Carbon Taxes, Cap and Trade and "Revenue Neutrality"

While many thoughtful people still wonder about the extent of humanity’s impact on our changing climate, the scientific consensus is all but unanimous that through our emissions of greenhouse gases we are having an unprecedented impact. Canada is a signatory to the Paris accord which sets targets for reducing these emissions. The goal is to limit global warming to 2 degrees Celsius, because scientists believe this may be possible and that it might avert the potentially catastrophic changes that greater warming could lead to. Even with this degree of warming, we will be facing major changes to weather patterns that will require humans to adapt.

Tax vs. Regulation

To reduce carbon emissions, governments are proposing to change our behaviours by making the use of carbon more expensive. Economists have demonstrated that people make economically rational decisions to make their lives better. Individuals may do things that don’t make sense, but in the aggregate people’s economic behaviour is predictable. For example, if air travel gets more expensive, people use less of it, if it gets less expensive, people travel more.

By making carbon more expensive, the prediction is that people will seek out less carbon intensive alternatives for such things as transportation, heating and cooling and manufacturing. Businesses will try to meet these demands by investing in technological research that produces ways of meeting our wants and needs that use less carbon and are therefore more price competitive. In Europe, the high price of gasoline is driving buyers towards alternative fuel vehicles, hybrid and all electric, for example. Both Volvo and BMW have announced that they will no longer be producing all gasoline-powered vehicles in the very near future.

The economic theory is that the marketplace makes good decisions if it has good information. The primary way in which information is communicated is pricing. Current pricing for carbon is too low because it includes costs of extraction, processing and distribution but not the costs of the damage it does to the environment. Therefore, the marketplace is making bad decisions because it has imperfect information. Carbon tax and cap and trade programmes aim to correct this.

The alternative way to modify our behaviour would be to regulate the use of carbon. Taxes and cap and trade programmes leave the decision making in the hands of individual citizens, who remain free to use as much carbon as they want as long as it is worth it to them to pay for it. Taxes and cap and trade programmes are also less likely to generate expensive governmental bureaucracies for their administration than regulations, which require drafting, analysis, and enforcement. In our free market system, taxes and cap and trade are more compatible with the idea that aggregate individual choices by consumers will in the end produce better outcomes than decisions made by government committees.

Carbon Tax vs. Cap and Trade

A carbon tax is straightforward. Based on the amount of carbon emissions an activity generates, a tax is added to reflect the environmental damage. The idea is that the target for reduction becomes more aggressive over time and the tax increases as people adapt and become less dependent on carbo and can therefore handle the tax better. The more difficult to change behaviours occur later as the cost of not changing becomes more expensive, and this approach gives business time to research and develop less carbon intensive options.

Cap and Trade involves setting a hard cap on carbon emissions, which becomes lower and lower over time to meet the Paris commitments. The trade component allows industries that can reduce their emissions below the mandated targets to sell carbon credits to those industries who cannot meet theirs. Carbon intensive industries would have to pay for these credits which would increase their costs, which would then be passed on to consumers, making carbon intensive products and services more and more expensive as the caps become more aggressive over time. This would drive consumers away from these options and also encourage industry to develop technologies to meet their carbon caps so as to have to buy fewer carbon credits. Critics of this approach believe it is more regulatory and less market oriented than a carbon tax. Proponents believe that the ability to trade on international carbon credit exchanges makes it more flexible and sets the stage for an international solution to a global problem. Ontario has chosen this approach and joined a market with Quebec and California to facilitate it.

In both cases, the idea is to communicate the damage that carbon does to the marketplace through price increases and cause consumers to make changes like moving closer to work, using public transport more, replacing vehicles that emit carbon with less polluting options, upgrading home insulation, switching to triple glazed windows, substituting electric for oil and gas heating (in Ontario electricity is relatively low in carbon emissions since coal plants have been closed). At the same time, industry will want to be competitive and attractive to consumers and will seek ways to reduce its carbon outputs with smokestack scrubbers or by changing to cleaner fuels for its processes, for example, as well as producing products such as heat exchange pumps to help consumers reduce their costs. As the transition away from carbon intensive products and services proceeds, caps get further lowered or carbon taxes increase.

The Cost to the Consumer: Revenue Neutrality

Before adjustments to behaviour are made, both carbon taxes and cap and trade increase consumers’ costs. These approaches also have a disproportionate impact on the poor who cannot afford the capital expense to replace their cars, for example, and on people with fewer options for reducing their carbon consumption, such as those living in rural areas and dependent on oil heating, or whose remoteness means that electric vehicles are not a practical option.

Governments make claims that they will not take this tax revenue and use it as another source of funds in general tax revenue but return it to consumers such that it is revenue neutral to the government.

In order to make carbon pricing effective without reducing people’s standard of living, governments can make equivalent reductions in existing sales taxes or increase the basic income tax deduction so that citizens have no financial impact. If this is done with true revenue neutrality for the government, citizens who see the increase in prices of some products and services and make choices to reduce their consumption of these actually end up with more disposable income than before the carbon tax. Over time, the carbon tax is further increased, and behaviours would adjust, reducing our overall carbon output.

There is considerable scepticism with respect to this among voters. Most do not trust government to return the carbon tax to the citizens, fearing that some or all of it will go into general revenue, and that in the end it will mean they are paying more overall tax and government is consuming and controlling an even greater share of the economy’s output.

Even more trusting voters have a well-founded concern that the government will interpret revenue neutrality as permitting less free market ways of returning the carbon tax or cap and trade revenue to the citizens. For example, governments may decide to use the money for their preferred environmental schemes, giving rebates for home insulation upgrades or for heat source choices for example, or for the purchase of “green” vehicles. Critics of these approaches say that the idea that taxes and cap and trade revenue is designed to allow the market to reduce carbon through consumer choices is contradicted by these kinds of interventions, and that they also are likely to leave the poor even poorer as they may not have the resources to take advantage of these incentives and rebates.

Further, such schemes require administration, which will lead to greater government involvement in the economy and greater bureaucratic overhead, reducing the funds available for the productive economy. Still further, governments do not have a great track record of picking the right solutions. (A current government of Ontario scheme for encouraging the use of heat exchange pumps to replace air conditioners and reduce the use of furnace heat only rewards those using electricity to heat their homes, and not those whose furnaces burn natural gas. Given that electricity in Ontario is cleaner than natural gas, this makes no sense.) This is symptomatic of the effectiveness of committees relative to markets in allocating resources.) While markets also make mistakes, they can correct them much more quickly: once a government department has been established and funded, we do not eliminate it easily.

Conclusion

Citizens are right to be wary of these taxes and cap and trade programmes. They must hold governments to their claims that these are market solutions to our environment problems and insist on true revenue neutrality: the return of these revenues to consumers to permit them to adapt to the changing costs of carbon-intensive products and services through sales tax reductions and decreases in income tax (targeting the lower income by increasing the personal income tax deduction.) These revenues should not be used to hire new armies of civil servants to manage rebates and promote the pet projects of well-meaning politicians. Carbon taxes and cap and trade programmes are the market solution to the problem of emissions causing climate change, and must not be window dressing for new a new regulatory superstructure that represents a new overhead on the economy.