Is Australia’s Carbon Tax Repeal Really Market Enhancing?

Some libertarians cheer whenever there is any tax repeal. However, we need to distinguish taxes in form versus taxes in substance. Taxes in substance have no relation to a benefit or penalty attached to the payment. Taxes in form, but not in substance, pay funds to the government, but are tied to some benefit or compensation for damages.

It is standard economic theory that the best way to prevent pollution, as with other negative The effects, is to make the polluter, hence also the buyer of its products, pay the social cost of the pollution. The economist Arthur Cecil Pigou provided a thorough explanation in his 1920 book The Economics of Welfare. A tax on pollution has since then been called “Pigovian.”

One of the most discussed Pigovian taxes has been on the use of carbon-based fuels such as coal, natural gas, and oil. A “carbon tax” can be on the fuel inputs or on the emission outputs. The most effective Pigovian levy is on the emissions, as that provides an incentive to reduce pollution such as by capturing the carbon before it gets spewed out. If the polluter does not compensate society for dumping on the commons, then in effect it gets subsidized, as it sells its output at less than the total social cost of production.

Many countries have been confronting pollution with inefficient policies such as regulations, credits for offsetting pollution with purchases of forest lands, and permits that can be traded. Australia enacted what was called a “carbon tax” with the Clean Energy Act of 2011, implemented in July 2012. But this was not a Pigovian tax. The Act created a “carbon price mechanism,” a cap-and-trade emissions trading scheme that at first set a price per ton of emissions. This mandated price had the effect of a ‘carbon tax’. But after 2015, the mechanism would have transitioned to a trading scheme.

However, in 2013 the newly elected prime minister sought a repeal of the “carbon tax” emissions trading scheme. In 2014, parliament passed the repeal.

The opponents of emissions taxes claim that this increases costs to business and households. This is narrowly true, but policy should consider the total costs to society. The pollution imposes a social cost on Australia and the rest of the world. This is not a cost paid in explicit money, but costs in the form of illness, a less productive environment, and possible effects on the climate.

The opponents of emission levies overlook that the absence of compensation for the pollution costs is in effect a subsidy to the polluters and their customers. A pollution charge is not a tax in substance, but rather the prevention of this subsidy, and compensation for dumping toxic materials on other people’s property.

The repeal did not provide a replacement, and this creates uncertainty for business about any future anti-pollution policy. This policy uncertainty reduces investment and growth.

The best way to implement a pollution tax is as a replacement of other taxes. Taxes in income, sales, and value added impose the excess burden of higher costs and less output and employment. If politicians are concerned with tax costs, why are they not repealing these taxes? When a pollution tax replaces such market-hampering taxes, the total costs paid by consumers does not increase, but rather shifts in favor of less- polluting products.

Actually, the revenue obtained from Australia’s brief carbon tax was used to compensate taxpayers and affected companies. But the most effective policy would have been to have an explicit tax on pollution instead of a trading scheme, and to lower other tax rates, along with a transitional compensation to those with net losses.

Some opponents claim that Pigovian charges would be good if applied globally, but in a single country, would put its industries at a disadvantage. But that would not happen with a “green tax shift,” the replacement of inefficient taxes with a “green tax” on pollution. A green tax shift would reduce the environmental cost of pollution while not increasing the total tax costs for the country’s economy.

Towards a Free-Market Global Climate Treaty

An article in the 19 March 2014 “NewScientist” featured Catherine Brahic’s interview of Christiana Figueres, executive secretary of the U.N. Framework Convention on Climate Change. She is leading a project to create a Global Climate Treaty in December 2015. A draft agreement is scheduled to be delivered to all country governments in May 2015.

A previous U.N. climate change conference in Copenhagen in 2009 failed to achieve an agreement. Christiana Figueres points out that while in 2009 there was doubt that countries would adopt policies to curb emissions, more than 60 countries now have climate legislation that apply to 90 percent of global emissions. There has been more investment in renewable energy. But this progress is much less than what is needed to reduce air pollution to a sustainable optimal level.

A major technological obstacle to the use of renewable energy is the expense of storing electricity in batteries in order to have a steady supply of power on grids. Another technology that is needed for emission reduction is carbon capture and storage.

Unfortunately this interview did not delve into the economics of climate policy. Economists are in wide agreement that the most effective policy to reduce widespread pollution is full-cost pricing, to make the polluters pay the social cost of the damage. The charge is passed on to the buyers of the products, who buy less. The firm either installs methods of reducing the emissions or else pays the fee and reduces pollution by producing less of the product.

A pollution charge or tax is more efficient than command-and-control restrictions, because the tax lets the polluter respond according to its particular costs. In contrast, when government dictates particular methods such as gasoline additives and engine technologies, these may not be the most effective means, and the mandates and restrictions may not encourage innovations.

There is much talk about carbon taxes, but carbon exists in both the inputs and outputs. A tax on the gasoline input does not create an incentive to capture the carbon and other emission outputs, and the tax imposes an excess burden on cars that have already reduced their pollution. A tax on the emission output does induce technology to capture the carbon, and avoids the excess burden.

The executive secretary talked about carbon neutrality, such that each factory, building, city, and vehicle has very low or zero carbon outputs. But the most effective policy is not to regulate and micro-manage, but to set an overall goal and an emission charge per ton of pollutant, and then let each person, enterprise, and facility adjust according to its own costs and benefits. If the cost of carbon neutrality is greater than the social benefit, then such neutrality is bad for the environment, because it wastes resources.

Unfortunately, governments are moving towards regulations rather than pollution taxes. The government of Australia is seeking to replace the carbon tax, enacted by a coalition of the Green and Labor parties in 2012, with a subsidy to industry and an emission permit trading scheme. On 20 March 2014 the Australian Senate voted against repealing the carbon tax, but the prime minister continues to seek repeal on July 1.

While emission permit exchanges are more efficient than regulations, the increase in the price of permits is a gain only to the permit holders, and the price of the permits may be different from the social cost of the pollution. A pollution fine, charge, or tax, however it’s called, enables the government to enact a “green tax shift” to replace market-hampering taxes on income, sales, and value added, with payment for emissions that not only reduce pollution, but also prevent what would otherwise be a subsidy to polluters by not having them pay the full social costs.

Economists and their journalist followers should be in the forefront of promoting a green tax shift as the best policy both for the environment and the economy. Even the skeptics of global warming should embrace the green tax shift, as pollution is harmful trespass regardless of climate change, and the shift promotes greater economic freedom along with productivity.

If the 2015 Global Climate Treaty is based on pollution levies, it will succeed. If instead the Treaty calls for “command and control,” it will doom the planet to yet another failure of central planning, and the result will be both a worsening global economy and a backlash against the tyranny of regulation strangulation.

The Pigou Club

Professor N. Gregory Mankiw of Harvard University initiated and hosts “The Pigou Club” of economists, journalists, and politicians who have favorably written about pollution levies as an efficient way to reduce emissions. Arthur Cecil Pigou was the economist who was the first to deeply analyze externalities (uncompensated effects on others) in his 1920 book The Economics of Welfare.

Pigou proposed a levy on negative external effects equal to the social cost, so that buyers and users pay the full social cost of products. The most common applications are tolls to prevent traffic congestion, parking meters that vary by time of day, and pollution levies.

The policy of charging those who create negative externalities is named Pigouvian, or Pigovian. Mankiw advocates higher gasoline taxes, but that would also tax those car owners with cars that run quite cleanly and are driven in roads that are not congested. The best Pigovian policy is to focus the charge on the negative element such as harmful emissions.  Continue reading