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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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!