Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business

by Robert Litan

  In any event, here is the way most economists think about how we could reduce CO2 emissions. There are far too many emitters of CO2, and even more who may suffer from the effects of climate change, both residing in many different countries, to allow a negotiated Coasian solution to reduce CO2 emissions. Accordingly, private markets and prices will not fully reflect the net social costs of CO2 emissions in the prices of goods (and conceivably some services) that either directly or indirectly generate CO2. To solve that problem, the sources of those emissions should be taxed at that social cost. Alternatively, one could put a cap on total emissions, and distribute or sell tradable permits for CO2 emissions. The price of the permits represents an implicit tax on CO2.

  Notice, however, the two important ifs that are required to justify a carbon tax or a cap-and-trade system: if man-made emissions are altering the climate, and if those alterations on balance are net negative. Both those propositions are in dispute, although I think it is safe to say that the weight of scientific opinion is that both propositions are true.

  William Nordhaus: An Economic Polymath

  Though I know many of the economists I have featured in this book, only a few I have known personally for a long time. William Nordhaus is on that list and I owe much of my career to his influence. Some would tell me that because of this bias I shouldn’t feature him here, but why should my friendship and admiration prevent others from knowing about one of the great economists of the latter portion of the twentieth and early twenty-first centuries?

  Bill and his very talented brother Bob (who became one of the nation’s leading energy lawyers and as a Senate staffer in the 1970s wrote a broad provision in the Clean Air Act that is cited as the legal authority for regulating carbon dioxide emissions) grew up in New Mexico. Upon high school graduation, Bill went to Yale, quickly found his calling in economics and earned his BA, then went to MIT to gain his PhD, studying under some of the greats in that department, including Paul Samuelson and Robert Solow.

  I have no doubt that Bill’s teachers recognized early on that he was an economics prodigy, gifted in math, highly creative, and yet able to write in clear and accessible English in an engaging way—a rare combination of skills among economists that took Nordhaus far in the profession. Bill is “true blue” and so it was no surprise that he accepted his first post-graduate teaching job at Yale, where he has taught his entire career, except for a brief two year interlude as a young member of President Carter’s Council of Economic Advisers (where I worked with him, following our work together during my graduate school years with Tjalling Koopmans on a major National Academy of Sciences study of the economic future of the nuclear breeder reactor—which as informed readers know, never fulfilled its early promise). Nordhaus also has served Yale as provost and vice president for finance and administration.

  I call Bill an economic polymath because he has authored pioneering empirical and theoretical research across a broad range of topics, including the economics and measurement of growth, energy economics (he was one of the first to use linear programming techniques, described in Chapter 4, to model energy cost curves), inflation, unemployment, regulation generally (a subject on which I was lucky to write my first book, with him), and environmental economics, with a special emphasis on the costs of living with or introducing policies to control greenhouse gases. In the latter arena, Nordhaus has built sophisticated models to calculate the benefits and costs of different insurance policies to mitigate climate change, which he takes to be a serious and potentially catastrophic problem. The idea of a carbon tax as the most efficient and effective policy to combat climate change grew naturally from his modeling of the economics of this phenomenon.

  It was surely because of the breadth of his work that the legendary Paul Samuelson chose Bill to be his coauthor in the later editions of Samuelson’s landmark introductory economics textbook. In 2014, Bill became president-elect of the American Economic Association, one of the profession’s highest honors (and long overdue in my opinion). He will surely garner many more.

  I am not a scientist or a climatologist, and thus cannot personally assess the truth of this scientific consensus or whether the minority of scientists who deny one or both of these propositions are right. My inclination, to put all my cards on the table, is to side with the scientific consensus on both propositions, but I will be the first to admit that I do not hold this view with 100 percent certainty. Likewise, except for perhaps some diehard climate-change deniers, I’ll bet many of those who privately or publicly express skepticism about the fact or extent of man-made climate change also—deep down, privately—would admit they, too, are not 100 percent certain of the correctness of their positions.

  The uncertainty about the existence and extent of climate change is like any other uncertainty in life—whether you will be hit by a car, or suffer damage to your house from fire, storms, or earthquakes. These events have some probability of occurring and can be costly or even catastrophic if they happen. Beginning with maritime risks, human beings have found a way to live with these uncertainties by reducing their economic impact by buying insurance that covers their losses if the events happen. The firms selling insurance are able to do so profitably by diversifying their customer bases, and thus their risks, across broad populations, while investing the insurance premiums they collect in interest or dividend-paying assets until they are needed to pay claims.

  A carbon tax or a cap-and-trade system can be thought of as social insurance against potentially catastrophic costs associated with greenhouse gases. Purchasing insurance against uncertain outcomes should not be a political issue; it is really a matter of prudence. Even Judge Richard Posner, a noted conservative intellectual, endorses the broad concept of purchasing some kind of climate change insurance in one of his many books.18

  Of course, global climate change presents a special problem because it is global, meaning that any steps taken to reduce CO2 emissions even by one of the largest emitting countries, such as the United States, will benefit the world. Or, in the language of economists, unilateral carbon taxes of cap-and-trade systems benefit free riders that reap the benefits without paying the costs. That is why the United States and other countries have sought to bind all countries to commitments to reduce greenhouse gases; this has proved problematic because poorer countries believe they should not have to pay, or even must be compensated by richer ones, since they believe that any country-specific limits on CO2 emissions will disproportionately inhibit their economic growth. Put another way, poorer countries see a global climate change regime as a way for rich countries to pull up the economic ladder before others can really climb on. For this reason, I (and many others) are dubious that any meaningful and enforceable global or even multilateral climate change agreement—one requiring either a carbon tax or a hard limit on CO2 emissions—will ever be reached (virtually all of the world’s countries signed on to the Kyoto Protocol in the late 1990s and many have imposed binding CO2 emissions limits in their own countries, but the U.S. Congress did not ratify Kyoto, and it is unclear at this point whether Congress would accept any international agreement).

  There are also numerous technical issues that must be resolved in designing any carbon tax or a cap-and-trade system. With respect to the tax, one central issue is the tax base: Does the tax apply both to energy producers and consumers, or should a subset of energy users be exempt for strategic or political reasons, such as automobile manufacturers? In addition, it is generally understood that the tax should extend to imported products, but as a matter of fairness and most likely legality under international trade rules that bar discrimination, the tax on imports should vary depending on the amount of the carbon tax or its equivalent assessed in exporting countries. Another issue is the level of the tax, which in principle should be set at the social cost of carbon, a figure on which there is no consensus, and understandably so, since even those who worry about climate change admit that all of its harmful consequences are not yet known. And then the
re is the issue of how to handle the regressive nature of the tax: Who should get rebates and in what form? There is an extensive literature on all these issues that I cannot summarize here, but I mention these questions just to illustrate that implementing even a relatively simple economic idea can be quite difficult.

  Cap and trade is potentially even more complicated. In addition to deciding who must have permits and how many—analogous to determining the tax base under any carbon tax—the central issue in any cap-and-trade system is whether the government should hand out the initial permits for free, which would make the system more politically palatable, or whether it should charge for the permits initially with the objective of raising revenue (analogous to both the carbon tax and to auctioning off electromagnetic spectrum). How should imported products be treated? Does the cap (or the tax) start immediately, or is it phased in, presumably at more stringent levels over time?

  Despite the free-rider problem and putting aside the myriad technical details of how a carbon tax or tradable permit system would be designed, there is one large potential benefit from the United States unilaterally imposing the tax or, equivalently, by selling permits: The money raised can make a substantial contribution toward deficit reduction. My former Bloomberg Government colleague Rob Barnett has estimated, for example, that a tax of $20/ton on carbon content would raise $1 trillion over a 10-year period, without any rebates to low and possibly middle-income residents to offset any distributional affects. Others who have not accepted the idea of a carbon tax as a net revenue raiser nonetheless have expressed support for a revenue-neutral trade of the tax for a reduction in other federal taxes, such as the social security tax, which is a tax on labor.

  However it may come about, a carbon tax or a cap-and-trade system could have significant business impacts, though they would be uneven. Firms engaged in producing carbon-free energy (such as nuclear or wind) or low in carbon content (natural gas) would benefit; oil producers and coal mining firms would be penalized, which of course is precisely the point of such a tax (to ensure that their prices reflect the full social costs of these energy sources). It is conceivable that a carbon tax or tradable permit system could be even more effective in promoting research and development and innovation in alternative energy than direct federal spending. A cap-and-trade system also would resuscitate one or more exchanges like the Chicago Climate Exchange, which was founded by an economist, Richard Sandor, in 2010, but later was purchased by the Intercontinental Exchange, which also now owns the New York Stock Exchange. Intercontinental has since closed the Climate Exchange because of inactivity in carbon credit markets.

  Apart from the effects on particular kinds of business, the net impact of a carbon tax or cap-and-trade system on GDP and job growth is unlikely to be large (and has been overstated by its critics).19 There are two reasons for this. If the tax is indeed part of a revenue-neutral arrangement, then there is no net fiscal drag from the tax, and thus no net dampening effect on the economy. But even if the tax is part of a larger deficit-reduction package, meaning that in the short run it may depress overall demand somewhat, over the long term deficit reduction will reduce interest rates below what they otherwise would be, stimulating investment spending. In addition, a reduction in the deficit toward a sustainable level substantially reduces, if not eliminates, the possibility of a sudden spike in interest rates caused by a collapse of investor confidence in the fiscal health of the United States, a low probability but high consequence event that is worth paying to avoid.

  There are no easy solutions for addressing threats from climate change. Any policy will produce winners and losers, but nearly all economists would prefer a tax or cap-and-trade system over a top-down command-and-control system of emissions limits.

  The Bottom Line

  This chapter has surveyed three broad policy ideas developed by economists that have been in the public domain for some time. Each either directly or indirectly can be deployed as part of a medium to grand long-term deficit reduction package and, in fact, none is likely to be implemented outside that context. I cannot predict when a president and Congress will seriously consider such a package, but I hope for the sake of my children’s generation and those who follow that this will happen sooner rather than later.

  Each one of the ideas surveyed here would have major impacts on business, with winners and losers. The impacts on the overall economy, however, are likely to be modest to highly positive, to the extent that each idea or all of them in combination make a major contribution toward changing the upward trajectory of the federal budget deficit.

  Notes

  1. Charles L Schultze, Public Use of the Private Interest (Washington, DC: The Brookings Institution, 1977).

  2. Charles L. Schultze, Memos to the President: A Guide to Macroeconomics for the Busy Policymaker (Washington, DC: Brookings Institution Press, 1993).

  3. Congressional Budget Office, The 2013 Long-Term Budget Outlook, originally posted September 19, 2013, revised October 31, 2013, at www.cbo.gov.

  4. Calculated from charts compiled by the Peter G. Peterson Foundation, www.pgpf.org.

  5. Congressional Budget Office, The Budget and Economic Outlook: 2014 to 2024, www.cbo.gov/publication/45010.

  6. H.J. Aaron and R.D. Reischauer, “The Medicare Reform Debate: What Is the Next Step?” Health Affairs 14, no. 4 (1995): 8–30.

  7. Melinda Beck, “Coordinated Health-Care Program Saves Millions,” Wall Street Journal, January 30, 2104, http://online.wsj.com/news/articles/SB10001424052702303743604579353133811400314?KEYWORDS=Health+Savings.

  8. This summary is based on both the author’s recollections and on a biography and tribute to Pechman’s life written by another longtime Brookings giant, George Perry. See www.brookings.edu/~/media/Projects/BPEA/1989%202/1989b_bpea_perry.PDF.

  9. Eric Toder, et al., “Using a VAT for Deficit Reduction,” Tax Policy Center and the Pew Charitable Trusts, www.pewtrusts.org/uploadedFiles/wwwpewtrustsorg/Reports/Fiscal_and_Budget_Policy/Using%20a%20VAT%20for%20Deficit%20Reduction.pdf.

  10. The best reference for this proposal is the updated version published on the twenty-five year anniversary of their idea, Robert E. Hall and Alvin Rabushka, The Flat Tax (Stanford, CA: Hoover Institution and Stanford University, 2007).

  11. Len Burman, “What Is a Flat Tax? (Surprise! It Is a VAT),” Forbes, www.forbes.com/sites/leonardburman/2011/10/24/what-is-a-flat-tax-surprise-it-is-a-vat/.

  12. The two proposals are summarized in Len Burman, “A Progressive Consumption Tax?” Forbes, www.forbes.com/sites/leonardburman/2012/06/04/a-progressive-consumption-tax/. For the original Bradford tax proposal, see David F. Bradford, Untangling the Income Tax (Cambridge, MA: Harvard University Press, 1986); for the Carroll and Viard proposal, see Alan D. Viard and Robert Carroll, Progressive Consumption Taxation: The X-Tax Revisited (Washington, DC: AEI Press, 2012).

  13. For a summary of the plan see Howard Gleckman, “A Value-Added Tax that Won’t Raise Revenues or Boost Taxes on the Poor,” Forbes, November 26, 2013.

  14. See Henry J. Aaron, Serious and Unstable Condition: Financing America’s Health Care (Washington, DC: Brookings Institution Press, 1991); Leonard E. Burman, “Pathways to Tax Reform Revisited,” Public Finance Review 41 (2013): 755; Leonard E. Burman, “The Value Added Tax: Gateway to the Elusive Grand Bargain?” Milken Institute Review, 2014; and John Shoven and Victor R. Fuchs, “The Dedicated VAT Solution,” SIEPR Policy Brief, http://fsi.stanford.edu/publications/the_dedicated_vat_solution/.

  15. William D. Nordhaus, “Why the Global Warming Skeptics Are Wrong,” New York Review of Books, March 22, 2012. Nordhaus displays a graph in this piece, which is one of the most cogently argued responses to critics of global climate change that I have seen, showing that despite year-to-year variations, the mean global temperature has risen about 0.8 degrees Celsius since the late 1800s.

  16. William D. Nordhaus, A Question of Balance: Weighing the Options on Global Warming Policies (New Haven, CT: Yale University Pres
s, 2008), 82.

  17. See “Free Exchange: The Weather Report,” The Economist, January 18, 2014, 76.

  18. Richard A. Posner, Catastrophe: Risk and Response (New York: Oxford University Press, 2004). For a shorter version of his thesis, see this interview: www.foreignpolicy.com/articles/2007/12/10/seven_questions_planning_for_a_climate_catastrophe.

  19. Nordhaus, “Why the Global Warming Skeptics Are Wrong.”

  Chapter 15

  The Future of Economics: What It Means for Business and Economists

  It may seem odd to end a book about the huge, often unseen, benefits of economists and their ideas, primarily for business but also for society at large, by speculating about the future of economics itself. Will economics continue to deliver these benefits, or will the field suffer diminishing returns, one of the economic propositions that has given economics its unwanted name: the dismal science?