Pigovian Prices

by Levi Russell

An interesting exchange occurred last month between two economists/bloggers. Stephen Gordon, an economics professor at Université Laval in Canada, wrote a column on the concept of a carbon tax price. In it, he argues:

As the Conservatives should really know by now, market-based approaches to reducing GHG emissions are more efficient than regulations. It’s better to let households and firms make their own priorities in response to price signals instead of having them imposed by the government. And the extra upside of market-based approaches like carbon taxes or cap-and-trade is that some of the costs of the policy are transformed into government revenues that can be used to compensate vulnerable groups or even to reduce other taxes.

So it seems that Professor Gordon equates a price with a tax. Hoover Institution economist David Henderson responded, taking Gordon to task for his apparent confusion of a price with a tax.

But carbon already has a price, or, more exactly, multiple prices. Natural gas has a price; oil has a price; coal has a price. And their prices are related to the valuable carbon component of those fuels because it’s carbon that makes those fuels valuable. Just as there’s no such thing as a free lunch, carbon is not free.

So why does Professor Gordon claim that taxing carbon means “putting a price on carbon?”

I can only speculate because I don’t know him, but here’s what I’m willing to bet dollars to doughnuts on: he calls a tax a price in order to lull the reader into thinking that it’s not a tax. Later in the piece he admits that it’s a tax but in his first mention, which sets the stage, he doesn’t.

Gordon later responded:

A market price is what a consumer has to pay in order to purchase a good or service. In contrast, a tax is, er, what a consumer has to pay in order to purchase a good or service.

This is one of those cases of a distinction without a difference. Unless you’re the sort of person who reads the fine print on the pumps at the gas station, you probably don’t know what the market price of gasoline is, and even if you do, you probably don’t care — at least as far as it affects how much gasoline you buy. What really matters is the total you have to pay. So when the focus is on how carbon taxes work to reduce greenhouse gas emissions — as mine was — then there’s not much point in using up column space to make the price-tax distinction. (Although if you want to play this game, think of a carbon tax as the price governments charge for degrading a communally owned resource.)

It's interesting to note here that neither Henderson nor Gordon are getting at the fundamental difference between prices and taxes. Prices, to one degree or another, transmit information about the relative scarcity of resources. If the price of a good rises, consumers of the good are incentivized to use it more frugally while producers are incentivized to produce more of it. It doesn't really matter whether the initial cause of the price rise was a reduction in supply or an increase in demand; what matters is the incentive the price change has on behavior.

One might be tempted to argue that a tax can be used to correct market prices when they don't reflect all relevant information. Indeed, this is the Pigovian paradigm that has existed in the profession for nearly 100 years. However, there have been significant challenges to this paradigm that are, in my mind, not fully appreciated. Though Henderson doesn't make this point in his final response to Gordon, I think it gets to the heart of the matter. Perhaps a tax on carbon is a sensible policy, but to simply assume that governments can get that price right ignores the reality that information and incentive problems present in markets are not absent from governments.