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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.

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24 Comments sorted by

  1. Chris Mulherin

    Postgrad, tutor, lecturer at University of Melbourne

    While all the ramifications of how the carbon tax revenue is spent can be debated, there is one very direct effect on low income families of the tax: the significant increase in the price of electricity. I think Professor Lloyd agrees thus far. But to compare electricity with drinking, smoking and gambling as a mainstay of his argument is inadequate.

    Professor Lloyd says "the government has not compensated drinkers, smokers and gamblers for the taxes imposed on them." But electricity is an essential…

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  2. Vince Canning

    Parts Manager

    I agree wholeheartedly with this article. I could never understand the point of introducing a tax to increase the price of, and therefore reduce the demand for, electricity, and then give a rebate to reduce the price of increased demand. Where are the environmental savings if, in the end, there is no increased cost for the same wasreful usage?

  3. John Phillip
    John Phillip is a Friend of The Conversation.

    Grumpy Old Man

    Peter, the logic of your argument makes sense. Could you please, however, explain what difference the carbon tax will make to Australia's emmissions of GHGs and, by implication, global warming. I am not after an answer in a 'general sense' but rather a specific, quantifiable amount. Cheers.

  4. Iain Wicking


    Australia has a small economy and carbon 'diversity' is low. The bulk of carbon emissions come from a narrow number of sources and a large percentage relates to electricity consumption. Price signals will have hardly any effect as households need power as a necessity of life and it will be next to impossible switch to alternative sources of supply even if the tax is driven upwards.

    The whole policy of unilaterally setting up a carbon tax and the structure of rebates will be a disaster and introduce more economic distortions into the operation of the economy.

  5. Dave Smith

    Energy Consultant

    Peter, do you really think that the "real income effect" is an efficient and equitable way to mitigate carbon emissions? If so, why bother going to the trouble of introducing a carbon tax at all? Why not just increase income taxes, particularly on low-income households for whom the income effect will be most significant?

    It is disappointing to see a professor fail economics 101.

    1. David Arthur

      resistance gnome

      In reply to Dave Smith

      Gday Dave,

      It would make far more sense to abolish all taxes altogether, and replace them with a consumption tax on fossil fuel.

      Do you think this might cause at least some people to invest their tax savings in solar hot water, solar PV, and electric cars?

      Do you think it might cause operators of municipal tips to cap their landfills, harvest the gas and generate tax-free (biogas is not fossil fuel) power? Likewise, will it cause operators of municipal sewage farms to anaerobically digest their biosolids, harvest the gas and generate tax-free (biogas is not fossil fuel) power?

      Do you think it might cause power generators to consider solar thermal power stations and wind farms when the time comes to retire the present generation of coal-fired power plants?

      After a couple of decades of this, when fossil fuel use has been taxed out of the economy, the government will have to reconsider its tax base.

  6. Peter Whiteford

    Professor, Crawford School of Public Policy at Australian National University


    I think it is important to point out that only relatively low income households will be fully compensated for the carbon tax/emissions trading scheme. The tax threshold is being raised, but the first and second tax rates are being raised to offset this. So for single person households, for example, with incomes over $80,000 a year there is no real change in their income tax liabilities. This threshold will be higher for families with children, but it is still the case that a very substantial…

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  7. Donncha Redmond

    Software Developer

    Peter, I think you're neglecting the fact that the compensation is not contemporaneous with the increased cost, so a pricing signal will still be clearly in effect.

    When the electricity bill comes in and it has gone up by, say 20%, Joe Taxpayer will get a strong price signal and is unlikely to say "oh, that's OK, the difference will be made up in my tax return at the end of the year".

    Even if he does make the connection, he should also realise that he's getting the tax reduction regardless of the amount of his electricity bill, so if he reduces his usage he'll save money on his electricity bill AND still be getting the extra compensation from the Govt. Double incentive!

    1. Susan McCosker

      Former school teacher

      In reply to Donncha Redmond

      Unless you have a family like mine, unable to reduce energy consumption much further without resorting to everyone going to bed when the sun goes down and having cold showers, who will also probably come in as 'under-compensated'.

      But on the whole, I agree with you. Most people I know should be able to come out ahead if they made effort to reduce energy use.

      Though I do believe it's wrong to focus on just reducing electricity usage. If we want to cut our emissions, we need to reduce our overall consumption, and thereby the emissions that we export to countries such us China.

    2. David Arthur

      resistance gnome

      In reply to Susan McCosker

      Investing the tax cuts in solar hot water and solar PV means avoided electricity price rises.

      These grid-connected solar deals, where each house simply has solar panels hooked up to an inverter that relies on the phasing provided by the mains AC power, is a pretty crude technique that does nothing to decrease the dependency of residences on that phasing signal supplied to the inverter from the mains. This means, for example, that your solar PV investment provides no power whenever there is…

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  8. David Arthur

    resistance gnome

    Compensating households affected by the carbon tax is not bad economic policy, because it gives them the money to invest in solar hot water, solar PV and electrically-driven transport devices.

    That is, it allows households to decrease their consumption, and start becoming producers. The enabling technology is solar PV panels.

    The last time people were encouraged to be more than just consumers was in In World War 2, when people were encouraged to grow their own vegetables, and keep chooks.

  9. Peter Lang

    Retired geologist and engineer

    One of the major issues not explained is what will be the compliance cost of a carbon pricing scheme?

    Can anyone please refer me to a link where the estimated compliance cost of the CO2 tax and ETS is documented. [Please don’t point me to the Treasury, DRET or DCCEE, as they have not done these estimates).

    What would be the compliance cost for the ETS once it is fully implemented and running at the level of financial security from fraud that will be expected? For example, what will be the annual…

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    1. David Arthur

      resistance gnome

      In reply to Peter Lang

      Thanks Peter. Let's address the four questions at the end of your comment as follows.

      The CO2 tax and ETS will not substantially reduce global CO2 emissions, and they will not substantially change the climate. They will have negligible impact on the ecology of the Great Barrier Reef, or on that of Kakadu National Park. They will even have negligible effect on sea levels.

      As you know perfectly well, this is because Australia is responsible for a relatively small proportion of anthropogenic…

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    2. Peter Lang

      Retired geologist and engineer

      In reply to David Arthur

      Good to see you admit, at long last, that pricing CO2 emissions will “not substantially reduce CO2 emissions”.

      However, I think you misunderstand that while pricing CO2 emissions in Australia would reduce Australia’s emissions (as well as jobs, wealth and prosperity), it will not reduce global CO2 emissions. That is because Australia’s emissions will be transferred to other countries which clearly have no intention of imposing such economy damaging policies for no benefit.

      So, Labor’s policy is a seriously damaging policy for Australia’s economy (i.e. productivity, jobs, wealth and welfare).

      Now, since you clearly believe you are well informed on matters to do with the Green-Labor CO2 tax, can you please provide a reference to an authoritative report where the cost of compliance, to the level that will be required for trading and trading all CO2 emissions, has been estimated and documented?

    3. David Arthur

      resistance gnome

      In reply to Peter Lang

      Peter, you misunderstand my intent. Perhaps I have not succeeded in making myself clear.

      AUSTRALIAN pricing of AUSTRALIAN emissions will decrease AUSTRALIAN emissions.

      This is a Good Thing because, whether AUSTRALIAN emissions are priced ahead of the rest of the world or not, Australia will have innovated its transition to a non-fossil fuel using economy earlier than the rest of the world. There are commercial advantages in being a technology exporter.

      I am NOT an authority on the CO2 tax/ETS, as you well know; I have repeatedly explained to you, in various fora, my preference for a revenue-neutral fossil fuel consumption tax, with treatment of exports and imports as set out by Geoof Carmody.

    4. David Arthur

      resistance gnome

      In reply to Peter Lang

      Please consult your gerontologist about your repeated poising of the same old rhetorical questions.

    5. David Arthur

      resistance gnome

      In reply to Peter Lang

      Thanks for this, Peter Lloyd. I had a look at your Australian Economic Review article, which gave a useful summary of Weitzman's 1976 paper (somewhat at odds with the reference in the Henry Review's justification for emission trading over consumption taxation).

      I tend to agree with Geoff Carmody.

      Emission Trading is just an excuse for bankers and traders to have another derivative market from which to extract wealth.

      An escalating price on fossil fuel consumption is a simpler, fairer, unrortable…

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    6. Peter Lang

      Retired geologist and engineer

      In reply to David Arthur

      What a hypocritical statement. Have you counted how many times youve repeated your silly, irrelevant lecture on photons?

    7. Peter Lang

      Retired geologist and engineer

      In reply to David Arthur

      Your answers are naive pub economics. If we damage the economy we can’t do anything. The assertions about green jobs and green businesses is demonstrably nonsense as the EU is demonstrating so clearly.

      The idea of Australia leading the way for the world is laughable, as Copenhagen, Cancun and Durban have demonstrated.

      I presume you haven’t been concerned about the compliance cost, and don’t want to answer the question, is because you are a rusted on Labor ideologue?

    8. David Arthur

      resistance gnome

      In reply to Peter Lang

      Peter, my summary of how the greenhouse effect works (and why anthropogenic enhancement thereof is problematic) is directly relevant to the bloody-minded Denialism that is posted by fools who merely seek to disrupt constructive discussions on addressing the issue.

      For the record, the following facts are beyond doubt; the issue for us is, what do we do about it?

      Earth is warmed by absorbtion of short wave sunlight. Because of this, Earth's temperature can remain unchanged by returning the same…

      Read more
    9. David Arthur

      resistance gnome

      In reply to Peter Lang

      Did I say anything about damaging the economy? I'm trying to prevent having the economy cactused up by economic activity devastating the environment on which the economy depends and within which 100 % of the economy exists.

      The European situation is a poor comparison; Europe's problems are created by its bankers and traders. The one part of Europe, where industry, science and manufacturing dominate is Germany, which is the one part of Europe where the economy is doing well; any idea who's leading…

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  10. Chris O'Neill

    Retired Way Before 70

    The main objective of a carbon price is to motivate a switch to non-carbon burning sources of energy. The effect on the consumption of carbon-based energy, though significant, is secondary.

    For example, it would take an enormous carbon price to halve carbon emissions if burning carbon was the only way of producing energy. If alternative sources of energy are available, the carbon price does not need to be as high as that.

  11. Richard Lester


    Yes, compensation is definitely a bribe for political purposes. However, if we view it, not as money to pay our higher energy bills, but as money to invest in ways of reducing our energy consumption (awnings, insulation, more energy efficient appliances) then we can see the scheme for what it is meant to be: a very big behaviour change program.

    The fact that the message is transmitted through the hip pocket is simply because that is the most widely understood language we have.

    The simplistic Barnaby Joyce argument that taking away with one hand while giving with the other achieves nothing suggests that either he is irrational or that he thinks the rest of us are - you be the judge.