A nuanced look at politicians’ favorite policy tool.
Everyone likes a puppy. You get a puppy you’re immediately in love. You never want to get rid of it. Puppies also come in all sizes. Look at that face!
The same is true for energy subsidies. The government essentially decides on what type of behavior (e.g., using public transport instead of your personal car to go to work) or purchase (e.g., electric vehicles instead of gas guzzling SUVs) to encourage and then hands out monetary incentives. Everyone loves them! Politicians and regulators can hand out “free” money to firms and consumers, who will be happier, and more likely to vote for them later. Everyone wins! It’s like the Oprah show, but at scale.
Even Chicago economists should like puppies, I mean subsidies, in some settings. Econ 101 tells us that there are some good reasons to subsidize certain activities.
Reason 1 is if there is a public goods nature to a firm’s activity. Research and development (R&D) of low carbon technologies is a good example. R&D is risky, as success is not guaranteed (if you would like a list of my failed ideas, email me. Make sure you have room for big attachments in your inbox.). Firms, if left alone, could engage in too little R&D for two reasons. If intellectual property rights are not perfectly enforced, firms do not get the full returns on their R&D investment as other firms “rip off” the invention.
Second, even if property rights are enforced, there could be learning that spills over to other firms, which is socially beneficial. In order to ensure the optimal amount of R&D, the public sector should hence step in and subsidize such efforts or engage in public R&D.
Reason 2 is if there are externalities. We have written extensively about the case of negative externalities and how one corrects these (e.g. via a tax or cap and trade). Subsidies play an important role here too. Often, instead of properly taxing the source of the negative externality (e.g. coal), we subsidize substitute cleaner technologies. It’s easier to hand out puppies than to tame a wolf. This is imperfect. It’s sort of like instead of yelling at the kid that drew on your living room wall with markers (who in response would change his/her behavior to the better – in theory), commending the other kid that did nothing for his/her good behavior.
There are reasons for doing both! Then there is the case of positive externalities. In the textbook, if a firm’s production has positive spillover effects, which that firm is not getting any profit from, the firm chooses to produce too little relative to what is socially optimal. For example, carbon free power generation in jurisdictions where carbon is not priced, provides a benefit to society by reducing damages from climate change and local pollution that the owner of the plant does not receive. They should get a free puppy! I mean subsidy.
Reason 3 for a subsidy is when we try and push a new technology, which we think has significant social benefits, into the market. This is especially true if such a technology requires a platform – such as EV chargers. In order for this technology to catch on, we need enough EVs around so that making charger ubiquitous makes sense. Having chargers everywhere, makes it more likely that folks will buy into the new technology. Subsidies hence can help “push” technologies. So overall, you should subsidize goods and tax bads.
But in reality, there are many settings where we, via subsidies or inefficiently low taxation, encourage bad behavior. In the US, we massively subsidize the production of corn, which (in its sugary form) has turned us into probably the fattest nation on earth. Globally, the combustion of fossil fuels receives implicit and explicit subsidies every year. How much do you ask? A team of IMF economists (including one of my grad school heroes, Ian Parry) estimates that the implicit and explicit subsidies to fossil fuels amount to 5.3 trillion dollars per year! That is 6.5% of global GDP!
But, Max, you say, you are being hysterical. No, I am not. You may argue that we should only count direct monetary payments from the government to the producers of fossil fuels as subsidies. Nope. Failing to charge a firm for the full cost of its activities, such as climate damages and local pollution externalities is an implicit subsidy. If you dump your trash in the public park, a cost is imposed on everyone. You should have to pay for it. Replace trash with CO2 and park with atmosphere in the previous sentence and you get my drift.
So, if I wrote an energy campaign platform, it would be centered around subsidies and leveling the playing field. (It still may never get my candidate elected, but bear with me.)
- I would phase out explicit subsidies that encourage the production of fossil fuels. Let these fuels compete on a “level-ish” playing field. Coal, which is subsidized, is losing this battle even now. Without subsidies, this would look even more bleak.
- Remove the implicit subsidy on fossil fuels by properly pricing carbon. I would shoot for a tax that starts where permits are trading now in places with a cap (e.g. California!) and ramp up the price at announced steps. You would still be able to drive your car, but you and manufacturers would be encouraged towards a mix of more efficient vehicles.
- I would use tax revenue to subsidize low probability, high return research and development for carbon mitigation technologies by private and public research institutions.
- I would attempt to address as best we can any attributable environmental justice consequences of market-based environmental policies (which we do not understand very well so far, so grad students, get to work).
But, after that it gets hard. There are lots of subsidies out there that sound good on the surface but may not be as effective as you’d think. I did enjoy the $5,000 rebate for my (I wish it were a Tesla) PHEV ski mobile, which I am going to take up to Tahoe to talk to some snow soon. So did my friends driving the $90,000 Teslas. Why am I struggling here? Last week, my ninja smart colleague Jim Sallee, whom we incentivized away from the University of Chicago, gave a talk about how hard it is to correctly redistribute tax revenue from a gas tax.
This made me think about how difficult it is to target subsidies. A blanket $5,000 subsidy, even with a per manufacturer limit, has led to a significant increase in the purchase of high end electric vehicles by people who would have bought them anyway. We have the same story, well documented by Lucas Davis and Judd Boomhower in Mexico for refrigerators – the number of free riders in appliance rebates is significant. I think it’s time to have a frank debate about our current use of these rebates and subsidies, and whether they have a measurable effect on the adoption of new technologies and the ultimate use of the new technologies. Getting at free riding empirically is hard. But all the causal evidence I have seen points to massive free riding of “anyway adopters.”
I think as a global society, while this Oprah style policy makes us feel good, it’s time to ask the harder questions about the real implicit subsidies and seriously leveling the playing field for fuels. Before long, that would turn fossil fuels into what they really are – fossils.