Carbon scheme fails on three key levels

ALL economics students are taught to assess taxation measures according to three criteria: efficiency, equity and simplicity.

Climate change

ALL economics undergraduate students are taught to assess taxation measures according to three criteria: efficiency, equity and simplicity. This is a useful starting point when it comes to assessing the carbon tax package to be announced tomorrow.

When gauging the efficiency of any tax measure, it is necessary to define the objective of the tax and then estimate the cost-effectiveness of the measure relative to other possible measures as well as doing nothing.

The carbon tax is what economists call a Pigovian tax -- it is designed to dissuade undesirable behaviour. Excise on cigarettes and alcohol also falls into this category.

One of the issues about the carbon tax -- tipped to be set at $23 a tonne -- is whether it will actually be high enough to dissuade CO2 emissions.

At least in the short run, the demand for many emissions-intensive products -- electricity and transport, for instance -- is relatively inelastic.

Over time, the demand may change to a greater degree, but this will only occur if the tax is high enough to remove the advantages of the ongoing production (and consumption) of emissions-intensive products relative to the production of substitute products with lower emissions.

Given what we know about the cost structures of the various means of generating electricity, it is absolutely clear the tax will not be high enough to induce the behavioural change that is the purpose of the tax in the first place. It is what I like to call a homeopathic approach to dealing with CO2 emissions.

What this means is that if the government is determined to meet the target of a 5 per cent reduction of emissions by 2020, then the jumble of inefficient schemes such as the Mandatory Renewable Energy Target will have to do the heavy lifting rather than the carbon tax.

If economists are unanimous about one thing, it is that these various schemes, designed to favour renewable industries, for instance, are a drag on per capita income and should be avoided.

So what about the equity effects of the carbon tax? The government is quick to point out that nine out of 10 households will receive some compensation and about 70 per cent will be fully or more than fully compensated.

So should the carbon tax be positively assessed on equity grounds? The first thing is that providing compensation to households actually operates against the purpose of the tax -- which is to change behaviour in order to reduce emissions. And to over-compensate some households suggests that the government has snuck in a redistributive objective to the tax.

What household compensation means is that it will only be the substitution effect that is in play in terms of changing behaviour, rather than the combined impact of substitution and income (the tax would reduce household disposable income without compensation) effects. This amounts to poor economics but probably good politics.

Of course, there are others who are affected by a carbon tax apart from households. The owners and shareholders of businesses who will pay the tax initially, the workers who are employed in emissions-intensive industries, the small businesses that will be affected by the carbon tax in a number of ways -- the tax for these groups will be perceived as highly inequitable.

Even if a tax measure more or less meets the criteria of efficiency and equity, if the means by which the tax is levied involves disproportionate transaction costs, then support should not be forthcoming. Transaction costs mount where there are exemptions, loopholes, excessive paperwork, compliance costs and a bloated bureaucracy created to administer the tax.

The manner in which transport fuel is being handled is a case in point. To have two classes of users -- one that is exempt and one that must pay the tax -- is a recipe for complexity and high transaction costs. And many of these costs will be borne by small business, even though we are assured that tradies will be exempt. The brighter students might add an additional point to their assessment.

Rather than simply reducing CO2 emissions in Australia, the real point of the carbon tax is to make a contribution to reducing global emissions. Only if there is a global effort will there be any impact on the climate and average temperatures.

Using the theorem of the "tragedy of the commons", however, the notion that all nations will get on board to reduce their emissions is fanciful. As a consequence, Australia's efforts alone -- contributing under 2 per cent of global emissions -- will be insignificant. An heroic assumption is required that our efforts will prompt other countries to follow our example.

Without equivalent global action, particularly among our competitor nations, measures will be necessary to prevent carbon leakage whereby local emissions-intensive operations shut down, only to be replaced by a similar operation in another country.

But measures to protect or exempt emissions-intensive industries only further complicate the tax package.

This constitutes another cross against the tax on the grounds of unachieved simplicity.

To secure top marks, overall, students need to point out that the tax must be set high enough to induce behavioural change. Without this, the tax is all compliance costs and unwarranted redistribution. Dealing with the equity considerations by compensating households mutes any behavioural impact and there are many losers from the imposition of the tax in addition.

To offset carbon leakage and to accommodate politically dictated special deals means the tax also fails the test of simplicity.

Professor Judith Sloan is an economist and company director