Update: Art Laffer agrees (via Greg Mankiw). Offset a carbon tax with an income tax cut.

The only real solution is Al Gore’s proposal to offset a carbon tax dollar-for-dollar with either an income or payroll tax reduction. If a carbon tax increase were offset dollar-for-dollar with an income tax rate cut, I for one would strongly support the policy. The economy would benefit because the progressive income tax does far more damage than a carbon tax would, and we’d use less oil. It’s a win-win situation.

 

The Organization of Petroleum Exporting Countries decided to cut oil production today, by a record 2.2 million barrels from current levels. The cartel of 12 countries, made up of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the U.A.E., and Venezuela, agreed to this new round of cuts after witnessing a crash in the price of crude oil over the last 5 months. Including previously announced cuts, OPEC will slash its daily production by 4.2 million barrels a day from its actual September production level, which was 29.045 million barrels a day.

Since peaking at an all-time high of $147, crude oil has crashed back down to Earth, plummeting 73% to a 4-year low of $40.06. In the last three months, oil has fallen more than 52%.

Despite the news of the massive production cuts, crude oil tumbled 8% in today’s trading, down $3.54 to $40.06. OPEC controls about 40% of the world’s oil production and oil prices are vital for the economic well-being of its member countries.

It’s not hard to figure out why OPEC is cutting production. People are driving less – a lot less.

WASHINGTON – Americans drove more than 100 billion fewer miles between November 2007 and October 2008 than the same period a year earlier, said U.S. Transportation Secretary Mary E. Peters, making it the largest continuous decline in American driving in history.

The members of OPEC aren’t the only ones suffering from lower prices:

CALGARY, Alberta (Reuters) – Producing heavy oil in Canada, much of which comes from the big oil sands deposits of northern Alberta, is a tough business and it’s getting tougher.

The tar-like crude trades at a discount to lighter varieties. That wasn’t a problem in July, when benchmark oil prices climbed above $147 a barrel, but after prices slid by more than $100 a barrel in the months that followed, some heavy oil producers are beginning to feel squeezed.

On Monday, small producer Connacher Oil and Gas Ltd (CLL.TO: Quote, Profile, Research, Stock Buzz) said it would restrict production of bitumen, a form of heavy oil, at its Great Divide thermal project in the oil sands to 5,000 barrels a day (bpd) from 9,000.

Producing oil from bitumen (oil sands) is an expensive process and really doesn’t make much sense at these prices. The company referenced in the article can’t cover its costs at this price and unless prices rise soon, they’ll have to shut down.

Right now, oil prices are falling because of demand destruction and producers are cutting back on exploration and production in response. Eventually, we will reach a new equilibrium price. It could be at the current price or maybe lower; there is no way to know right now. The recent fall in the dollar would normally mean that oil and other commodity prices would rise, but right now the demand destruction is overwhelming the currency effects.

The current price of oil is not a permanent condition anymore than it was when prices were $100 higher. Once economic growth resumes demand will rise again and so will the price of oil. The value of the dollar will also influence that future price rise. If the dollar is falling, the price will rise more than if the dollar were steady or rising.

This is the market working as it should. When oil was $147/barrel Congress wasted countless hours trying to find a scapegoat. Now that prices are falling we don’t hear about the evil speculators who were blamed for the price spike. I guess speculators only have an effect when prices are rising.

One final note. If we want the price paid to producers such as OPEC to remain low for geo-political reasons, now is the time to introduce a carbon tax. Obviously, the only way to keep the price to producers low is to keep demand down. The only way to do that is to either limit economic growth (which no one wants to do) or impose a tax. Obviously, raising taxes during a recession makes no sense so if we adopt a carbon tax it should be offset with other tax cuts. I would suggest a cut in either payroll taxes or corporate taxes or both. Cutting payroll taxes would give lower income people money to spend and lowering corporate taxes would create jobs. Call it a Keynesian supply side tax cut.