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Speaking of the Economy
Speaking of the Economy - James Stock
Speaking of the Economy

Jan. 20, 2021

Taxing Carbon: A Macroeconomist's View

Audiences: Economists, General Public, Policymakers
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James Stock, a professor of political economy at Harvard University, discusses his research on the effects of carbon taxes in the European Union and its implications for enacting similar taxes in the United States. Stock presented this research at the Climate Change Economics conference organized by the Richmond Fed in November 2020.

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Jessie Romero: Hi, I'm Jessie Romero, director of research publications at the Richmond Fed.

I'm talking today with James Stock, the Harold Hitchings Burbank Professor of Political Economy at Harvard University. His research focuses on empirical macroeconomics, monetary policy, econometric methods, and energy and environmental policy. In November, Professor Stock presented his research on the effects of carbon taxes in the European Union at a conference hosted by the Richmond Fed.

Thank you for joining us, Professor Stock.

James Stock: Well, it's my pleasure, Jessie. And I'm really grateful for having this opportunity.

Before we get started, I just wanted to say thank you to the Richmond Fed for the great conference. And, I guess, thank you to the entire Federal Reserve System for getting on board with the importance of studying climate change. There's an awful lot that we need to learn about how climate change interacts with the macroeconomy [and] how policies interact with the macroeconomy. A lot of this falls right in the wheelhouse of the Fed, and it's terrific to see Fed leadership in this area.

Romero: Great, I'm glad to hear that. Again, thank you for participating in the conference. I was wondering if there were any key takeaways for you from that conference?

Stock: Oh, sure. The most important takeaway is there [are] big challenges out there in terms of the macro effects of climate change and what the effects of climate change are going to be on financial institutions for which the Fed is responsible.

We've already seen really significant changes in macro institutions in response to climate policy. Let me just bring up a very recent one.

There was a lease sale in ANWR, the Arctic National Wildlife Refuge, just last week. In advance of that oil-and-gas lease sale, which is something that the Trump Administration has been pushing very hard, a large number of banks simply said they would not be financing any bids for those leases.

What happened is that a couple of the leases went to very small companies [and] the rest of the leases went to the state of Alaska. The leases generated $15 million in sales, when they had actually been scored, as part of the 2017 tax act, as generating like, I believe it was $900 million in sales. So, [this was] a giant failure for lease sales and a giant success for the realization that we need to keep those fossil fuels in the ground and, of course, preserve the Arctic National Wildlife Refuge.

That was a place where banks took independent action. … I suspect it wasn't because they are environmentalists in their hearts, although some of them might be. I think it was based on financial risks associated with climate decisions, and climate policy and energy policy. The Fed needs to be on top of all of that.

The conference at the Richmond Fed was one that really drove home how important various features are, such as natural disasters and financial adaptation and so forth.

Romero: As you note in the working paper, "The Macroeconomic Impact of Europe's Carbon Taxes," which you co-authored with Gilbert Metcalf at Tufts University, there is a broad consensus among economists that pricing carbon emissions is the most efficient way to reduce greenhouse gas emissions. If that's the case, why haven't we seen such policy implemented in the United States?

Stock: You know it's true that if it were up to the paid members of the American Economic Association, we would have had a carbon tax a long time ago.

It's easy to point to [the] politicization of climate. It's easy to point to how there has, in fact, been obstructionist behavior by certain interest groups. That's true for all climate policies.

But I think there's actually some legitimate things about a carbon tax that are out there that need to be addressed. It's worth pointing out a few of those.

A legitimate concern is whether or not a carbon tax is going to have negative effects on employment and the economy. It kind of stands to reason that if you raise taxes, maybe that's not such a good thing. If you raise energy prices, maybe that's not such a good thing. The jobs issue was actually a really big part of the stated reasons why the Trump administration withdrew from the Paris climate agreement. That's what we address in the paper, and that's one important thing to be aware of. We tackle that.

There's other ones, too. There's concerns about regressivity of a carbon tax. Now that, within the last four years, has been really thought through — how to make a carbon tax not regressive.

There is concern among environmentalists that a carbon tax might not actually deliver the goods, that it might not achieve the emissions reductions we need. There has been a lot of recent work on that, too — how to make sure that it has a belt and suspenders.

And then there is legitimate concerns about the effect of a carbon tax on impacted communities, especially coal communities. That is something that economists need to continue to work on. We have ideas and people who have been studying that. We need to continue work on how to support transitions in impacted communities.

Romero: So, turning to your research more specifically, the paper you presented at the conference focuses on Europe. I was wondering if you could briefly describe the system of carbon taxes there and how that influenced your choice of which countries you were going to study.

Stock: The short reason why we focused on Europe is that it's a really good dataset for studying this type of intervention. There are 31 European countries in our dataset, and 15 of those have a carbon tax. They have an awful lot in common, importantly in the climate sphere. They are all members of the EU emissions trading system, so they have similar climate policies. However, some of them have adopted a carbon tax — mainly a carbon tax that hits the transportation sector — and others have not.

Putting on my narrow hat as an econometrician, it's a great dataset to study because there is variation. There's variation in when the carbon taxes were imposed. There's variation in … the levels of carbon taxes. And then there's the countries that we use as comparisons that don't have a carbon tax.

Romero: Even with a clean dataset, I imagine there are quite a few challenges in teasing out the causal effect of a carbon tax on growth rates and other variables. How does you research tackle some of those challenges?

Stock: That's an insightful question.

It's worth just stepping back and remembering what the challenge is when we try to estimate causal effects in general.

The basic problem in estimating any causal effect is that, for any one individual or any one entity or any one country, you only observe one situation. … Finland imposed a carbon tax and we got to see what happened in Finland with the carbon tax, but we never see the Finland that didn't impose the carbon tax. We see one of the potential outcomes, but we don't see the other. So somehow, you've got to figure out a way to … construct that counterfactual of Finland without a carbon tax.

That's the fundamental challenge of causal inference. There are a couple of different ways to address that, and we use those [in the paper].

One of them is you use countries as controls. For example, Denmark maybe that's kind of like Finland in a lot of different ways. Well, they imposed a carbon tax, but they imposed it at a different level and they imposed it at a different time. We can use those differences to try to identify causal effects of a carbon tax.

The other thing we do is borrow an identification method from macroeconomics, and that relies on a feature of timing with carbon taxes. In particular, carbon taxes need to be set in advance so that you can basically set the tax rate for that year. … That means that whatever the carbon tax rate [will] be unrelated to future developments in the economy. What you need to worry about is some sort of feedback of the form that if the economy is doing really well, then we say, okay, we can increase the carbon tax or adopt a carbon tax. Or, if the economy is doing poorly, we might say we'd better not change the tax rate. Well, the tax rate is set in advance — any unexpected movement in the macroeconomy and GDP and employment is going to be unrelated to that. We can then look at innovations and the carbon tax rate and see how those innovations trace their way through the economy.

Romero: There is a lot of other research, of course, estimating the effects of cap-and-trade systems and carbon taxes, much of which you cite in your paper. What is unique about you and your co-authors' approach?

Stock: Broadly, there is two different approaches to studying the effects of carbon taxes. The traditional one and, I would say, the dominant one is to use a fairly theoretical or structured framework that then would be calibrated to various empirical data values. One of these, for example, is the Hafstead Goulder E3 model, and that's a computable general equilibrium model. It traces through the effects of a carbon tax through a whole bunch of different parts of the economy.

[General equilibrium] models have dominated the discussion, and they basically point to carbon taxes as having fairly limited effects on employment and GDP. We view those [models] as largely theoretical.

The counterpart to that, which is quite complimentary, is to look just at data and say, well okay it's nice to have those theoretical models, now what really happened in the real world? There's a lot fewer empirical studies than there are computable general equilibrium-type studies. Most of [the latter] have studied fairly narrow circumstances such as British Columbia or Scandinavia. There hasn't been systematically large-scale focus on looking at empirical evidence on employment and GDP in a broad swath of countries.

That's really our main contribution — looking at this situation in Europe and looking at the history since 1990 when [carbon] taxes started to be imposed in some of the Scandinavian counties and seeing what those effects actually are. And then there's some methodological things we do, too, in terms of trying to make sure that we identify the causal effect. Those are the more technical things in the paper.

Romero: That's a great segue to the question that probably everyone is wondering. What did you actually find about the effects [of a carbon tax] on GDP and employment?

Stock: When an undergraduate comes to my office and says they are really interested in something and then they ran some regressions and didn't find anything there, maybe they should find another project. Well, here's a circumstance where what we found was basically very little effect. We found no effect, and, you know, that's super-interesting.

The [theory behind] the computable general equilibrium model suggests that there's going to be a modest effect. We find that, if you look up to six years out, there is really small blips in both GDP and employment, basically just noise.

A minor correction — the small positive effect that we found was on employment, and that was in the initial year of a tax rate increase. We studied unexpected tax rate increases and, in the initial year of the tax rate increase and then the subsequent two years, there seemed to be a small positive effect on employment. It's kind of tempting to tell stories about transition to green jobs or something like that, but I don't think the data really support that. These [effects] are basically just noise within one standard error of zero. And after the first couple of years, this effect just goes away.

The better way to summarize the findings is that we found no effect on employment growth and we found no effect on GDP growth, and that a carbon tax just doesn't seem to have any effect one way or another on the overall macroeconomy.

Romero: Well, what about on emissions, which is, of course, the purpose of the carbon tax is to lower emissions. Did you find any effects there?

Stock: That is where you do find an effect.

What we found is that for a $40 a ton tax covering 30 percent of emissions, we estimate a reduction of emissions of about 4 to 6 percent on the sectors covered by the tax. That's our result [which is] consistent with some very recent work by Geoffroy Dolphin, Ryan Rafaty and Felix Pretis. There does seem to be an effect.

Romero: You also note that effect could be a lower bound, which means that the effect could be a lot larger. Why is that?

Stock: First of all, it's worth pointing out that 4 to 6 percent [is] a meaningful contribution. At the same time, it's hardly transformative. We need to go to 100 percent.

There is a couple of reasons why that would be. The main reason is that the tax in these countries falls on the transportation sector, a tax of about $40 a ton is about 40 cents a gallon. That's not going to make a whole lot of difference in your driving patterns.

I should mention that, in separate research, we and many other people have estimated elasticities of demand with respect to gasoline. A 40 cents a gallon carbon tax [in Europe] maybe amounts to a 7 percent increase in a $6 price of gasoline. If you multiple that out with elasticities, you get estimates that are completely consistent with those 4 to 6 percent reductions that we found.

Our finding at the aggregate level is consistent with microstudies of elasticities of demand of gasoline … In our current economy, gasoline is a necessity, it's not a luxury good. There is not a lot of room for substitution.

I want to stress this — the reason I think [the emission reductions of a carbon tax that we calculated] is a lower bound is that, first of all, this only applies to the transportation sector. If it were to apply to, for example, the power sector, things could be quite different. Second, at the moment and certainly historically in these data, there really aren't good alternatives to using gasoline. You can use a little less gasoline or, I guess in Europe, diesel. But there are not good alternatives to it like electric vehicles, and I think those account for, at least historically, a fairly small contribution and one that we think can be much different in different settings.

Romero: If you had to guess, what would be your best guess about the effects of a carbon tax in the United States?

Stock: First of all, on the macro side, I go with our estimates. In Europe, a carbon tax basically was noise in GDP and noise in employment. We just wouldn't see any aggregate macro effect.

On emissions, I think the situation could be very different in the United States than we found in Europe. And here there is two reasons.

First of all, we don't have regulation of emissions in the power sector right now. There was an attempt to do that through the Clean Power Plan in the Obama administration. That plan was stuck in the courts. The Trump version of that is going to be stuck in the courts and withdrawn by the Biden administration. So, we basically don't have any emissions regulation in the power sector.

If a carbon price were to supplant Clean Air Act regulations in the power sector, I think we'd see very large effects. All of the estimates that I have seen suggest that this would really drive a significant amount of decarbonization in the power sector.

In other work that we've done, we've looked at the declining coal consumption in the power sector. … Coal consumption [between] 2008-2019 [has declined] about 40 percent. That is virtually entirely because of cheap natural gas — price is king in the power sector. A carbon price would very significantly change the landscape towards natural gas and, especially, towards clean generation like wind and solar.

So, I think we'd see very effective, deep decarbonization quickly in the power sector, something to bear in mind if you're thinking about achieving Paris climate goals.

The second reason I think that we'd see something more potent in the United States — according to my estimates and those of others, my guess is that the price of electric vehicles and batteries declines for the next few years at the same rate that it has been for the last 10 years. Then, we'll probably be at the point in maybe three years, or four years at the most, that we'll have price parity between electric vehicles and internal combustion engines in the mass market. At that point, that's just transformative. Even a tax of 40 cents a gallon could end up making the difference in getting some people to buy those EVs, which are a lot more fun to drive anyway and a lot cheaper to maintain. Then, I think we could see some really big effects.

Of course, it will take a while for electric vehicles to take over the market because the gasoline vehicles are going to last 10, 12 or more years. But I think we'd see a jumpstarting of the transformation of the transportation sector.

Just to summarize, [a carbon tax in the United States] would have a big effect right away in the power sector and a big effect in about four or five years in the transportation sector.

Romero: Thank you so much for talking with us today. This has been a really great conversation and I really enjoyed it and learned a lot.

Stock: It's my pleasure. Thank you very much, Jessie.

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