Why Taxes Trump Subsidies

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My last post explored the inefficiencies in the primary objective of the Clean Energy and Security Act bill, mainly carbon-offsetting. This post will focus on the other provisions in the bill, mainly, subsidies in the form of tax credits and business grants for those entities choosing to use clean energy technologies.

I must preface that though I am criticizing the abilities of this bill, it is a monumental legislative step in the right direction; though it must still pass in the senate. A friend of mine who does not believe in global warming has even expressed admiration for the bill and its intentions, though agrees with my assessment of its planned execution of those intentions.

The US government has long suffered from control issues. This bill provides subsidies and tax credits for those people who choose to use energy efficient technologies. To understand why this is not a great idea, we must look at the effect subsidies have on decision-making and rationality. In economics, we assume that people are rational agents acting on perfect information, among other things. If information is perfect, then prices represent the actual cost of the goods produced. By subsidizing clean energy technologies through business grants or tax credits the government is essentially creating prices that do not reflect the true social value of the good. Therefore, more is consumed of these goods than would otherwise be optimal and creates a higher social net cost without the same social net benefit that would have occurred if the prices were representative of the value of the good.

So what would be the solution? Instead of making it cheaper to consume certain energy sources, make it more expensive to consume the bad energy technologies. This may seem to achieve the same objective of having consumers substitute good energy with bad but this results in a more socially optimal solution.

Bad energy goods are labeled “bad” because they create an externality and further, this externality is not internalized in the price. This means that the cost to society of using this good is higher than the price being charged by firms because the firms are not held responsible for the negative effects the result from production and use of the good. By increasing the cost of these bad energy goods we can internalize the externality caused by the goods.

Why is this better? This gives consumers perfect information by way of prices so that they are able to choose the socially optimal level of consumption of both, or just one, good(s). The problem with subsidizing goods is that it gives signals to the consumer that the good creates a positive externality, i.e. it increases social welfare. While clean energy technologies trample less heavily on the earth, solar panels and wind turbines must still be produced by a firm using hazardous materials and non-renewable energy. One cannot argue that using such technologies reverse damage in the atmosphere, they only damage it less; therefore, they do not create a positive externality and should not be subsidized.

An Energy Bill with a Catch

Yesterday, a monumental energy bill was passed in the House. While liberals and conservatives are shouting out praise or disapproval, respectively, few have looked past party lines to gauge the real effects of the bill.

The bill is attempting to achieve one main objective which is a 17% reduction in economy-wide greenhouse gas emissions by 2020. The proposed strategy is a cap-and-trade system with large amounts of domestic and international carbon offsetting opportunities. There are provisions in the bill which will assist and mitigate the primary objective such as renewable energy requirements on utilities, energy efficiency incentives for consumers and businesses, grants for green jobs, and research and development on carbon sequestering technologies.

Though I support a bill to mitigate use of carbon-producing technologies, I cannot say with confidence that this bill will be able to achieve that. A system of cap-and-trade can be effective but is easily sabotaged with offset credits. The theory behind cap-and-trade (in this case) is that the government will set a limit on CO2 emissions that can be released into the air and then issue permits to businesses to pollute in the specified range. This provides economic incentives to businesses to reduce emissions for whom it is inexpensive to adopt cleaner air technologies. These businesses can then sell their permits to businesses that cannot easily adopt clean air technologies. So far so good. But then the offsets begin. This allows a business to pollute above their permit allowance so long as they invest in carbon offsetting activities. These carbon offsetting activities could be planting trees in Brazil to encouraging US farmers to adopt energy saving farming practices. Businesses will then invest in the offsets until the cost of offsetting reaches the cost of buying permits. The problem is that offsets reverse any intention and effect that capping has - i.e. it is the purpose of the cap to reduce emissions but offsets allow firms to pollute past the cap as long as they pay for it.


Economically, this makes sense. Those who pollute must pay. But the goal of the bill clearly specifies a 17% decrease in greenhouse gas emissions by 2020. If the goal is a reduction, then offsets will not help. If the goal instead is to increase the cost of polluting to reduce consumption, then cap-and-trade with offsets is the right system. it might seem that in both cases the reduction in emissions is realized, but in the first system, without offsets, the amount of emissions is set and final, while the with the offsets, the amount of emissions will depend on a multitude of factors such as firm's cost structures, elasticity of demand for that firms products, elasticity of supply of that firm, etc. And this is where it becomes complicated.

Further, though I have not done the research, it seems a bit far fetched to me that planting forests in South America will offset emissions released in the US. On average, maybe this is true, but this isn't statistics where the average rules. This is our air and I want the air I breath in the US to be clean, not clean "on average."

Consuming Health Care

The Obama Administration released a report the other day claiming that Americans must start to reduce their consumption of health care in order to avoid soaring budget deficits and further damage to the economy.  In a time when the government is trying to increase consumption in every other sector, why is consumption on health care considered bad?

Insurance: Using insurance to pay for health care consumption create moral hazard and inefficiency.  Moral hazard occurs when people take greater liberties in risky behavior because they know they are protected by the insurance.  Insurance is based on a set of data based on behavioral patterns in the absence of insurance.  When these people get insurance, their behavior invariably changes because they are now responsible for less of the burden if injury should occur. 

But this doesn't only make people more risk-seeking, it also makes them medi-holics. Americans consume an enormous amount of health care services.  We go to the doctor when we have a cold, we get flu shots every year, it's over precautious.  There is a certain level of precaution that is considered optimal but we are surpassing that level and it results in inefficiency.  

I suppose the argument against this is that it's the market-determined level of health care consumption so it is not bad that we spend so much on health care.  To that I would argue that the optimal level of health care consumption can only be found when insurance is not offered.  Insurance effectively subsidizes health care costs so the level of actual consumption is higher than the optimal level; again, resulting in inefficiency.

Medicare: It is a fact that people aged 65 + spend more on health care than those under 65 and that those older people are on medicare. This means that the government's health care burden is enormous.  Medicare accounts for 14% of the federal budget and we can expect to see this number rise as the elderly population increases. Though people 65 + made up 13% of the population in 2002, they accounted for 36% of health care consumption. Further, the relative size of the aging population has increased greatly since 2002 and will continue to increase for the next 10 years.  This creates an even greater burden for the government, especially in this recessionary time, since many of these medicare recipients will drop any outside coverage and rely solely of medicare for health insurance.

Since health care expenditures are subsidized our consumption is far above the level it should be.  There is no easy solution and I think the Obama Administration is not unjustified to ask Americans to spend less on health care.  Further, since our consumption on health care is inefficient, reducing the amount spent on health care and transferring it to other sectors would not only create a more efficient economy but also a more efficient household allocation of resources.

Fast Facts

Health care consumption per person

1980: $1,106

2004: $6,280

Health care as a percentage of GDP

1980: 9%

2004: 16%

Thanks to http://www.ahrq.gov/research/ria19/expendria.pdf and http://facts.kff.org/