Megan McArdle writes,

Ryan Avent has been doing some great posting on cap and trade versus carbon taxes. With all information known, the two are theoretically identical. But in the real world they will differ; the question is how much.

One way to think about it is that we are choosing between two kinds of transparency: transparency to regulated companies, and transparency to voters. Politicians like cap and trade because the connection between the plan and higher energy prices will be less obvious to the voters. For that reason, a libertarian should generally prefer a direct tax.

I will discuss the theoretical equivalence of a carbon tax and cap-and-trade below the fold.

In practice, cap-and-trade creates an irresistable opportunity for politicians to use carbon permits as political favors to be handed out to special interests. This in turn means that there will be special interests with a large stake in keeping cap-and-trade policies in place, regardless of what transpires in terms of global temperature.

What is the probability that the United Nations derivation of climate model consensus overstates the problem of man-made global warming? Unless that probability is zero, it seems to me that we should prefer a climate change policy that is reversible to one that it irreversible.

Because I think that the probability that the UN is misleading us is significantly greater than zero, I think that the issue of irreversibility is quite important. Therefore, I think that a carbon tax is far preferable to cap-and-trade. Ten years from now the global warming scare might be completely debunked, and yet we will still be unable to unwind cap-and-trade. As with farm subsidies and many other policies, the problem will be long gone but the solution will be with us in perpetuity.In theory, cap-and-trade can be equivalent to a tax.

Suppose that your goal is to reduce carbon emissions by 50 percent. You estimate the responsiveness of carbon usage to price, and you raise the tax or taxes on carbon-using activities by the amount that you think will get a response of 50 percent. If you start seeing responses that are different from what you expected, you adjust the tax rate up or down, as necessary. The result is that people substitute away from carbon-intensive production methods and consumption, and government gets revenue from the tax.

With cap-and-trade, you issue a set of permits to be bought by firms that sell carbon-intensive goods or use carbon-intensive production methods. However, you only issue enough permits to allow for 50 percent of today’s carbon use. You auction off these permits, and these permits then can be traded between firms as they get a clearer idea of where substitution away from carbon is easy or difficult. This trading takes place in a market, resulting in a market price. The price or carbon permits raises the cost of carbon-intensive consumption and production relative to other forms of consumption and production, causing people to substitute away, exactly as if it were taxed. Assuming that government auctions off the permits, then government gets revenue from the cap-and-trade system, exactly as with a tax.

In theory, you can make cap-and-trade equivalent to a tax. What I worry about is that under cap-and-trade Congress is very unlikely to have a pure auction of permits. Instead, permits will be given to favored industries. The equivalent under a carbon tax would be to set different tax rates for different industries, with favored industries getting anywhere from a partial exemption to a full exemption to a negative carbon tax, or a carbon subsidy. I think that this would be a complex set of tax rates for Congress to manage, both computationally and politically. Therefore, my guess is that using the tax approach there would be less micro-management, and Congress would create fewer clear winners with a stake in perpetuating the policy.

Finally, there is the famous Weitzman paper on “prices vs. quantities.” He points out that if the welfare-maximizing government is uncertain about some of the parameters in the system, then setting a price (via a tax) is not equivalent to setting a quantity (via a cap). Students of economics should take time to appreciate the argument, but I think in this case it is less important than the political economy of cap-and-trade. I get the sense that Tyler Cowen, in his comment on this issue, is perhaps indirectly alluding to Weitzman.