Scheme fails on three key levels

I have a piece in the Business section of the Weekend Australian today:

All economics undergraduate students are taught to assess taxation measures according to three criteria: efficiency,
equity and simplicity.  This is a useful starting point when it comes to assessing the carbon tax package to be announced on Sunday.

When gauging the efficiency of any tax measure, it is necessary to define the objective of the tax and then estimate the cost effectiveness of the measure relative to other possible measures as well as doing nothing.

The carbon tax is what economists call a Pigovian tax – it is designed to dissuade undesirable behaviour.  Excise on cigarettes and alcohol also falls into this category.

One of the issues about the carbon tax– tipped to be set at $23 per tonne – is whether it will actually be high enough to dissuade carbon dioxide emissions.  At least in the short run, the demand for many emissions-intensive products – electricity and transport, for instance – is relatively inelastic.

Over time, the demand may change to a greater degree but this will only occur if the tax is high enough to remove the advantages of the ongoing production (and consumption) of emissions-intensive products relative to the production of substitute product with lower emissions.

Given what we know about the cost structures of the various means of generating electricity, it is absolutely clear that the tax will not be high enough to induce the behavioural change that is the purpose of the tax in the first place.  It is what I like to call a homeopathic approach to dealing with carbon dioxide emissions.

What this means is that if the government is determined to meet the target of a 5 per cent reduction of emissions by 2020, then the jumble of inefficient schemes such as the MRET (Mandatory Renewable Energy Target) will have to do the heavy lifting rather than the carbon tax.

If economists are unanimous about one thing, it is that these various schemes, designed to favour renewable industries, for instance, are a drag on per capita income and should be avoided.

So what about the equity effects of the carbon tax?  The government is quick to point out that nine out of ten households will receive some compensation and some 70 per cent will be fully or more than fully compensated.

So should the carbon tax be positively assessed on equity grounds?  The first thing to say is that providing compensation to households actually operates against the purpose of the tax – which is to change behaviour in order to reduce emissions.  And to over-compensate some households suggests that the government has snuck in a redistributive objective to the tax.

What household compensation means is that it will only be the substitution effect that is in play in terms of changing behaviour, rather than the combined impact of substitution and income (the tax would reduce household disposable income without compensation) effects.  This amounts to poor economics but probably good politics.

Of course, there are others who are affected by carbon tax apart from households. The owners and shareholders of businesses who will pay the tax initially, the workers who are employed in emissions-intensive industries, the small businesses who will be impacted by the carbon tax in a number of ways – the tax for these groups will be perceived as highly inequitable.

Even if a tax measure more or less meets the criteria of efficiency and equity, if the means by which the tax is levied involves disproportionate transaction costs, then support should not be forthcoming.  Transaction costs mount where there are exemptions, loopholes, excessive paperwork, compliance costs and a bloated bureaucracy created to administer the tax.

The manner in which transport fuel is being handled is a case in point.  To have two classes of users – one that is exempt and one that must pay the tax – is recipe for complexity and high transaction costs. And many of these costs will be borne by small business, both directly and indirectly, even though we are assured that ‘tradies’ will be exempt.

The brighter students might add an additional point to their assessment. Rather than simply reducing carbon dioxide emissions in Australia, the real point of the carbon tax is to make a contribution to reducing global emissions.  Only if there is a global effort will there be any impact on the climate and average temperatures.

Using the theorem of the ‘tragedy of the commons’, however, the notion that all nations will get on board to reduce their emissions is fanciful.  As a consequence, Australia’s efforts alone – contributing under 2 per cent of global emissions – will be insignificant.  An heroic assumption is required that our efforts will prompt other countries to follow our example.

Absent equivalent global action – particularly among our competitor nations – measures will be necessary to prevent carbon leakage whereby local emissions-intensive operations shut down, only to be replaced by a similar operation in another country.

But measures to protect or exempt emissions-intensive industries only further complicate the tax package.  This constitutes another cross against the tax on the grounds of unachieved simplicity.

To secure top marks, overall, students need to point out that the tax must be set high enough to induce behavioural change.  Without this, the tax is all compliance costs and unwarranted redistribution.  Dealing with the equity considerations by compensating households mutes any behavioural impact and there are many losers from the imposition of the tax in addition. To offset carbon leakage and to accommodate politically dictated special deals means the tax also fails the test of simplicity.

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16 Responses to Scheme fails on three key levels

  1. hc

    This is a disgraceful op Ed. All three claims are wrong. Elasticities of substitution are not negligible in the power sector since there are options to switch to gas. These options will set in with a medium term price of around $37. firms undertaking these substitutions will be advantaged.

    You kinda got a bit confused on the substitution effects which you at least recognize. Given that the implied income changes are so small there will not be much of a difference between the total and income effects of the price changes.

    The equity implications are dealt with by the compensations. It’s no drama – those on lower incomes who suffer most pain get the compensations.

    The policy is simple because in the main it impacts on a few firms in the power sector. The transaction costs are negligible relative to the GST implementation and not high absolutely.

  2. Sinclair Davidson

    Great op-ed.

    hc – you need to look away from the blackboard and out the window at the real world.

  3. Alex Robson

    It isn’t the starting price that’s so important. It is expectations of the future price path which will drive behavioural change (and therefore economic costs) on the supply side. The Treasury modelling assumed that under the CPRS-5 scenario the nominal permit price will reach about $350 in 2050, with an assumed nominal price of about $24 in 2011.

  4. Judith Sloan

    $37? Will that be in Julia’s Dog and Pony Show tomorrow? So will she be forecasting a price of $37 anytime soon? And where does the MRET fit into this – gas is being leapfrogged by this incredibly inefficient intervention.

    If you lived in the real world, Harry, you would not say that about compliance. The companies I am associated with already bear high compliance costs associated with reporting and the ridiculous scheme about energy efficiency. Pages and pages to be filled in and for what purpose?

  5. Judith Sloan

    Oh, and at least we got something from the GST – a more efficient tax system and lower income tax. From the carbon tax – lower per capita income and nada on the environment.

  6. .

    You kinda got a bit confused on the substitution effects

    You get confused about the efficiency of tariffs vs quotas and the stupid system that ETS is being imposed on top of.

    This is a disgraceful op Ed. All three claims are wrong. Elasticities of substitution are not negligible in the power sector since there are options to switch to gas. These options will set in with a medium term price of around $37. firms undertaking these substitutions will be advantaged.

    This is foolish as gas needs more than a $40 tariff to replace coal.

    The equity implications are dealt with by the compensations. It’s no drama – those on lower incomes who suffer most pain get the compensations.

    Except if all of the interactions of the ETS and MRET schemes cause an overall welfare loss.

    Well done Prof. Candide.

  7. hc

    As Alex says it is the longer term price that matters not the price announced tomorrow. Once a $23 per tone tax is announced and the world is seen not to collapse support for charging should improve. If prices grow the utilities – many busting to switch to gas – will make the switch.

    The only sector that needs compensations is the non-ferrous metals – aluminum sector – the rest of the EITES will be almost unaffected.

    My admiration for Julia is increasing. The campaign of misinformation being directed against her is unparalleled. She will get a carbon charge off the ground and eventually will gain respect for this. She might even be reelected.

  8. .

    My admiration for Julia is increasing. The campaign of misinformation being directed against her is unparalleled. She will get a carbon charge off the ground and eventually will gain respect for this. She might even be reelected.

    Unhinged.

    The DECC or whoever did the modelling on this will eat crow.

  9. .

    Once a $23 per tone tax is announced and the world is seen not to collapse support for charging should improve. If prices grow the utilities – many busting to switch to gas – will make the switch.

    Why do you keep on repeating this bollocks? $23 isn’t enough to do anything.

  10. Jim Rose

    Excellent op-ed.

    The key question is whether unilateral action by Australia will make any difference at the global level? Of course, it will not.

    Pro-climate policy voters know this, but as expressive voters, they do not care. It’s about feeling good, not doing good.

    They vote as they do for as along as booing and cheering for action against climate change does not cost these expressive voters too much.

    Repeated assurances of compensation reinforce the status of climate action as an expressive symbol.

  11. Viva

    My admiration for Julia is increasing.

    I must get lonely for you and roughly 10 others who actually admire Gillard – sitting out there in that empty expanse with the wind howling around you.

  12. Peter Patton

    Judith, while I ain’t trying to fuss with no economics professor m’am, my recent trawling for a thesis topic included the issues surrounding legal origins and subsequent economic development. I got the distinct impression that the “tragedy of the commons” thesis was very unfashionable nowadays. Just sayin’

  13. Judith Sloan

    Could have called it other things – free rider problem, for example. I’m surprised you make your statement because I thought the work of Elinor Ostrim was all the rage showing that small-scale collective action can sometimes avert these tragedies. She has some great examples.

  14. hc

    Viva, I didn’t say I admired her I said my admiration is increasing. She certainly has much more intellectual integrity than Tony Abbott but that is setting the bar low. I don’t think Kevin Rudd would have produced a better carbon policy than she has.

  15. JC.

    She certainly has much more intellectual integrity than Tony Abbott

    Really harry. You believe that, or perhaps you want to believe it.

    She advises Rudd to shelve the ETS. When Rudd gets crucified at the polls she knifes the worthless twerp in the back.

    She then promises on numerous occasions on the campaign that ‘ there will not be a carbon tax under my government” and then introduces it.

    And you think she has more integrity than Abbott.

    You can be for a carbon tax and still believe she is a lying, two faced, incompetent sack of shit, who deserves to be thrown out of office and her name blacked out forever.

    Frankly I’ve supported a carbon tax along the lines that John Humphreys once advocated that was totally income tax neutral and exed out the exporters, as long as the subsidy whores were taken out on a stretcher, and still do.

    Do you?

  16. Alex Robson

    “$37? Will that be in Julia’s Dog and Pony Show tomorrow? So will she be forecasting a price of $37 anytime soon?”

    No, I doubt that $37 will be forecast. If you read the February announcement of the MPCCC carefully, a “fixed price” does not mean that the price will not change – it just rises annually by pre-detemined amounts. If permit prices rise at 4 per cent plus inflation of 2.5 per cent, it would take around 8 years to get to $37. We’ll be well and truly into the floating price phase by then.

    Incidentally, it appears (surprise surprise) that the ETS not be a free market – it will have both a price ceiling and a price floor

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