Carbon tax and budget deficit


Sinclair Davidson’s article in the Australian today got me thinking about the basic economics underpinning the carbon tax. My initial thoughts suggest that it makes sense to link a carbon tax to a budget deficit. I am sure others have made this point, but my run through is below.

  1. For the carbon tax to make sense we have to assume that the climate scientists are correct and there is a negative externality associated with consuming products that involve carbon emissions. So from an economic perspective these goods and services are ‘mispriced’. Their relative price is too low compared to other products and this leads to over consumption of carbon-emission-producing (cep) goods and services. A tax on these goods and services will raise their relative price and change consumption patterns.
  2. If the revenue from this carbon tax is returned to the people who pay the tax as lump sum compensation (i.e. compensation that does not alter with the actual consumption of cep goods and services by the individuals) then the relative price effect still changes consumption patterns but the compensation means that individuals need not be worse off. Indeed, in the basic ‘Robinson Crusoe’ model of the economy, the tax improves economic welfare so individuals are better off. The price distortion is corrected by the marginal tax and individuals are compensated by the lump sum tax.
  3. Of course we do not live in a Robinson Crusoe economy and individuals differ. Indeed they differ in two key ways. First they differ by income and consumption patterns today. Second they differ by when they live.
  4. I will skate past the first of these. Any carbon tax and lump sum compensations today will lead to redistribution. This seems to upset Sinclair but is unavoidable. It worries me less. Governments are continually setting policies that redistribute welfare. If this policy is both correcting a negative externality and redistributing generally to those who are poorer, in my opinion, it is more likely to create benefits overall than detriments.
  5. It is the second that is key. Who benefits from the reduction in carbon emissions? Or to put it another way, who suffers the detriment from the negative externality? The answer is clear. Future generations (possibly including today’s young depending on how quickly the negative externality creates harm). So a tax that corrects the future harm today but is budget neutral will make today’s generation worse off but future generations better off. Note that this has nothing to do with ‘reduced growth’ or other macro factors – it is simply based on the distribution of the gains and costs. Of course, overall there is a welfare gain, but this is all achieved by future generations plus a transfer associated with a loss of economic welfare today.
  6. The conclusion is clear. A carbon tax that corrects prices today to avoid a future welfare loss, where we do not want today’s generation to be worse off, should not be budget neutral. It should involve a deficit that will be paid for by tax increases on those future generations that get the benefits.

So from Sinclair’s article I conclude that what we need is a carbon tax with over compensation today, a government deficit from the tax that is funded by government debt and an expectation that our childrens’ children will be paying off the debt through higher taxes.

Somehow I dont think Sinclair is going to like this conclusion!


    12 Responses to "Carbon tax and budget deficit"
    1. There would also be a spinoff benefit to today’s generation because of the reduction in particulate pollution from burning less coal and petrol.
      Also, does this logic hold up given that many people (e.g. parents, grandparents) experience sacrificing to provide for future generations (their children) as a good rather than a cost? Providing for one’s children’s future makes one feel like a good parent.

    2. According to that logic shouldn’t we also retrospectively tax older people who got away with their dirty, carbon loving, lifestyles for so long?

    3. I don’t really get the logic here. At the moment we are damaging future generations. You argue that they need to pay us to stop hurting them. Along the lines of the Coase theorem that assumes that they don’t have a right to be unharmed and we have a right to harm them if we feel like it. Maybe some people would agree to that. But we can equally reverse the logic arguing that they have a right not to be harmed and if we harm them we need to compensate them and if we stop harming them then they don’t owe us anything. Most people will probably agree to this second assignment of rights I think.

    4. It seems that the entire construction of the proposed carbon tax is fundementally flawed as it is principally a production based tax rather than a consumption based tax. A production based tax runs the risk of destroying export driven industries, i.e. steel, coal etc, with none of the advantages of lowering world wide CO2 output (that is what we are trying to do) as CO2 intensive industries are simply replaced by cheaper imports which may or may not have CO2 regulatory controls.
      By creating a consumption based tax, i.e. identical to that of the GST, we are able to exempt exports and tax imports at the equivalent rate of domestically produced and consumed products. A tax of this design changes the “who should pay” arguement as you, as the consumer, chooses what products you will buy. This will result in the structural reform which fits nicely in with benefiting future generations by spreading the cost over time.
      The arguement that the future generations should be soley held responsible to pay for the structural changes required to reduce CO2 output is incorrect. If we build a major road/bridge/dam/major infrastructure project, this benefits not only the current generation but many generations to come. We divide this cost over the lifespan of the project so that everyone pays their dues for the infrastructure benefit.
      I seem to be missing the point regarding compensation. I thought the idea of the scheme was to create a “low CO2 economy” hence, doesn’t the premis of structural reform depend on consumers being hit with a tax to change their habits? If so, wouldn’t compensating almost everyone affected by this tax effectively make the tax null-and-void?
      Seems like policy and economics are once again mismatched.
      Nick Lonergan

    5. Just to pick up David Stern on one point. I believe Stephen was making the positive observation that if:

      a) the externality is to be internalised (via a Pigouvian tax) TODAY;
      b) the prevention of the welfare loss occurs IN THE FUTURE; and
      c) the objective (which he takes as given) is for current generations to be left with a pareto efficient allocation

      Then it follows that the tax should not be revenue neutral.

      As to whether this is fair, I note that it is entirely possible that if transaction costs were low enough (particularly if the metaphysics would allow) future generations would be willing to pay the current generation to curtail its pollution today – what would be so wrong about such a Coasian outcome? 

      On a different point, I think Julia Gillard, on Q&A and elsewhere, has done a good job in pointing out, albeit implicitly, that if the compensation is in the form of a lump sum transfer then it shouldn’t affect relative prices. Yet people keep rabbiting on that if the intention is to change behaviour then you shouldn’t have compensation! Even the Fin Review’s Brian Toohey seemed to be confused about this on Insiders the other morning!

    6. ‘[T]he compensation is in the form of a lump sum transfer then it shouldn’t affect relative prices’. Counterintuitive and correct. But try explaining that to the public!

    7. Unfortunately, you are missing an important macro implication of over-compensation. Over compensation will raise aggregate demand today, without raising aggregate supply, and so would result in a positive output gap (assuming the starting point is balance) if accommodated by the central bank. In practice the RBA is most unlikely to accommodate such a policy and so would tighten monetary policy relative to its baseline path. The distributional implications then become rather complicated. Bottom line though is that monetary policy is endogenous to any policy that changes the balance between demand and supply in the economy.

    8. Nick,
      The implementation of a consumption based carbon tax would be much more difficult – it would require some kind of system to track carbon content through the supply chain. In a production based tax, prices implicitly contain all of this information automatically.
      Additionally, when you have a supply chain that ‘narrows’ (i.e. many upstream companies feeding to a single downstream company) there will be an averaging of carbon content along the way, which may dilute the incentives of upstream producers to mitigate carbon production. In order for the system to work well the narrow part of the supply chain would have to act as a de facto regulator for its suppliers.
      While there are some benefits of a consumption based system (and some prominent supporters), overall the balance of consensus is that a production based tax is preferable.

    9. /* Style Definitions */
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      It has not been mentioned in your article or in the comments that the matter has been well studied in different applications of laureate Coase theorem. It makes sense to tax pollution in order to internalize externalities. Benefits include but obviously exceed leaving a better environment to future generations, the taxation impulse equilibrium to a point of higher prices and less consumption, transferring through a Pigouvian form of tax, more funds that may compensate in present generations the negative environmental impacts (or other desirable social objectives).
      Best regards
      Dr. Martin A. Morgenstern
      Chair Professor Health Economics
      Universidad Isalud

    10. Stephen,
      from the usual economic point of view (whichever generation gets to decide must be bribed to do the right thing) your point is a textbook one. However, under that same logic the future generations should compensate us for their mere existence and can be asked to give up 100% of their surplus utility. We dont do this partially because the future generations are in our utility function (in which case they only need to compensate us for part of the things we do for them) and partially because many voters are incapable of looking at decisions in that way. I doubt many voters realise the problems with climate change are mainly going to occur centuries from now.

    11. Coase would say that the two sides (the polluters and those suffering from polluters) should get together and negotiate an agreement.  The nature of that agreement would depend upon the pre-existing property rights of the two camps.
      It would be difficult for current and future generations to negotiate on carbon pollution.  However, your conclusion implies that the current generation holds a “property right” over the planet to the extent that it is entitled to destroy it for future generations unless those generations pay for the cost of the clean up.
      A plausible assumption, I guess, but perhaps a rather extreme one.

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