A Bug, Not a Feature

In discussing climate change legislation over at his blog, Paul Krugman says something that I believe to be correct, but he does not fully draw out the logical implications of what he says. Here what Paul writes:

And the burden on households from cap and trade depends on what’s done with the rents. In the original Obama plan, the rents would be used to pay for middle-class tax cuts; in Waxman-Markey, many of the permits are initially granted to utilities — but since these utilities’ profits are regulated, many of the rents would end up being passed on to consumers through lower prices.

In my view, that is a bug, not a feature, of the Waxman-Markey bill. From the standpoint of economic efficiency, the price of carbon emissions should be passed on to consumers in the form of higher energy prices, so that consumers can make optimal decisions regarding energy consumption. Consumers should be compensated for paying these higher prices via cuts in income or payroll taxes. Those tax cuts would be financed by the revenues received from the auctioning of carbon rights (or, better yet, a carbon tax).

To promote an efficient allocation of scarce resources, relative prices should reflect true social costs. Shielding consumers via the regulatory process, rather than through tax cuts, fails to achieve that goal and, as a result, makes environmental protection more costly than it needs to be.