Carbon tax

by zebra on 8 March 2011 · 24 comments

Our regular guest writer James Glover (@zebra) returns to the Stubborn Mule today to look at the real cost of carbon tax…and who pays the cost.

It is no surprise that the latest Newspoll shows the Labor Government sinking under a concerted attack by the Opposition, and its supporters in the media, over the Carbon Tax. The incessant cry of “a great big new tax” was bound to have an effect on the marginal voters who derive their political views in atavistic ways. In fact most of the political arguments lately recently seem to revolve around the distinction between levies and taxes. The trick seems to be if your opponents propose it then it is a tax and if you propose it is a levy—the latter being used by both sides to describe variously the flood levy (Labor) and the parental leave levy (Coalition). Taxes, as opposed to levies, apparently lead to profligate spending and are downright un-Australian. It makes you wonder what they use to fund hospitals, schools and roads.

So how does the Carbon Tax work? And what does it mean to say it is “revenue neutral”? Is it really a tax or “not really a tax” as the Treasurer, Wayne Swan, claims? Suppose the government wants to set up a Carbon Tax for the purposes of reducing carbon emmissions. It does this by imposing a tax (or levy or fee) on the price of goods and services that are deemed to ultimately cause high but avoidable (hence no agriculture) emissions of carbon. This of course raises the price of these goods e.g. electricity. If we impose a Carbon Tax on coal-generated electricity (the sine qua non of carbon emitters) then expect the power companies to pass on all or most of the increase to consumers. Now here’s the thing, the money the tax raises will have gone to subsidise the increased power bills of these very same power consumers. By exactly the same amount as the price should rise. So in effect nothing happens. In other words, at a base level the Carbon Tax does nothing. It has no benefits and no costs. Isn’t it really “a great big snooze tax” and not “a great big new tax”?

The Carbon Tax has one (fully intended) important consequence. If power emitters want to increase their profits they can do so by switching to lower carbon emitting alternatives. These might already be available or they can pay to research and develop them. And because of the tax what was previously uneconomic will now be made viable. Since these alternatives are really more expensive than coal-based power, without the tax, you might ask what is really happening at the cost end. It seems like a tax which costs nobody nothing, magically makes alternatives to carbon emitting industries economic. Voila!

Well that’s what the government would have you believe. On closer examination though it is precisely when the Carbon Tax has its intended effect that the cost gets passed onto consumers. But not when the Carbon tax is first introduced. To see why let’s have a look at an example.

Suppose the cost per unit of producing electricity from coal is $100. The power company charges $110 to consumers and so makes a $10 profit. The Govt introduces a 20% Carbon Tax on the cost of producing electricity using coal. This raises the price to $130 in order for the company to maintain its $10 profit margin. That’s $100 for the coal, $20 for the tax and a profit of $10. The extra $20 gets passed onto the consumer whose bill is now $130 per unit. However after the $20 subsidy (paid for by the $20 proceeds of the tax) they still only pay $110.

In other words: the producers, the consumers, and the government are no better or worse off immediately after a Carbon Tax is introduced. But what happens if the Carbon Tax is successful in reducing emissions? That is when consumers end up paying more. The cost to the company, including the tax, of producing one unit of electricity is $120. Suppose an alternative non carbon-emitting energy source is found which costs $115 per unit. This is more than the coal-based cost before the tax, but less than the cost with the Carbon Tax as this carbon-free energy source, let’s call it “sunshine”, attracts no Carbon Tax. So the company, in order to maintain their profit of $10, charges $125 per unit, less than coal based power with a Carbon Tax. But now the consumer receives no subsidy either so even though their total bill has dropped from $130 (with carbon tax and a subsidy) to $125 without a subsidy. It now actually costs them $125, an increase of $15 over the cost before the carbon tax was introduced and even immediately afterwards. This of course is the extra $15 per unit that it costs to produced electricity from sunshine rather than coal.

That is how the Carbon Tax really works and ends up costing the consumer. You start out with a Carbon Tax which costs nobody anything and end up without a Carbon Tax that everybody ends up paying more for. When it has its intended effect, and there is no coal based power, but also no more money for subsidies. And, in principle, no more carbon pollution.That of course though is really the point. There is a (currently) hidden cost of producing carbon as carbon dioxide and methane in global warming and that is, if the system works, the $15 extra you pay to solve the problem by removing carbon from the economy.

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{ 23 comments… read them below or add one }

1 Nathan March 9, 2011 at 2:02 am

this is a good post, however i want to point you to one thing. a climate bill in the united states called the CLEAR act is designed in such a way as to distribute money collected by auctioning carbon permits (that can’t be sold on a secondary market) on a per-capita basis to consumers. My point is that a carbon tax doesn’t necessarily have to be a net tax on consumers.

2 Zebra March 9, 2011 at 10:22 am

Nathan, thanks for pointing this out. In the end though the result would be the same as a Carbon Tax (which also isn’t a net tax on consumers). It would eventually be cheaper for the power companies to use alternative sources of power. At this point producers would no longer need to buy carbon permits so the proceeds of these would fall to zero, so there would be no money to distribute to consumers, effectively removing the subsidy, at which point they pay the higher fuel costs in full.
The difference perhaps with CLEAR, like the original Australian CPRS, is that the market sets the “tax” rather than imposed by the govt. In effect if there is a single alternate source of power like sunshine, then the market will price in the cost of permits until they are indifferent to sunshine or coal – this would set the price of the tax/permits in my example at $15/unit. It seems though that it doesn’t really matter if the govt sets the tax/price at $20/unit as long as it is above the marginal cost.
The real aim of these schemes is to encourage producers to use alternate sources of fuel, not to prevent consumers from bearing the increased costs of alternate energy. I think this point gets lost in the shouting.

3 Magpie March 9, 2011 at 6:04 pm

You’ve lost me here, Jimbo.

I may have missed the plot somewhere, but I believe Nathan’s point was that the US CLEAR tax SOMEHOW compensates consumers for the additional cost of the greenhouse emission saving:

“My point is that a carbon tax doesn’t necessarily have to be a net tax on consumers.”

Or, in other words, it appears there’s something in the CLEAR act tax that SOMEHOW makes producers pay for carbon pricing.

The key are the “somehows”. As I don’t know the CLEAR act tax, I can’t pronounce an opinion on this.

However, in principle, I don’t think there’s a way around the need to make consumers pay for greenhouse emissions savings measures. At least, it’s not obvious to me.

To put this another way: one way to reduce greenhouse gases emissions is through taxing demand (making consumers pay a higher price).

The two things I don’t see mentioned anywhere is what will be done to tackle supply (that is, how to make producers pay for unnecessary emissions) and how to avoid rent seeking behaviour among producers.

Nathan mentions that “carbon permits (… can’t be sold on a secondary market)”. This could be useful to control rent seeking. Is there anything similar in the Gillard plan?

4 Zebra March 9, 2011 at 7:09 pm

I’ll let Nathan speak for hisself but here is a link to a summary of the CLEAR Act http://goo.gl/WkANc. They seem to be only redirecting 3/4 money from auction to subsidies and other 1/4 to a special fund. Theoretically once no more carbon permits are required there will be no income to distribute so all costs will get passed on to consumers if producers have there way.

I can’t really see how you can permanently subsidise consumers from producers once they entirely use clean energy without legislating their profit margins. You could set up a specific tax like the mining tax for companies who formerly burnt fossil fuels but it seems a bit harsh and not likely to fly in US. Of course you can just subsidise everyone from general revenue but that’s a bit circular. Even if you only subsidise poor people that’s really just wealth redistribution rather than anything specific to carbon.
But if you have any ideas let me know.

5 Zebra March 9, 2011 at 7:13 pm

It occured to me that one way consumers could prevent the transition to more expensive and higher cost alternate fuels is to boycott their producers. Maybe the govt could introduce a carbon tax on this basis and say if you don’t want to pay more then boycott clean energy providers and pick up your carbon subsidy.

6 Stubborn Mule March 9, 2011 at 9:45 pm

Zebra Although I don’t think that it really undermines your core argument, there is one assumption in your analysis I would challenge. When faced with a bill of $130 for power that previously cost $110, you assume that the consumer will consumer the same amount of power safe in the knowledge they will receive a $20 rebate. However, while the details of the scheme are not yet clear, I suspect that the rebate will not be simply and directly linked to the consumer’s expenditure. I suspect that the result would be a substitution effect: while the rebate restores the consumer’s wealth, the increase in the direct cost of power may lead them to consume less power and redirect their spending elsewhere. I recall some statistics from the period of oil price rises prior to the GFC which showed that petrol consumption dropped in the US. I think there would still be a form of “sticker shock” when people see the price at the pump or see their electricity bill, even if they receive some kind of rebate at another time. This means that even before the effect you describe kicks in, there could be some reduction in carbon emissions as people rebalance their expenditure away from goods/services that have seen price rises as a result of a carbon tax.

On another subject, as you say, the effect you describe would result just as much from a trading scheme as a tax (or levy). That leads me to wonder whether there is a theorem (if they use such a term in economics) which shows that any externally imposed cost must inevitable erode wealth somewhere, somehow under certain technical economicky idealised conditions. If not, perhaps there is a Glover theorem waiting to be written up!

7 Zebra March 10, 2011 at 7:00 am

Agreed Sean – I was really trying to highlight the effect of the price rise coming back in once the subsidy was removed. I agree with your point and also a couple of others that would make it more realistic (1) the govt doesn’t intend to fully subsidise the initial price rises and this will be means tested (or similar based on cap) (2) it seems likely to me that the companies would want an increased profit for their investment in alternate sources of energy, perhaps raising the post-carbon price to $116, in my example, burying an increased profit under claims of increased costs – like that’s never happened before. I’m also guessing there would be an ongoing means-tested subsidy paid out of general revenue.

In a sense we are borrowing against (by deferring) the costs of climate change for current economic development – like any sort of borrowing this might, perversely in this case, ultimately lead to a positive outcome if the current economic development based on a carbon-economy leads to enough excess wealth to cover the later costs of solving global warming, plus some. Now that’s a controversial (and risky) proposition. Time will tell.

8 Michael Michael March 10, 2011 at 5:34 pm

Mule,

Wouldn’t sticker shock only be a factor once smart meters are properly in place? Isn’t electricity consumption a classic example of consumers of something where consumers are basically very ignorant of the purchase price – sure, geeks can compare their quarterly statements after the fact, but most of us currently have only the vaguest notion of how much our usage is costing us.

(Sidebar, does each state/territory have a different way of pricing electricity for consumers? e.g. in Victoria we have a privatised system, but I think a government agency has to scrutinise pricing structures.)

9 Stubborn Mule March 10, 2011 at 7:30 pm

Michael Michael in NSW electricity prices have risen quite a bit lately and, anecdotally, the bills have caused a bit of a shock for many. Overall though, I think there’s something in what you say and there is probably more price sensitivity for something like petrol where you can see the price every time you fill up. Even then, though, I think it takes quite a price rise for behaviours to change.

10 Zebra March 11, 2011 at 1:53 pm

MM and Mule – I do wonder if some people’s perception that they are paying more for power bills comes about because they keep getting told this by media and (opposition) politicians rather than because they know what their bills actually are? Of course I am about as far away from middle-Australia as it is possible to be without actually claiming refugee status so I am probably just being cynical and elist and should go back to my lattes until it’s chardonnay-o-clock.

11 Cargo March 15, 2011 at 8:35 pm

Of course, a blog on economics is hardly the place to propose ethical questions, but I am going to ask one anyway. Who *should* pay for carbon pollution?

12 Zebra March 18, 2011 at 7:27 pm

CArgo – I appreciate you commenting but who do *you* think should pay for carbon pollution?

It seems to be logical (to me at least) that producers pass on their costs until we eventually reach a pure consumer who uses the good and/or services for their own benefit rather than creating a g&s that gets sold. I guess that’s who ends up paying for the costs inc carbon pollution. On the other hand govts step in and do a fair bit of redistribution of income and it wouldn’t be out of place for them to do that in this case so others may pay for the carbon pollution, at least partly, for the less well off.

If the aim of the carbon tax is to encourage energy producers to switch to more expensive but less polluting sources then it doesn’t really matter who pays, within that paradigm. I admit though my post didn’t address consumer behaviour, which may be just as important, in which case user-pays would be the answer.

13 michael March 25, 2011 at 10:42 am

a lot of focus on the cost of power and changes in consumer power bills. It would appear the impact will be more widespread and more indirect, where the impost is initially paid by business then passed to a wholesale business who them passes to the consumer. In a simple example, take the cost of building a new home. It would be interesting to see the price escalation that say Metricon will have to pass on as it relates to concrete, tiles, steel, exruded aluminium windows/doors etc. Likely to be much more that the annual increase on the power bill !

14 Zebra April 8, 2011 at 7:43 pm

Michael – this comment a bit late but it seems to me like you are right. Some of the costs will get passed on directly to consumers via higher power bills and other indirectly. Power bills will get subsidised (say 75%) but obviously wont happen with indirect costs – the govt has already said they wont subsidise businesses.

But it all comes back to consumer costs in that power companies can decrease their bill to business if the choose to use non-carbon sources of energy. That will make them more economic I guess.

I get the feeling it’s a big lever from an economic point of view. Once the govt accepts the need to contribute to global carbon reduction what other choices do they have but listen to economists? Plant more trees?

15 Andrew April 15, 2011 at 12:57 pm

So assuming we’re all entirely economically motivated what motivation does the consumer have to actually use the energy provided by the newly converted “green” engergy companies. Wouldn’t the savvy consumer realize that they can get a cheaper bill by staying with the companies that have not yet converted to green energy? In your example it is a comparison of $130 + subsidy of $20= $110 VS $125 total (no subsidy). So it makes sense for consumers (in purely economic terms) to disregard green energy. If this is true couldn’t it occur that when companies change to green energy they actually lose customers who change back to a cheaper, more damaging, energy source?

Perhaps i’ve missed something or have overlooked an important point. . . help me out here?

16 Gerard May 31, 2011 at 9:33 am

An addition to Andrews comment, what’s lacking in the debate is a clear alternative to a Carbon Tax. What other ways can we reduce emissions? Beginning, I assume, with a reduction in subsidies to the coal industry!
We seem to be having a debate with only one offered solution.

17 Brad June 6, 2011 at 5:00 pm

I have been away for a while and I am not quite up to what has happened regarding the carbon tax, however it was my understanding that 10% of the carbon tax was to be given to the UN (so Kevin 747 may make his way into UN). The 10% was to be distributed amongst third world countries.
If I am wrong could someone please correct me because I would hate to think some of the powerbrokers amongst these third world countries, like for instance crazy Robert Mugabe, would have a say in how the monies would be distributed within their country.
Remember all the rock concerts where world donations took place for food. Out of 1000 loaves of bread donated maybe 1 slice of bread got to the people.
Our money would be wasted for the sake of K747 jumping into the UN.
Once again it comes down to politics. Gillard would never had contemplated this tax if she did not need the Greens.
In todays world with advanced technology surely we can run cars off hydrogen, utilise the sun, (however I am not sure how they can save that energy)?
Once again it all comes down to politics. The powerbrokers like the oil companies and coal mines manipulate the government with this last remark ” Well we got you into government now you owe us”?
If you think what I said is incorrect please advise. That is my basic understanding of the carbon tax. Sorry I forgot to mention Al Gore who also has an interest in this.

18 ALAN July 18, 2011 at 2:52 pm

ZEBRA- I thought this would be over and done with last month, but since it’s still plodding along why not, in place of Carbon Tax; introduce something like:
C.R.E.D.I.T: Carbon Reduction- Energy Drive- Innovative Technology.
Coal and High carbon or Polluting industries could be taxed 10 to 20% on their profits which need to be fixed based on profits declared over the last 5 or 10 years in order to ensure profits do not suddenly reduce to compensate the tax. This is the price paid by the share holders or the owners, for using the countries natural resources in a polluting manner and not passed on the people.
Such Polluting industries should also be allowed, over the next 5 to 10 years to invest in technologies, to reduce pollution in their plants through world bank Aid, government aid (from the Tax they recover above) or market shares (Long term Tax exemption Bonds) and in doing so be allowed a considerable Tax set off equivalent to the repayment of such investments, to drive this initiative.
If such measures can’t be immediately be sought by polluting Industries, they should be compelled to invest 10 to 20% or more of their gross income before tax, in clean renewable energy, in a phased manner over the next 10 to 20 yrs. The polluting energy production could be reduced proportionately and manpower trained and diverted for development, installation and maintenance of renewable energy. Over a period of time they should be able to research and implement new or suitable pollution reduction technologies for their existing polluting industries.
This will spur reduction in existing carbon levels and give an impetus to investment in clean renewable energy without decrease in employment and encourage more forms of renewable technology in or around their plants.
It is obvious; Pollution first affects each of us, our families, our State and Country first, before travelling the Globe to have a global effect. So let us find means and solutions to curtail pollution at our end first, to be able to enforce and compel other polluting nations ( who’s people many a time can’t afford a meal a day or a shelter over their head) to follow our example. Our Industries can in doing so, en-cash on the technologies, systems and methods implemented, to reduce pollution in our existing production, utilities, power and Industry by sale of technology and process to other countries.
If these thoughts came to me over the last 30 minutes, after reading a few articles on the Carbon Tax and related issues, why not call for Brain storming sessions by reputed economists and unbiased financial advisors who could make out reports to the government within a few weeks and the results put up to Parliament or even public vote. The one whose plan and idea is found most suitable and popular could well be rewarded by the government a few million $’s which is only a fraction of the amount currently lost in time and money spent on debate and policies which are not favourable to many, reducing popularity and fame to the implementers.
More thoughts like these could lead to a better solution ! ! !

19 Magpie July 18, 2011 at 4:31 pm

On a related (and if you believe the following report, deeply disturbing and even scary) subject:

Background Briefing: The Lord Monckton roadshow.
http://www.abc.net.au/rn/backgroundbriefing/stories/2011/3268730.htm

20 Liz Stewart July 22, 2011 at 11:17 pm

Carbon Tax

Why compensate us … don’t tax us in the first place, so we don’t have to be compensated.
We are already being charged the Carbon Tax by the Big Polluters, who put the prices up for electricity, etc. to compensate for their share of Carbon Tax.
And on top of that … the Government is making us pay Carbon Tax again, so that we can get used to that tax and … in a few years time that tax will go up and the compensation will go down, until there is no more compensation left for us to fall back on.
In the meantime we’re already used to the Carbon Tax and we won’t be able to get rid of it anymore. Then we are stuck with it … and the Government thinks that we are incapable of thinking that far ahead …

We don’t want to be taxed in the first place, so there will be no need to compensate us.
KISS – Keep It Simple Stupid – as Judge Judy would say …

21 Zebra July 23, 2011 at 5:32 pm

@alan – you have the same thought as everyone else who wants to reduced carbon pollution. What is the best way to do it? Unfortunately there is a disconnect between the creators of the pollution (producers of energy) and the people who must ultimately change their behaviour (consumers of energy). Govt economists only have what they call “big levers” to do this. At one extreme you go around to every consumer and ask them to turn off their lights etc. That is best done through advertising. At the other end you get producers to use less carbon intensive technologies. Govts try and do both actually. They’re not dumb. Economists have theories about how you get people to change their behaviour through taxes. Make something more expensive then people will use less of it or use relatively cheaper alternatives.

The current situation regarding the Carbon Tax is not about raising revenue it is about reducing carbon pollution. About 3 years ago both the liberal and labor parties agreed on this approach. It’s quite sad that Abbott has used this as a short-term way of increasing his chance of being elected.

22 Stubborn Mule July 24, 2011 at 8:34 am

@Liz – at first blush it doesn’t seem to make sense to simultaneously impose a tax and and provide compensation. Doesn’t that defeat the purpose? But here’s a highly simplified scenario that illustrates that it can make sense.

Imagine we have a population of 1 million people who currently all generate the same volume of emissions in the course of their daily lives and, with the new price of carbon we are imposing, this will cost each of them $100 per month. So, our new tax will raise $100 million per month. But we decide the tax should be revenue neutral and so we give everyone a tax rebate of $1,200 each year. Anyone who keeps their emissions stable will be no better or worse off. Now imagine one person adds to their emissions by 50% and one other person manages to reduce their emissions by 50%. The first person will now pay $150 per month in carbon tax, while still only receiving a tax benefit of $100 per month, and is now out of pocket $50 per month. Meanwhile, the person who reduced emissions is now only paying $50 per month but still receives $100 per month in tax benefits and so they are now ahead.

So, even though the carbon tax was initially completely offset by rebates, it still provides incentives to reduce emissions as long as the rebates are not themselves linked to the ongoing levels of emissions. The arguments here applied for individuals apply in exactly the same way to corporations.

Now I will concede that the actual proposals on the table are far more complicated than this and there is plenty of room to criticise specifics of the scheme and the compensation mechanisms. However, it is certainly not the case that combining a price on carbon with a compensation scheme necessarily undermines the effectiveness of the carbon price in achieving emissions reductions.

23 john September 12, 2011 at 11:58 am

Good read, however, I disagree with you when you talk about non carbon polluter companies which get no subsidy being 15 dollars more than the original price; do you not think coal industry will then reduce their prices? It’s simply either that or collapse as who is going to pay extra for something that destroys the planet. Furthermore, as sustainable energy then becomes cheaper it will lead to more efficient energy, more competition and eventually cheaper than the current prices for coal and gas. Ultimately they are finite sources and will only go up themselves over time, and sure we can wait for private enterprise to lift its game and create sustainable energy at a cheap rate, by which time the environment will be screwed and the cost of living will be well above that of what’s caused by the carbon tax. Ultimately this will help to not only look after our planet, but put pressure on more advancement in a sustainable energy, which in turn will make the cost of living much cheaper.

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