More on How To Make a Carbon Tax a Generational Win-Win

Last April, Laurence Kotlikoff, together with three distinguished colleagues, published a long, highly mathematical working paper on how to make a carbon tax a “generational win-win,” that is, something that can benefit those of us who are alive to day as well as our great-grandchildren. Both Kotlikoff and I think the answer is “Yes,” but for different reasons.

Earlier, I published a commentary on Kotlikoff’s working paper here on Medium. In the meantime, he has written a shorter, much more readable version of his “win-win” thesis for the Milken Institute Review. The editor of MIR asked me for a comment on the new version, which has now been published. Here is what I said:

In his Milken Institute Review article, “Leaping the Divide,” Larry Kotlikoff identifies a key problem of political economy that complicates efforts to slow climate change: a large part of the costs of the transition to a low-emission economy must be paid upfront as the economy retools, while the greatest benefits will become apparent only decades, even centuries, down the road. That makes costly policies like taxing emissions to spur green investment a hard sell.

Kotlikoff would like to fix that. Somehow, he says, we need to make a carbon tax a “generational win-win” that would “give all generations an equal stake in the policy.” If so, we would not have to rely on the weak reed of intergenerational altruism to build a successful political coalition behind a climate action plan.

Can it be done? I agree with Kotlikoff that it can, but I have serious reservations about the way he proposes to do it. Let me explain.

The Kotlikoff Plan

Kotlikoff uses a simple analogy to show what he means by a generational win-win. Imagine an island divided by a wide river. On one side live the As, who are good at growing apples but don’t like to eat them. The Ps on the other side of the river are good at growing pears, but they, too, don’t like to eat what they grow. Both sides could benefit by building a bridge across the river so that they could exchange fruit. The gains in consumer satisfaction, it is assumed, would more than repay the cost of the bridge. If the two sides shared the construction cost, the project would be a win for both the As and the Ps.

Now superimpose the climate problem onto the island story. Let us (the present generation) be the As and future generations be the Ps. The analog to the cost of the bridge is the cost of building a green economy powered by wind instead of coal — and one with more Impossible Whoppers and fewer of the traditional version made from methane-belching cattle. There are many alternative designs for the metaphorical bridge. We could subsidize private construction, or mandate clean-energy production, or let the government do the heavy lifting. Kotlikoff — like most economists, including me — would opt for building the bridge by taxing carbon emissions sufficiently to make it profitable to switch to wind turbines and plant-based meat.

But let’s return to Kotlikoff’s analogy of the island’s fruit trade. The “apples” the future receives from us are easy to identify: they get the economic and environmental benefits of a planet less damaged by global warming. But what can future generations give us in exchange? That’s where the analogy between the islanders’ problem and the climate problem breaks down.

The trouble is, any climate bridge we build can carry only one-way traffic. Yes, we can deliver the benefits of a better climate to the future if we cut carbon emissions now. But the future cannot send us truckloads of Future Meat produced with yet-to-be-invented technologies that make it both environmentally immaculate and unimaginably tasty. Nor can they deliver trainloads of the turbine towers and lithium batteries we need to decarbonize our electric grid. This means paying for the “apples” we give to the future with any kind of tangible “pears” is definitely out.

But Kotlikoff has a trick up his sleeve: as a solution to the problem of one-way traffic, he offers a financial sleight of hand. He proposes that we in the present give ourselves a hefty tax cut, financed by selling bonds that the future Ps will have to pay off. In return for bearing the costs of decarbonizing the economy, we get a consumer binge financed by lower taxes. In return, they get a more bearable climate and a more productive economy but are stuck with higher taxes to service a bigger public debt.

Cool, huh? As long as you don’t dig too deeply into the underlying logic.

The Limitations of the Kotlikoff Plan

I see three problems.

1. There is no way to enforce the deal. By the time the bonds come due, we will be long in the grave. The Ps will be basking in the pleasant climate that we decarbonized for them, but why should they take seriously their obligation to pay off our bonds? What happened when the bonds matured that our grandparents issued to pay for World War II, which they fought for our benefit? We paid off those specific bonds, but we rolled over most or all of the actual debt by selling new bonds. There is nothing we can do to stop future generations from doing the same as long as somebody’s willing to lend the money.

2. Even if the future Ps paid off our bonds in full, nothing material or financial would flow across the bridge as a result. The taxes levied to pay off the bonds would be imposed on some future Ps, and the payments would be received by whomever owns the bonds when they mature. In the island example, the Ps paid for their apples by sending pears to the As across the bridge. In the climate example, the future-taxpayer Ps meet their obligations by sending pears to the bondholder Ps who live on the same metaphorical side of the bridge that they do.

3. Meanwhile, no matter how it is financed, the decarbonized economy we build now for the benefit of the future has to be built with labor, capital and raw materials that are already on our side, the present side, of the bridge. In the simplified world of the Kotlikoff economy, those resources could be used for a limited number of purposes:

• Building clean-energy infrastructure

• Building fossil-fuel infrastructure (which, in the model, is cheaper, at least in the near future)

• Building other sorts of production facilities to produce future consumer goods

• Direct consumption by the present generation

Any increase in the inputs used for one of these purposes requires reducing the quantity used for some other purpose.

This all sounds a little complicated, and in some ways it is. To understand it fully, you have to work through the math in the technical version of the Kotlikoff plan, which he and several coauthors published as a working paper for the National Bureau of Economic Research. By the way, they are all better mathematicians than I am. I see no technical errors in their analysis. The problems lie in the way Kotlikoff explains the model, not in the model itself.

When we cut through the mathematical razzle-dazzle, here is how I think the Kotlikoff plan actually works. The central fiscal element is a carbon tax. The revenues are refunded fully to the public, making the carbon tax itself revenue-neutral. A sweetener is then added in the form of additional tax cuts. As a result, there is an increase in the budget deficit, which is financed by selling bonds.

Next, we turn to how this affects the real economy. The carbon tax incentivizes a shift in the allocation of labor, capital and natural resources by making production of carbon-intensive energy less profitable and clean energy more so. Meanwhile, the additional tax cuts — those that go beyond the refunds of revenue from the carbon tax — increase the disposable income of households and allow them to increase their consumption. On balance, then, clean-energy investment and current consumption end up absorbing more resources, while investments in dirty energy and the production of future consumer goods fall.

Putting it all together, the current generation is better off, at least to the extent that “better off” is measured solely in terms of current material consumption. Future generations are also better off, because the shift to cleaner energy slows the rate of global warming, which would otherwise be a drag on economic growth. The model specifies expected damage from emissions and expected costs of alternative energy sources in a way that ensures the benefits of lower warming more than offset the fact that clean energy is (at least for the next few decades) more costly to produce and the fact that total investment must initially fall to make room for the increase in consumption by early generations. In the end, then, future generations are also able to increase their lifetime level of consumption.

It’s a neat trick. Mathematically, it works. But it “works” in a sense that is very different from the island example. In the Kotlikoff model, there is no bridge from the future to the present. The As in the present generation finance their own higher consumption through cuts in their own taxes and a shift of their own investment away from dirty energy and future consumption. The Ps in future generations get a clean-climate gift from us without sending us any metaphoric pears. It is true that the Ps do face the need for taxpayers to hand over a lot of pears to their neighbors, the owners of all those bonds. But the administrative costs of doing that would be trivial compared to the benefits of a better climate.

The task facing climate activists is not how to devise an elegant set of taxes and tax cuts that leaves all present and future consumers better off. Rather, it is the frustrating task of building a climate-action coalition that is broad and sustainable.

Human Nature and Politics

Theoretically, then, the Kotlikoff plan really could produce the promised generational win-win. But, however sound theoretically, is the proposal practical? Kotlikoff rightly criticizes earlier models of climate policy based on “dynasties,” in which today’s decision makers are custodians of the welfare of their descendants or social planners, who are fully aware of the future consequences of their actions. He finds those models to be “removed from reality.” But this may be a case of the pot calling the kettle black: Kotlikoff’s own model also incorporates assumptions about human nature and politics that are pretty far removed from reality.

One such assumption is that all members of a given generation are alike in terms of their preferences. That assumption allows us to say that an entire generation is “better off” if its aggregate level of consumption increases, without having to worry about whether the carbon tax makes some members of a generation better off and others worse off — an issue that in practice is one of the thorniest problems facing designers of such a tax.

A second assumption is to make welfare solely a function of each person’s own lifetime consumption — each generation is in that sense “selfish.” Presumably, no one cares about the intangible benefits of a cleaner environment. And no one cares about the welfare, tangible or intangible, of subsequent generations.

Kotlikoff waves away intergenerational altruism with a link to an earlier paper on financial behavior within extended families. That paper counted people as altruistic if it could be shown that they valued a dollar added to (or subtracted from) their own income as equal to a dollar added to (or subtracted from) the income of a member of the subsequent generation. The statistical evidence suggested the people in the sample tested were, at most, only weakly altruistic.

Other economists, in contrast, use “altruism” in a less restrictive sense — but one that is still ultimately rooted in selfishness rather than self-sacrifice. Here, for example, is an entry from the Handbook of Economics and Ethics:

[Individuals] follow their self-interest, even when satisfying other-directed preferences. In other words: altruism exists only when it increases the utility of the altruist to a larger extent than self-directed actions would have done, with given prices and constraints.

Does it seem cynical to suggest that Bill and Melinda Gates give billions to fight hunger and disease just because it makes them feel good about themselves? Or to suggest that millions who are too poor to benefit from tax deductions nonetheless give generously to charities and churches for the same reason? Under more poetic names — love, honor, compassion — “other-directed preferences” have been celebrated in song and verse throughout history. They are deeply rooted in human nature.

What’s more, leaving altruism and diversity in human preferences out of a model can lead to strange results. For example, suppose a carbon tax, linked to a debt-financed tax cut that fuels increased consumption (as it is in the Kotlikoff plan), is put to a referendum. Assume, as Kotlikoff does, that the population of voters is homogeneous and generationally self-interested. If the referendum frames the proposal as a take-it-or-leave-it choice, with business-as-usual as the alternative, then it will be approved unanimously.

But suppose the referendum offers a choice between the Kotlikoff plan and a modified plan that preserves the bond issue, the tax cut and the increased consumption — but drops the carbon tax. Why would a homogeneous and generationally selfish electorate not unhesitatingly favor the amended version over the original one?

This, by the way, looks uncomfortably close to what we have now, at least in the United States. The last few years have brought us debt-financed tax cuts, an increasing share of consumption in GDP, and little, if any, political progress toward a carbon tax. To me, that looks like the inevitable political equilibrium for a world of homogeneous and narrowly self-interested generations.

How, Then, Can We Get to Win-Win?

Happily, we do not live in a world of homogeneously selfish preferences. Yes, many people’s views of the world undoubtedly do turn primarily on their own level of material consumption. But others take genuine satisfaction in the well-being of others, including people far removed from them in time and space. People also vary widely in the degree to which they value intangible environmental amenities, whether those be biological diversity, opportunities for outdoor recreation or simply a climate conducive to personal comfort.

In this real world, the task facing climate activists is not how to devise an elegant set of taxes and tax cuts that leaves all present and future consumers better off. Rather, it is the frustrating task of building a climate-action coalition that is broad and sustainable.

Of course, the work of coalition-building is complicated by the very real problem identified by Kotlikoff: carbon taxes and other mitigation measures tend to have front-loaded costs and delayed benefits. But don’t give up just yet. Climate activists of different schools are pursuing a variety of strategies to overcome that problem:

• Buy them in. Some take an approach that is not far different from that recommended by Kotlikoff: impose a carbon tax and distribute the revenues in a way that will enlarge the coalition. Proposals from the Citizens’ Climate Lobby and the Climate Leadership Council are the best-known examples. Their carbon-tax plans would distribute the entire proceeds equally as “citizens’ dividends.” Even though their proposals do not envision an overall net tax cut, as Kotlikoff’s does, the dividend would be greater than the tax burden for a majority of people.
• Moral exhortation. Other activists prefer to appeal to other-regarding preferences rather than to selfish interests. The Swedish teen activist Greta Thunberg is a good example. The Christian climate stewardship movement is another.
• Emphasize the risks. Some activists try to frighten people into doing something with vivid descriptions of catastrophic scenarios drawn from the thin tail of the probability distributions defined by climate science. “We have 12 years [10, now] to limit climate change catastrophe” warned The Guardian in one famous headline. Personally, I worry that such alarmism is as likely to trigger hopelessness and apathy as it is to spur constructive engagement.
• Manage the risks. A related but more responsible approach portrays the climate threat as a problem of risk management. As Gernot Wagner and Marty Weitzman tell us with their book Climate Shock, we routinely take precautions to avoid even a small chance of a catastrophic outcome when we drive a car or construct an investment portfolio. Shouldn’t we do the same for our planet?
• Double dividends and co-benefits. Still other proponents of climate action emphasize that emissions reductions can have substantial short-term benefits that supplement the long-term effects of reduced greenhouse gases. For example, some economists suggest that swapping a carbon tax for lower tax rates on personal income and investment income could pay a “double dividend” by spurring the rate of economic growth. Efforts to reduce carbon emissions could also have substantial co-benefits, such as the reduction of harmful local emissions of particulates, nitrogen oxides and other noxious effluents. In some cases, especially in congested urban areas, the immediate co-benefits alone would be sufficient to justify a substantial carbon tax.

The bottom line

Kotlikoff and his colleagues have done a real service by emphasizing the problems that front-loaded costs and delayed benefits pose for effective climate action. Whether their particular solution ends up being more than an elegant mathematical curiosity is really beside the point. Unless we can convince people that climate action can be a generational win-win, it will be hard to assemble an effective coalition to get it done. Managing that will probably require parallel efforts of all the types outlined above, and more besides.

Reprinted with permission from Milken Institute Review. Photo courtesy of Pixabay.com