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Taxation and the Environment

Environmental Economics Seminar Series
Department of the Environment, Sport and Territories
March 1996
ISBN 0 642 24878 8

The economic effects of a carbon tax in Australia: how much do we know?

Rob McDougall
Centre of Policy Studies, Monash University

It may be just in recent months that the carbon tax has been a front-page issue in terms of current policy in Australia, but it has certainly been a headline item in a lot of professional economic discussions over several years, since David Pearce pointed it out as the natural instrument for achieving substantial widespread greenhouse abatement, which would also be reasonably consistent with economic efficiency in getting an optimal trade-off between greenhouse abatement and material welfare.

A great deal of economic research and modelling work has been done on this in Australia, as elsewhere. I think we have reached a position where at least we do know a fair bit about the economic effects of the tax. I would argue that the limitations of our economic knowledge are still significant and that in many ways this is not the constraining factor on political debate.

As orthodox market economists, we tend to start off asking about efficiency and equity issues. Basically, we have done them. We know the costs of the tax, we know the equity implications. The last word hasn't been said on the subject, but we know enough to tell us that ignorance on those topics isn't - or shouldn't be - a constraint on policy considerations. Yet it doesn't seem to have got us all that far.

We don't know how to handle the national distributional implications; we don't know how to handle the international burden-sharing. One thing we do know absolutely clearly is that whatever the cost of the tax would be, the costs of the tax that would achieve the framework convention targets are ones that Australia will not wear because we will not come close to meeting those targets.

What's known essentially for sure? We know that in gross terms, as Mick puts it, the tax is going to cost us. There have been arguments about revenue recycling, but we know that generally speaking they are not going to get up. There may be climatic benefits, which is the motive for the exercise, but on the non-climatic side of the ledger there has got to be a cost. We know that there is essentially no regressive effect. We know very roughly that the cost will come out of the order of one per cent of GDP - the ongoing costs of making the very deep cuts that we would be committed to under the framework convention for 2005, about 40 per cent below business as usual.

'Known' is a relative term - when I say we know it is of the order of one per cent, it could easily be double that. To say that we don't really know, well, that's pretty precise knowledge as far as economic policy goes. We know that the costs are time-sensitive: that the clock is ticking and every year that we do nothing, the costs of meeting the framework convention target by 2005 are rising. They may not be prohibitive yet, but they will be fairly soon.

We have heard that not everybody loves taxes. Let me go to some of the basics of the carbon tax. The carbon tax is costly because abatement is costly - not because it is a tax, not because a tax is a nasty instrument, but because abatement has got to cost you. For a country like Australia, abatement means forgoing a lot of dirty but cheap processes.

Do we stop doing those things? Well, we have got to take the hint. So the abatement by a carbon tax is costly not because it is by a carbon tax, but simply because it is abatement and we do have to forgo something to meet this proposed additional policy objective of lower greenhouse emissions.

We know that competitiveness effects of the tax are not or should not be an issue at all. We know that in any open economy over the long run competitiveness is a non-issue. There is a floating exchange rate which sets competitiveness at where it has got to be, based on macro-economic constraints. What you do with a carbon tax isn't going to change those constraints and isn't going to change competitiveness over the long run. In the short run competitiveness impacts can be managed.

We know that this idea that the tax is a nasty, punitive instrument, that it is costly, unpleasant because we are doing it by a tax, doesn't make sense. A tax is money paid by Australians to Australians. The net cost to Australia is a big zero, barring some distortions in the way of transactions costs which are second order.

We know quite a bit about how the costs of the tax depend on its design features. As the degree of abatement goes up, the cost of abatement goes up pretty rapidly, whether it is by a tax or other instruments. Doubling the abatement table from a 20 per cent to a 40 per cent cut, could give you roughly a quadrupling in terms of efficiency cost.

We know that industry exemptions increase the cost of the tax. Basically it means that some people who are in a position to make at least some cheap abatement do nothing while others do too much. We have had ORANI simulations where exemptions to energy intensive industries have raised the cost of a given degree of abatement by about half.

We know that our petrol is highly taxed and that absorbing the existing petroleum excise into a carbon tax does have a big potential to decrease the cost of a tax, at least when the carbon tax itself is relatively low. There are gains from rebalancing away from petroleum to coal and gas, both economic and environmental.

On revenue recycling, I think it is interesting to tie this into some of the discussion earlier this morning. People have said that a tax has no legitimacy unless the revenues are hypothecated. Also, it was pointed out that in Sweden the tax was sold on the basis that other taxes would be reduced, which entails basically zero hypothecation. There the tax got legitimacy not from being hypothecated but from being taken into consolidated revenue and used to cut other taxes.

If that is the case, it doesn't wash out the efficiency costs of the tax at all, but it can significantly ameliorate them. Recycling can also not just ameliorate but remove the short run competitiveness effects of the tax. If the government uses that revenue which it has been taking from business, as the phrase goes somewhat misleadingly, and gives it back to business, there is no presumption that competitiveness will suffer at all. We have done some simulations which in the short run show a competitiveness gain.

It is also reasonable to expect, however, that with any substantial carbon tax, there will be substantial demands for compensation. Obviously if you have to hand out a substantial proportion of revenue to compensate losers in one way or other, then the side benefits of recycling will be smaller.

We are talking about very large taxes here. The taxes that we have estimated would be needed to meet the framework convention targets for 2005 would return something like a 400 per cent tax on brown coal, and about 200 per cent on black coal. The small carbon levy that Senator Faulkner was proposing was a small levy from the point of view of abatement, but in an ordinary tax context it was not a small levy at all. You are looking at about 13 per cent on brown coal and about nine per cent on black. That's what you would call a moderate impost, I think, in a public finance context. Yet in the greenhouse context it is tiny.

The international aspects of this tax seem to be particularly rife with misconceptions. People argue about unilateral versus multilateral deduction. In Mick Common's background paper, which I think is quite admirable, he points out that we mostly model unilateral introduction. We have done some sums in respect of multilateral. The costs to Australia of abatement unilaterally and abatement multilaterally are virtually indistinguishable. The only difference between them is that it costs us a little bit more when the whole world does it. The reason is that when everybody else is abating, they are creating incentives to do some dirty deeds. Those incentives are higher when other people are abating.

People say: 'We can't afford to do it unless other countries do it because it will hit our competitiveness. Presumably, they have got to do it so that their competitiveness will suffer too, and we will end up all square. It makes no sense on an economic rationalist analysis. Firstly, competitiveness ought not be the big issue in this debate. Secondly, the impact of other countries abating to an energy exporter like Australia has to be adverse. What does abatement by other countries mean? It means, for instance, Japan buys most Australian coal; it means Korea buys Western Australian coal; the development economies get into the act.

Where is the good news? For Australia abatement by other countries is a bad news story. When we talk about burden sharing in a national setting, that is something we need to remember. It is not just whether our abatement is costlier to us than in other countries it is costly to them. Other countries' abatement is costly to us too.

As to distributional impacts, yes, the carbon tax is regressive - very slightly regressive. It depends a bit on your benchmark. As Andrew Chisholm pointed out this morning, if you take an equal taxation of income benchmark, it has got to be regressive because the rich save more. If you take a consumption tax benchmark, an expenditure tax benchmark, which is equally logical and well -tested in the literature, there is very little in it. It is a very large tax to get you to the framework convention target. It is a bit regressive on the expenditure side; it lowers the cost of living for the poor by about less than half a per cent relative to the cost of living for the rich. So, yes, it is regressive, but really the take-home message should not be that progressivity is a negative number. It should be that progressivity is virtually zero, and whatever it is can be very readily dealt with the revenues the tax itself generates.

The horizontal distributional impacts is where the real story is. It is bad new for tradespersons, for the skilled blue collar. A lot of the industries that have got to shrink to meet this abatement will be composed of skilled blue collar workers. It is relatively good for people like us, which raises the moral hazard question, I guess.

As for regional implications, it is bad news for the mining states - Queensland and Western Australia. The states that are least severely affected are Victoria and South Australia. The Latrobe Valley is an awful operation from a greenhouse point of view, but Victoria is not a very electricity-intensive economy. We figure it is one of the states which can meet this tax best. When you look at the industrial picture, the impacts are very highly focused, and this deserves a little more discussion.

We have heard a bit this morning about how the levies that have been proposed would have not much effect on consumers; they are very indirect and tax business costs and so on. Well, that is right and that's not a bug but a design feature and it is meant to do the job.

As for impacts of the tax at consumer level, they are pretty minor. Again, it will act as a very high tax if it is to meet the framework convention target. We figure it at about $40 a tonne, but maybe that's a bit too low. I think it will go up a bit, but it is of the right order of magnitude.

As to consumer products and petroleum products, 10 per cent dearer; electricity 25 per cent dearer. That will have some impact, and if anyone says in criticism that it will not make people transform their whole lives and make them more energy-focused, they are right. That's not the way the operation needs to go.

The abatement effect from this tax would involve enormous impacts on a narrow range of industries; it would involve moderate impacts on a broad range of industries. In many ways this tax is like a Smart missile. It is a highly targeted instrument, and will devastate the Latrobe Valley perhaps, but it leaves the rest of Gippsland unaffected. It is an instrument which utterly transforms the electricity supply industry. But in terms of many other industries it leaves business proceeding apparently almost under business as usual.

So what are the real barriers to the tax? I don't believe it is equity because I do not think there is a big equity problem. I do not believe that it is efficiency. The equivalent of one or two per cent of GDP is not to be thrown away lightly, but I do not think that that is the operative constraint.

The three main reasons are distributional, distributional and distributional. One would be into both industry and government distribution problems. There is also the question of what is a fair share for Australia to bear of an international abatement cost.

As economists in this area, we have come along and said: 'What is the economically efficient way to achieve an abatement target?' We talk about what the tax does. It gets the abatement, it minimises the national welfare costs, and there are some side effects which we do not necessarily talk a great deal about. This is to the effect that it will bankrupt certain firms, put certain people out of work and perhaps annihilate a few regions. Not everybody treats those as insignificant side effects. In fact, what we have seen is that in terms of practical political pressure these things that have been treated as side effects are the main game.

There are some other problems too. It is certainly not universally accepted that global warming will be greatly costly. We seem to have reached a position where there is consensus, but people still argue as to whether overall it will really be such a bad thing. If we have warmer weather, it could be argued that it would be good for wheat yields in Siberia, or would cut the cost of residential heating in Canada. There appear to be as many pluses as minuses. So I think there is not anything like a community consensus on the costs of global warming.

Also, there are great business uncertainty issues to deal with. Suppose you are a Minister in the Victorian Government and have some coal-fired power stations to sell. Would you care to have that task in a political environment where the rate of carbon tax in 10 years' time will be between zero and, say, $50 a tonne? I know that I would not care to be in that position.

Finally, let me turn to where we are in the general debate and the nature of economists' contributions to it. In the policy arena in government I think the existing economic understanding is a little on the demand side. It is not that we can't give it: it is that those guys don't use it. Why don't they use it? It is not that they don't know it or that they don't care about it. It is because the forces that are driving them, the pressures they have to respond to, are generated much more by the distributional impacts of the tax than by the efficiency considerations. There is a much stronger constituency for not wiping out certain parts of the coal industry, for instance, than there is for reducing the welfare costs to Australia in total.

On the issue of debate in the general public arena, I feel there is an awful lot of myth and rubbish coming out on both sides of the debate, which in the general press has recently been dominating the knowledge that it is so. And to a degree I think the economics profession has to say that it hasn't done as much as it could have done to get the right message across in that area.

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