instead, then we could find we’re responsible for even more carbon emissions than before! [OK, an explanation: I know the consumer pays tax on the embodied emissions (actually I consider such a tax to be entirely impractical, but let’s be hypothetical for a moment), but if the scarcity value of oil is high, the cost of manufacture low and the carbon import tax not too high, the embodied emissions in £1000 worth (even after applying a carbon import tax) of Chinese manufactures could easily exceed the potential emissions in £1000 worth (after the carbon import tax) of oil! Oops!!].
2. Hang onto that point about efficiency. If we’re using less oil, but achieving the same economic output, perhaps by driving smaller cars, then – oops – we’ve improved the efficiency of the UK economy per unit of output! This will allow us to undercut our competitors and export more. We’ll therefore have more than £10bn to spend on imports. Oh dear!
3. OK, let’s get serious. We’ve taxed the oil we’re importing from Saudi, so that we import less. Instead, we blow the money on something containing no embodied carbon (for the sake of argument) – Indian Premier League cricket, for example. Now all we’ve done is put pounds into someone else’s hands (or perhaps dollars if we use that for such trade) – i.e. Indians working in the cricket industry. Now Saudi has this oil to sell and Indians have the pounds the Saudis were happy to take from us in return for their oil… All we’ve done is move the problem and put another link in the trade merry-go-round.
I seriously doubt that demand-side financial engineering (such as carbon taxes) will alone have any positive effect at all in reducing global carbon emissions. In fact, it could easily make the problem worse!
Tim, you raise a lot of different points in this blog entry. This comment is a response to one of them.
I suppose I should address Adrian’s point directly. He argues that the higher the price of drink, the less will be consumed relative to massages. I seriously doubt it. This may well be “classical economics”, but in real life value is determined socially, not just in terms of utility. In this case, the social consideration is paramount. People will only spend on massages what they have left after peer-pressure has forced them to drink with their mates until they fall over.
The economists would describe this in terms of elasticities of demand. What you say is a strong argument *for* the tax on drink, not against it as you claim! Taxes which have little effect on behaviour allow a lot of tax to be collected with very little distortion. If the distortion is desirable, that’s even better. There is *no* place for taxes with harmful distortions (like VAT or Stamp Duty). Taxes on very inelastic (supply or demand) goods which produce mainly beneficial side-effects when at a high level are the best. Petrol/gasoline, land, booze tend to be in this category. Wages, home sales, accounting profit are at the opposite end of the scale and should simply be abolished (and preferably banned by constitution as an irrational breach of natural freedoms).
Tim,
What you have described in part 1 with your thought-experiment reminds me a bit of the concept of a Giffen good. http://en.wikipedia.org/wiki/Giffen_good
– A Giffen Good (this is a theoretical concept – ) is a necessity (and therefore price inelastic) which is also an inferior good (consumption rises when income falls). The classic example (which turned out to be false it seems) was the potatoes in the potato famine. The ‘real income effect’ of the increase in potato price (ie I have less real income because the price of one of the main constituents of consumption has risen) dominates the ‘substitution effect’ (that the exchange rate between potatoes and meat favours meat more than before), because one doesn’t have any money to spend on meat.
Here you have both inferior good (for the rich) and normal good (for the poor) aspects.
In your case, I think you are assuming that the substitution effect is nil; but it is now a *normal* good for the poor with a strong income effect. The distribution effect of the tax redistribution is such that more is consumed when income is higher, and you are assuming that the poor people have more money (whereas for the rich, you are assuming that alcohol is an inferior good). So, the normal-good aspect of the redistributive revenue recycling in the poor people overcomes the (assumed zero) price effect.
I won’t comment as to whether this is at all likely; just aiming to clarify what you are saying.
It’s really straightforward how (high) carbon prices solve the problem. They reduce demand (a little bit); raise revenue (a lot) and most importantly they encourage alternatives without subsidies.
Comment 3 comes across as rather patronising, but I’ll take it seriously anyway. It’s not “straightforward” at all; I thought the idea was to reduce demand a lot, not “a little bit”; and high carbon prices will not in themselves “solve the problem”.
The position I am criticising is one that argues that pricing carbon/fossil-fuels (e.g. by a tax) at the level of a currency bloc (usually a nation, but we also have the euro and a huge de facto “Bretton Woods 2” dollar zone) will in itself reduce consumption of fossil-fuels through the law of supply and demand, specifically the part of the law that demand is affected by price, normally reducing as price rises, although there are exceptions.
This is not the case, for the reason – the Man in the Wardrobe fallacy – that I explain in my post.
Like all laws, the law of supply and demand is only valid provided a number of assumptions are satisfied. These are rarely stated, but are “implicit”. I can think of more than one such assumption, but the one that concerns me could be stated as, (demand follows price) “provided money spent on the product does not itself become available to purchase the product”. This is a rebound, effectively reducing the price of the product in question.
Fossil fuels are one of the main imports of many countries – Stoft in “Carbonomics” gives some interesting figures for the US (on p.19), which at times (1979) has spent as much as the staggering sum of 10% of GDP on oil imports, near as damn it. A redistributive (Pigovian) tax on oil with the idea of encouraging Americans to spend less on oil imports would cause some to do just that but would leave other American citizens with more $s to spend – which they might spend on oil imports…
It’s interesting how you could end up worse off. For example, if expenditure on (imported) gasoline leads to less carbon emissions per $ than expenditure on (imported) heating oil, which I believe to be the case, you may find redistributing carbon tax revenues leads to more carbon emissions as, at the same time as the wealthy trade in their SUVs for hybrids, the poor import more heating oil to keep warm.
The only rationale that stands up to scrutiny for pricing (e.g. taxing) carbon is to make fossil fuels more expensive than fully renewable alternatives so that these technologies are developed and rolled out. Even then there is the problem of what you import instead with the money you’ve saved. You might import more fossil-fuel or cause emissions indirectly by giving the money to someone else who imports fossil fuels themselves. Chinese manufactures could be (if energy from coal is used in their production) more carbon intensive per $ or £ than oil (or at least gas).
This is really quite a simple point.
People are clearly making policies without sufficient clarity as to what they are trying to achieve, nor sufficient understanding of the likely outcomes.
For example:
(1) If there are non-financial obstacles (such as dysfunctional planning processes) to the production of renewable energy then the price of carbon is almost irrelevant in determining the level of consumption of fossil-fuels.
(2) Policies aimed at improving the efficiency of consumption of fossil-fuels may raise living-standards, but are entirely ineffective in reducing overall carbon emissions in the economy.
(3) However much renewable energy is produced in the economy, price signals alone will be insufficient to reduce fossil-fuel consumption and hence carbon emissions.
Perhaps policy-makers are relying on econometric computer models where future currency exchange rates are an input rather than an internal variable of the system.
A lot of people also seem to assume “cost-plus” pricing when it suits them. Oil is obviously not priced on a “cost-plus” basis. But that doesn’t stop people assuming renewable energy would be. It won’t. Its price will be determined by demand like that of anything else.
The policies that are going to be most effective at reducing carbon emissions at a global level are those that are directly aimed at keeping fossil fuels in the ground or preserving “standing carbon”, a.k.a. forests, wetlands and so on.
To be honest, I find it quite astonishing that a serious economist can believe that a redistributive tax on a basic, essential commodity will in itself reduce consumption of that commodity rather than simply redistribute consumption of that commodity.
I suspect that when Pigou proposed taxes on externalities he had a different set of assumptions in mind to the energy market conditions that exist in the world of 2009.
The problems I’ve identified on my blog – Displacement, the Rebound Effect or Jevons’ Paradox and the Man in the Wardrobe fallacy – all arise because fossil-fuels are essential to the modern global economy – that is, to its energy system and productive processes – and a large component of trade between countries.