The Keystone Pipeline is a proposal by TransCanada Corporation to build a large-diameter oil pipeline to bring increased quantities of oil from northern Alberta to the major oil distribution centers in the Midwest and Oklahoma and ultimately down to Houston Texas. The project has an ultimate cost of about $13 billion all supplied by private investors. The result would be an improvement by one of our closest allies in the efficiency of the US oil logistical system at no cost to the Treasury. So how did we get to a decision to turn this down? The answer lies in both substance and process.

The major objection from environmentalists is that the pipeline would support the development of yucky, high-carbon oil sands in Alberta. Unlike conventional oil, oil sands are mined with trucks and shovels. The oil is then separated from the sand, and processed lightly to produce a heavy crude oil that can be pumped through pipelines to refineries. On balance, the increase in carbon dioxide emissions for oil sands versus conventional oil from the mine to your car is about 20%. The “Climate Community” doesn’t like any hydrocarbons, but they particularly don’t like this type of oil. In fact, however, the Canadians are going to produce this oil no matter what the US does. Canadian oil sands may be as large an oil resource as the Middle East, and its development will be essential to meeting growing world oil demand. Production is highly profitable at $100 per barrel, and the governments of Alberta and Canada will receive considerable tax revenue for these projects. Asking the Canadians to stop developing this resource would be like asking the people of Iowa to stop growing corn. They are just not going to do it.

So what happens if we refuse to receive the oil through the Keystone Pipeline? The Canadians can easily build a pipeline to the west coast and ship the oil by tanker to Asian markets. The US would have to replace the Canadian oil with tanker imports from other sources, particularly in the Middle East. The results would be (1) the same amount of oil would be produced, (2) US consumers would pay more for oil and Canadian producers would receive less for their oil, (3) the amount of carbon dioxide emitted to the atmosphere would increase because the same amount of oil would have to be moved longer distances and (4) the Canadians would be mightily put out. Sound like a good outcome?

If the Climate Community proposes to deprive American consumers of oil to power their vehicles, they will first need to offer some other technology as a replacement. As I have discussed many times in this space, there are no such technologies available at the present time.

In fairness, environmentalists have several other arguments, so let’s look at them one by one.

One objection is that the pipeline would pass through the Ogallala Aquifer, a major source of water for much of the Midwest and Southwest. Preservation of water supply is an important issue, but this objection fails on two points. First, pipelines do rupture, but the damage is generally found rather quickly, since pipelines are carefully monitored and heavily instrumented, and the damage is limited to the immediate area around the pipeline. Furthermore, oil is not soluble in water. It’s really not reasonable to argue that this pipeline could spill enough oil to foul any significant amount of this aquifer. Furthermore, the Ogallala is already criss-crossed by hundreds of miles of oil pipelines. If you’d like to see how many, check out this maps at http://www.usfunds.com/investor-resources/frank-talk/?i=7318. By the way, TransCanada has offered to reroute the pipeline around the Ogallala if that would help.

Another objection is that there is an enormous amount of study work that needs to be done to address the issues around the Endangered Species Act as well as the impact on Native American tribes. Most people accept the need to protect whales, elephants, eagles, tigers, and other majestic creatures from extinction. It’s not clear, however, how many species we really want to worry about. The State Department’s Environmental Impact Study (EIS) of the Keystone Pipeline (which you can find at http://www.keystonepipeline-xl.state.gov/clientsite/keystonexl.nsf?Open. Scroll down to the “Executive Summary of the Final EIS) found that “the proposed Project would likely adversely affect the American burying beetle and a formal consultation was initiated…” How long do we really want to impede economic development to study the impact on local beetles? Maybe there is an issue here and maybe not, but as the number of listed species grows, the process of obtaining project approval will get longer and longer. Even projects that are ultimately approved will suffer years of costly delay. Is this process really consistent with sustained economic growth?

The State Department EIS further states that “DOS [State Department] initially contacted over 95 Indian tribes to find out their level of interest in becoming a consulting party.” It makes obvious sense to consult with people who are potentially impacted by the pipeline, but does it make sense to openly solicit people to file objections? In our legal system, it’s easy for anyone who can obtain status as a “consulting party” to delay the project in anticipation of compensation. We are getting perilously close to a “unit veto” system in which anyone can block any proposed investment for any reason. The result would not be a harmonious society in which everyone felt included and all concerns were addressed. We would instead have a fractious society in which nobody could accomplish anything, and anger and resentment would accelerate as the economy continued to stagnate.

A final environmental argument concerns the potential destruction of the boreal forests in Alberta by the vast despoliation of open pit mining. This argument is also wrong. Alberta is a pretty big place with a total area of about 250,000 square miles. The total land disturbed by oil sands mining is about 250 square miles or 0.1%. Furthermore, the governments in Ottawa and Edmonton impose strict regulations on oil sands operations which will require extensive land reclamation. The small amount of boreal forests cut for the projects will ultimately grow back to their original state.

It’s interesting that the President is a strong supporter of long-distance high-speed rail systems built at enormous public expense with atrocious economic prospects. The President apparently doesn’t see these systems, which are far more intrusive than buried pipelines, as raising large numbers of complex issues that need to be studied interminably. I guess the real criterion for approving projects is not a detailed understanding of their economic and environmental impact, but whether the President thinks they are a “neat idea”.

President Obama came to office promising to restore America’s standing in the world. His decision on the Keystone Pipeline shoves a stick into the eye of our closest ally to support the President’s campaign efforts and further undermines any claim that the US supports free trade principles. The US can probably get by without this pipeline, but our economy may not be able to survive the continuous application of this disastrous review and approval process.

The latest – and most troubling – manifestation of this problem is the attacks on Governor Romney’s tenure at Bain Capital, not by the usual anti-market democrats, but by other republicans claiming to have a found a new conservative critique of the free market. Governor Perry is attempting to distinguish between “venture capital” and “vulture capital.” Speaker Gingrich and Governor Huntsman accuse Romney of destroying jobs for personal gain. These attacks all smack of political consultants developing campaign themes in focus groups. Let’s take a step back and look at the reality of private equity firms. (I will bring this back to energy, so be patient.)

Private equity firms – like Bain Capital – make money for investors by buying companies and then increasing their value. The operative word is “buy”. Companies like Bain don’t just grab, steal or kidnap companies. They purchase the stock from the current shareholders at market value. As a general rule, the share price of any company will approximate the expected net present value of its future earnings. If the shareholders think they can do better by keeping the company themselves, they are not obligated to sell. Private equity firms buy companies when they believe the stock is undervalued. When they acquire a company, one of several things can happen.

First, the perfect outcome. The private equity firm injects capital into the acquired firm, which then grows rapidly, increasing employment and providing excellent returns for shareholders. Nobody complains when this happens.

Second, the private equity firm restructures the acquired firm, eliminating unprofitable parts of the business and/or reducing costs and increasing efficiency. In this case, some people lose jobs, but others gain secure long-term employment in a successful firm. The workers who are laid off are very unhappy and appear on talk shows and at the campaign events of liberal politicians attempting to show how hard-hearted capitalism is. The workers who benefit are too busy to working to retort.

Third, the private equity firm can try as hard as it can to improve the acquired company yet fail to make it successful. In some cases, the private equity firm will give up and sell the shares for whatever it can get. In other cases, the acquired company has to be liquidated, and the private equity firm loses its investment. Acquisitions are, after all, quite risky.

Every once in a while, an acquired firm is so badly structured and its business model so flawed that the company is worth more in liquidation than it was in operation. A factory making chocolate covered onions may have no chance at all of making a profit. The machinery, buildings, office equipment and chocolate and onion inventories may be worth more on the open market than the company was. In such a case, the laid off workers may be unhappy, but the capital is much better used for some other purpose.

What virtually never happens (Mr. Gingrich’s and Governor Perry’s claims notwithstanding) is that the acquired company is mismanaged by the private equity firm, broken up and put into bankruptcy with all its workers laid off while the private equity firm makes a ton of money. There are, of course, cases where a company’s management will borrow a lot of money, distribute it to themselves as dividends and then default on the loans. That’s part of what happened at Enron, and it constitutes criminal fraud. I have not seen anyone accuse Governor Romney or Bain Capital of such behavior. The accusation of pillaging a company for profit is rather like claiming that real estate developers can buy homes, smash all the windows, rip out the plumbing, throw away all the appliances and then sell the home for a profit. The world just doesn’t work that way.

The economy grows by utilizing all the available resources – both capital and labor – as efficiently as possible. Capital in our society must be free to move to its most productive uses, and the people who move capital around take considerable risk in so doing. Jobs are not property rights, and investors are not obligated to maintain workers who are not adding value – even if it’s not the fault of the individual worker. It’s better for everyone if workers at unprofitable firms do something else for a living. Otherwise, an opportunity for economic growth is lost, to the detriment of the society and workers.

Now we can come back around to energy. The creation of “green jobs” through government support for companies like Solyndra is a misallocation of both capital and labor. As I mentioned in my last post (“More Solar Power Myths”), solar energy is wildly uneconomic. Profitable investments add wealth to the society, while unprofitable investments do not. The advantage of keeping capital in the private sector is that investors are extremely careful putting their own money at risk. Mr. Gingrich acts as though it’s really easy to make hundreds of millions of dollars in the private equity market. It isn’t. Government, on the other hand, invests other people’s money and doesn’t have to care about the results past the next election cycle.

Both republicans and democrats are falling into the trap of believing that any investment that creates jobs is good, and any action that eliminates jobs is bad. If that were true, we would still have elevator operators, buggy whip makers, blacksmiths and coal delivery trucks. One can only wish that at least one of our elected officials would take the time to understand the economy and how it really works, rather than worrying only about voter reaction to sound bites.

The basic principle of Mr. Wald’s piece is that solar electricity will be worth more if it can be stored and provided at times of peak power, such as late on a hot August afternoon. At such times, businesses are still operating, but many people are at home preparing for dinner. Air conditioners are running full-blast, and utilities are straining to meet demand. As a result, electricity available at peak times commands a premium.

Let’s just have a quick look at the economics of electricity generation. Some electric-power generating technologies, such as nuclear, have a very high capital cost and a very low fuel cost. According to the Energy Information Administration (EIA), a new state-of-the-art nuclear plant would cost about $5.34 per Watt of capacity – quite expensive. If we assume that the utility can obtain 80% financing at 8% for 20 years (a very optimistic assumption), it would need about 9.5¢ per kilowatt-hour (kWh) to earn a 15% return on its 20% equity share of the project. That’s fairly high, given that (a) the average price of residential electricity in the US is around 12¢/kWh and (b) there are additional costs and losses involved in moving electricity from the power plant to the consumer.

How about solar thermal, the subject of Mr. Wahl’s article, in which large mirrors focus the Sun’s rays on tower that heats water – either to generate electricity or to melt salt to store the heat for future power generation? The EIA estimates the cost for such a system at $4.69 per Watt of capacity – a little cheaper than nuclear. Furthermore, the fuel for the solar system is free, and the operating cost is less than the nuclear plant’s. Sounds great, right? The problem is that the nuclear plant can run 24/7, shutting down only for periodic maintenance, inspections and refueling. On balance, nuclear plants run about 91% of the time. In other words, one kW of nuclear power can generate about 8,000 kWh of electricity each year. Solar thermal plants, on the other hand, run on average about 22.5% of the time, generating only about 1,970 kWh per year for each Watt of installed capacity. Storage doesn’t change that limitation. As a result, under the same assumptions, an investor in a thermal power plant would need to earn on average 33¢/kWh – nearly three times the average retail price.

How does this situation change when we add storage? Mr. Wahl’s article suggests that storage capacity would add about 5% to the capital cost, and the laws of physics suggest that there would be some losses in storage and recovery – let’s say 5%. These two changes would raise the average required revenue from 33¢ to 36¢ per kWh.

The good news for solar fans is that peak power may actually be worth 36¢/kWh – perhaps even more. The bad news is that other power generation technologies could provide peak power at much lower cost. Natural gas combined cycle – a highly efficient system – can generate power for less than 5¢/kWh if it’s allowed to run 90% of the time. Even if a natural gas plant were operating only 10% of the time, it could still generate electricity profitably for 16¢/kWh – less than half the cost of thermal solar. Why? Because the capital cost of natural gas combined cycle plants is very low – only $0.98 per Watt according to the EIA. At this low cost, only about one-fifth the cost of solar, the plant can afford to sit idle most of the time and still make money – particularly with today’s low natural gas prices.

If the market were allowed to function, there would be virtually no solar electricity generated in the US other than a few small off-grid applications. Governments, however, at the federal and state levels, both mandate renewable energy and subsidize its use. Power companies are forced into a position where they must evaluate not the lowest cost way to generate power for consumers, but the lowest cost way of generating RENEWABLE power. Investors may find solar thermal power plants attractive in this sense, but consumers certainly won’t.

Mr. Wahl is trapped in a circular argument. He seems to be saying that solar power is becoming commercially viable because he sees investors building these plants. Investors build them, however, only because they are both forced to and paid to do so. Solar energy is hitting constraints in physics – limitations that are particularly difficult to overcome by political means.

T.S. Eliot’s famous words are a fitting epitaph for the late, but unlamented Climate Change Movement. The UN Framework Convention on Climate Change (UNFCCC) was signed in 1992. Since that time, the UN has held 17 Conferences of Parties (COPs) and seven Conferences of Parties Serving as the Meeting of the Parties (CMPs). The latest session of each just wrapped up in November and December of this year in Durban, South Africa. The global effort to combat climate change has progressed from its original 1992 promise to do something in the future about climate change to its most recent decision in Durban to, well, do something in the future about climate change. In between, we have experienced the Kyoto Protocol, which established extensive rules for carbon trading, systems for crediting carbon mitigation investments in developing countries, procedures for joint implementation projects and employment for thousands of climate change bureaucrats, but did not, of course, reduce carbon emissions. According to the US Energy Information Administration (EIA), in 1997, the year the Kyoto Protocol was negotiated, global emissions of carbon dioxide were about 23 billion metric tonnes (mt). A total of 191 countries signed and ratified Kyoto, yet global carbon dioxide emissions in 2010 were an estimated 32 billion mt – an increase of nearly 40%.

If you ask members of the “Climate Community” why they have been unable to make any real progress toward carbon reduction, they will generally answer that “climate deniers,” financed by oil companies, right-wing extremists and other sinister forces have deceived the public with deliberate disinformation, making political support for a substantive carbon mitigation agenda impossible. Some people, like Tom Friedman, even long for a more dictatorial form of government like China’s, where politicians can force people to do the right thing, even against their will. In reality, there are three reasons why global climate negotiations have produced nothing.

Although the scientific evidence for some linkage between temperature and carbon dioxide is strong, evidence for an impending climate apocalypse is weak. (See my August 25, 2011 post “The Climate Change Switcheroo” for more details on this point). The average person understands that arguments based on credentials (I’m a scientist, and you’re not) are unpersuasive. The Climate Community has tried and failed to convince the public that scientific consensus is the same as scientific evidence. Fortunately, the public is not that gullible.

In a democracy, no policy can be implemented unless the electorate is convinced that the policy is both necessary and cost-effective. The Climate Community has utterly failed to persuade the American public that their apocalyptic visions are real. Despite the prevailing view on the American Left, Americans are not sheep, but are in fact quite capable of weighing arguments on important issues and reaching sensible conclusions. Fortunately, most Americans have not been subjected to elite university educations where students’ bulls**t detectors are surgically removed.

The second point is that carbon mitigation is expensive. At the low end of the supply curve for carbon mitigation steps are a few low-cost actions. Unfortunately, these inexpensive steps have no real impact on our national carbon footprint. For example, if every American household planted an extra tree in their yard, we would cut our net carbon dioxide emissions by about 2 million metric tons a year – about 0.04% of the total. A complete change-out of all incandescent light bulbs with compact fluorescents would save about 1.2%. If we assume that every kilowatt-hour (kWh) of solar electricity generated in the US replaces a kWh of coal-fired power, our entire solar power generation reduces our national carbon footprint by 0.02%.

In order to reduce US carbon emissions significantly, we would have to stop tinkering around the edges of the problem and begin to impose punitive taxes on economic activity. A carbon tax of $1 per mt is equivalent to $0.01 per gallon of gasoline. How much of a tax would be required to really cause people to reduce their energy consumption? The “Cap and Trade” bills submitted to Congress in recent years have put a ceiling on the price of carbon of between $25 and $50 per mt, equivalent to $0.25 to $0.50 per gallon of gasoline. A $50 tax would cost the American people $280 billion per year, but does anyone really believe that this tax would change peoples’ behavior? Clearly, politicians of both parties understand that the purpose of climate legislation is to appease environmental constituents, not to bring about significant reductions in carbon dioxide emissions.

The third point is that it makes no real difference what the United States does. According to the EIA, global carbon dioxide emissions are expected to increase from 32 billion mt per year in 2010 to 43 billion mt in 2035, an increase of 11 billion mt. The US accounts for only about 6% of the increase, while Western European emissions are projected to be flat. China, on the other hand, accounts for almost half the growth. Most of the rest of the increase is in other developing countries. These are the nations that had no obligations under the Kyoto Protocol. The Climate Community argues that it’s only fair that the rich countries bear the brunt of carbon reductions, since they enjoyed the benefit of all those years of economic growth. That may be true, but there will be no progress without a determined effort by China, and China shows no inclination whatsoever to accept lower economic growth in return for reduced carbon emissions.

China’s biggest problem is moving a billion people from poverty to a modern living standard before the Communist Party gets thrown out of power. (A second goal is to increase the reach of China’s military power in Asia at the expense of the US, but we’ll leave that issue alone for today.) Economic growth, particularly at rates of 5-10% annually will require cheap energy – and lots of it. Despite all its PR about renewable energy, the International Energy Agency’s data show that China’s energy consumption is about two-thirds coal – the highest carbon energy source there is.

The Climate Community wants the United States and other wealthy countries to convince China to ultimate get on board with carbon mitigation by offering an example. If we show the way, the Chinese will ultimately follow. Unfortunately, what we have shown China over the last 15 years in the clearest possible terms is (1) no Western politician will compromise economic growth for carbon reductions, (2) therefore, Western climate change policy is based on symbolic actions and promises of future progress, combined with complex accounting tricks and (3) the environmental movement is easily satisfied by these rhetorical efforts. China is, in fact, following our lead.

Amazingly, the UN calls the inaction of the recent Durban meetings “a breakthrough.” Over the next year, look for the climate change issue to continue down the path to irrelevance.

Happy Thanksgiving to all!

Prof. Krugman’s piece is helpful to the public debate on soar energy, since it makes explicit a fallacy that has been implicit. Everyone remotely connected to the modern world has been astonished at the rapid improvement in computer technology and the accompanying decline in price. This cost curve was articulated by Gordon Moore, the founder of Intel, in what is now known as Moore’s Law: the number of transistors on a computer chip will double every two years. Moore’s law has proven remarkably accurate and accounts for the inexpensive, high-performance computers, laptops and cellphones we have today. Prof. Krugman announces triumphantly that we may be on the verge of a Moore’s Law for solar energy – a time when prices will drop so fast that solar will begin to displace other forms of energy on a large scale. You should really do your homework, Professor.

Solar energy has obvious appeal, since the energy is out there for the taking. Capturing that “free” energy, however, particularly through solar photovoltaics, faces some serious limits in physics. Solar radiation at the top of the atmosphere is roughly 1,366 Watts per square meter (W/m2). By the time that energy reaches the Earth’s surface, however, it’s been attenuated by air, clouds, rain and pollution. We’re generally left with 200-250 W/m2, depending on where you happen to live. Current solar technologies allow us to capture no more than 15-20% of that energy. In other words, we’re actually converting 2-4% of the incoming sunlight into electricity.

Furthermore, although the sunlight is free, the solar panels that convert the sunlight into electricity are not. According to Solarbuzz, a website generally favorable to solar energy, the cost of retail solar systems in the US declined gradually from about $5.50 per peak Watt in 2002 to about $4.50 in 2004. Between 2004 and 2008, the cost actually increased and leveled off at about $4.75 through 2008. The prices since that time has plummeted to its current level of about $2.50 per W.

Very impressive, but here’s where Prof. Krugman has been fooled. He has concluded that the drop in price is a result of technological progress likely to continue into the future. In fact, two developments combined to drop the price – neither one technological and neither likely to persist.

The first was the entry of China into the solar market. Climatistas and renewable advocates see China’s actions as validation of the future of solar energy. In fact, the Chinese don’t want solar energy for themselves. It’s way too expensive and cannot compete with the massive amounts of cheap coal they are burning. The Chinese simply saw a business opportunity in the US and Europe, where governments have created markets for a non-commercial technology. Since the primary cost of solar energy is the manufacturing cost of the solar panels, the Chinese quickly recognized that they can undersell western companies on solar panels, just as they do on clothing and toys. American politicians assumed, quite wrongly, that the artificial markets for solar panels would be supplied by US companies, thereby creating both jobs and lots of campaign contributions. If the US government mandated that every American wear a pink shirt on Thursdays, Chinese, rather than American companies, would probably end up making the shirts. The cost reduction attributable to lower Chinese manufacturing costs is significant, but probably a one-off change. The Chinese are not making any more technological progress in this area than we are.

The other effect is simply the recession. Given the flat levels of economic activity in the US, demand for solar panels has dropped. US solar panel manufacturers, seeking to take advantage of the heavy US subsidies, mandates and other market distorting mechanisms, built lots of solar panel manufacturing facilities, with Washington assuring profitability. The drop in demand plus the unexpected assault on the market by the Chinese have created a large glut of solar panels on the market. When that happens, manufacturers will drop the price to move their inventories and keep their factories operating. As long as the price of solar panels remains above cash operating costs, this discounting will continue.

Too many people have come to believe that all new technologies follow Moore’s Law, but the essence of this phenomenon is miniaturization. The smaller computer chips get, the better. The only real drawback is the need to keep the chips cool. Other things, like refrigerators, helicopters, bookcases and solar panels, cannot be miniaturized without losing their functionality. Sorry, Prof. Krugman, we’re seeing an oversupplied market, not a set of technological breakthroughs.

The other Times article asks some legitimate questions about the huge subsidies offered to solar power installations in the US. According to the article, federal and state governments have put in place arrangements for solar power companies that virtually guarantee profitability regardless of cost or efficiency. These arrangements include direct tax breaks, low-cost government financing, requirements for utilities to buy solar power (and pass the cost on to consumers), property taxes holidays and other goodies. According to the article, federal subsidies for solar energy in 2010 were $14.7 billion, up from $5.1 billion in 2007. What do we get for these subsidies? Supposedly, clean, domestically produced energy and green jobs. Is that what we are really getting? Let’s have a look.

Solar energy competes with other forms of electric power generation. In 1978, the US generated about 17% of our electricity using oil. Advocates for renewable energy could therefore legitimately argue that these new technologies could replace imported oil. Today, oil accounts for less than 1% of our power generation, and most of that is either special diesel turbines for peak power use or remote diesel generators. Our electricity today comes almost entirely from coal, nuclear, natural gas and hydro – all domestic sources.

Furthermore, on the margin, most of the growth in power generation is coming from natural gas – a very clean fuel. Because of the rapid growth of shale gas, the price of US natural gas sold to electric power plants has fallen in half in the last several years. This price decline, along with highly efficient combined cycle technology, makes natural gas the fuel of choice for new power plants. Burning natural gas emits almost no sulfur or soot and very little of other types of pollution.

As for “green jobs”, see my April 16, 2009 post “Green jobs or con jobs?”. Manufacturing solar panels does of course create jobs, many of them in China, but it also destroys jobs. Raising the price of electricity to accommodate expensive solar energy takes from consumers money they would have spent on other things. Government subsidies divert capital from more productive uses.

The Times article also offers, without any comment, the worst argument offered by the proponents of renewable power: oil companies get subsidies too! According to the article, oil and gas producers received $2.7 billion in subsidies in 2010. If you read the study that produced these numbers, you’ll see that many of these subsidies are merely Congressionally mandated accounting conventions, many of which are available only to small oil companies. Even if the number is correct, however, it’s meaningless for two reasons.

First, the subsidy is spread over a lot more energy. In 2010, the US consumed roughly 275 billion gallons of oil. Natural gas consumption was equivalent to another 190 billion gallons. The oil and gas subsidy of $2.7 billion was thus equivalent to about half a cent per gallon (2.7 divided by 465). The US consumed solar energy equivalent to less than 1 billion gallons of oil, so the $14.7 billion solar subsidy is equivalent to $14.70 per gallon.

Second, solar energy incurs virtually no taxes at any stage of production. Excise taxes on oil-based fuels (mainly gasoline and diesel) totaled about $72 billion per year, equivalent to about $0.26 for every gallon of oil we consume. In addition, oil companies, distributors and retailers pay property taxes and income taxes. On balance, oil is a heavily taxed commodity. Proponents of renewable energy should really stop using this argument.

For decades now, solar energy has been the domain of wishful thinking. Even with heavy subsidies, it’s nowhere near economic viability. The technology may someday become cheap enough to use, but, until that day comes, let’s stop pretending.

My apologies for my silence over the past couple of weeks. My class at The Fletcher School has 81 students this semester, so I’ve been pretty busy. Another post coming in the next 48 hours.

(Please note that the video shows a bit of milling around at the beginning, but I am the first speaker, so be patient!)

We start with the premise that many people, including most wealthy people, earn much of their income from investments and that those earnings ought to be taxed. Tax policy, however, should not interfere with capital flows, which are the life-blood of the economy. Taxes on investment income must be structured with particular care, since distorting capital markets leads to reduced economic growth with dire consequences for everyone, especially the poor.

Let’s look at different ways of taxing investment income. First, we can tax earnings at the corporate level in the year in which they occur. Second, we can tax dividends paid to shareholders, and, third, we can tax the appreciation on share prices (“capital gain”). The first two are pretty straightforward, but capital gains are a bit more complex. Most economists argue that share prices reflect the net present value of the company’s expected future earnings. For example, if a company earns $10 per share every year and investors expect these earnings to continue at that level indefinitely, the value of a share at a 12% discount rate would be about $83. In theory, the share price will not appreciate unless the company’s expected earnings increase (or the expected value of alternative investments decreases, but we’ll ignore that issue for now). Capital gains taxes are, like dividend taxes, a way of taxing the earnings of the company.

Now let’s consider a few scenarios. In our current tax structure, a marginal corporate tax rate of 35% is applied to a company’s annual earnings. If the company retains those earnings for future investment and shareholders hang onto their stock, the government collects no additional taxes on these earnings in that year. If the company distributes some or all of its earnings as dividends, however, shareholders must pay a 15% tax on those dividends on their personal tax forms. In addition, shareholders must pay a 15% capital gains tax on any share appreciation if they sell the stock.

Overall, this system imposes a steep marginal tax rate of almost 45% (35% plus 15% of (1-35%)), but it also creates some powerful distortions. Companies have a strong incentive to retain earnings and thus avoid saddling their shareholders with additional tax. That’s fine if the company has a list of quality investment opportunities, but shareholders might prefer to invest their share of earnings elsewhere. Inevitably, some capital is diverted from higher quality opportunities to lower quality ones when earnings are retained. The current system also creates a strong incentive for shareholders to hold onto their stock, even if they believe they have better investment opportunities elsewhere. We thus have a tax structure that not only imposes high tax rates on investment earnings (see my last post on The Buffett Rule) but also impedes the free flow of capital.

I should note here that complex tax laws generate creative thinking. Many companies, including the large oil companies, distribute money to their shareholders through stock buy-backs. Reducing the number of outstanding shares increases the price per share. This process essentially turns current corporate earnings into capital gains for shareholders. Taxes on these gains can be deferred until the stock is sold. Many politicians hate this process because it circumvents their ability to get their hands on these funds.

Now let’s consider President Obama’s proposals. He wants to increase the tax rates on dividends and capital gains to “at least” 20% for individuals earning more than $200,000 a year. Such a move would increase the overall marginal tax rate on investment earnings to 48% (35% plus 20% of (1-35%)) not only extracting a greater share of investment capital for the government, but also reinforcing the incentives for companies to retain earnings and for shareholders to hold onto their stock. As Charlie Gibson astutely pointed out, the result is likely to be less revenue for the government through tax derral, but also greater distortion of capital markets.

Another theoretical possibility would be for the government to deem corporate earnings to have been distributed to shareholders whether dividends have been paid or not. This approach would eliminate perverse incentives to retain earnings, but would also be hopelessly complicated and would require shareholders to pay cash taxes on money they have not yet received. Definitely a step in the wrong direction.

The simplest solution would be to tax investment earnings only at the corporate level and eliminate all taxes on dividends and capital gains. Setting a steep marginal corporate tax rate of 40% would be better than the current system, giving companies complete flexibility on retaining or distributing earnings and giving shareholders flexibility to sell or hold their stock. Even better would be a lower corporate tax rate of 20% to encourage investment, but that rate would provoke cries of unfairness and make the Buffett Rule actually come true. Even though there is a good theoretical argument for reducing taxes on investment and increasing taxes on consumption, this approach is simply politically impossible.

Once again, simplification is the key. Taxing investment income at an appropriate rate at a single point is the economic answer, but not a good political answer. The Democratic Party is still committed to extracting as much money from the economy as it can. Crying “unfair” has been their strongest weapon for over a hundred years. That’s what happens when your only analytical tool is the Focus Group. We deserve better.