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Why compensating households affected by the carbon tax is bad economic policy

There are many features of the design of the Gillard government’s controversial and complex carbon legislation that can be questioned. For example, Australia’s unilateral action; the two-phase carbon tax…

The one feature of the government’s carbon price framework which has received little analysis is compensation to households. AAP

There are many features of the design of the Gillard government’s controversial and complex carbon legislation that can be questioned. For example, Australia’s unilateral action; the two-phase carbon tax and emissions trading scheme; the carving out of many emission-intensive trade-exposed industries; and the $10 billion subsidies for clean energy technologies.

But there is one feature that has been treated as axiomatic by the government and has received no substantial analysis - namely, the compensation of Australian households adversely affected by the impact of carbon pricing on goods and services consumed by these households.

They are to be compensated, in full, by a combination of an increase in the tax-free thresholds for households paying personal income tax and increases in social security payments for those dependent on welfare payments.

The carbon tax weakens the incentives to reduce greenhouse gas emissions. AAP

My contention is that this is bad policy. There are two reasons for this view.

The first is that these households do not deserve to be compensated. The rationale for carbon pricing is that the production of emission-intensive products and services, and most particularly electricity, as this is the most important single item in household budgets affected by these measures, is associated with a by-product that is harmful to residents of Australia and the rest of the world. This by-product is greenhouse gases (GHGs).

GHGs are responsible for some of the increases in global air and water temperatures that are expected to have severe consequences on climate patterns, water levels, agricultural production and many other activities. This is what economists call an externality because this effect is not included in the prices of products and services. The carbon price corrects this situation by pricing this externality.

A carbon price sends a price signal. Producers responding to this signal can reduce the GHG-intensity of the their outputs (for example, the amount of electricity generated). Consumers can switch to less GHG-generating alternatives, such as hybrid and electric cars and even diesel-powered cars.

GHGs are a “bad”, much like the bad by-products produced by consumption of cigarettes and tobacco products (the negative heath effects on active and passive smokers); alcohol (the negative health effects on drinkers and the harm imposed on other family members and members of society hurt by drunk drivers and other drunken behaviours); and gamblers (the harm imposed on both the gambler and other family members). Taxes on these products are designed to reduce this harmful behaviour.

Compensation weakens the incentive for households to decrease their carbon emissions. AAP

The government has not compensated drinkers, smokers and gamblers for the taxes imposed on them. They are the agents who cause the problems to society. Neither should it do so for consumers of products that generate GHGs.

The compensation was a bribe to voters to get them to accept the carbon pricing package. Without this, it was feared that the general public would strongly oppose the legislation. This is probably an accurate political judgement. If true, what this indicates is that voters are not prepared to collectively pay the price to correct the present market failures associated with economic activities that generate GHGs.

The second reason why this is bad policy is that it weakens the incentives to reduce GHG emissions. The government has argued that the prices of products and services that embody a carbon price will increase relative to the prices of other goods. This may not be true in some cases. Prices of goods such as electricity are subject to direct price regulation in states by statutory authorities. Some of these may choose not to approve the costs increases in full or to allow electricity retailers to increase the base components rather than the kilowatt-hour (KWH) components of the pricing formulae used by retailers.

Even if carbon price-induced cost increases are passed on in full, the price incentives to economise on these products and services are weakened. Economic theory shows that a rise in the price of a commodity affects the quantity consumed in two ways. One is the increase in the relative price of the product. The other is the “real income” effect. Consumers' real incomes are reduced and this causes them to consume less of the commodity. Compensating households eliminates this second effect.

Of course, government revenues collected by a new tax must be disbursed in some way. There are many alternatives. For example, there are many unmet demands for increased education and health services. In the present difficult macroeconomic environment revenue could be used to reduce the deficit in the public sector. Now is not the time to be generous with tax reductions.

This piece is based on Peter’s article, “Designing a carbon price policy” published in the February edition of the Australian Economic Review.