To tax or not to tax; that is the question

Yesterday the Senate passed the 18 Clean Energy Bills for control of greenhouse gas emissions, more commonly known as the carbon tax laws. The Gillard government after initially promising not to introduce a carbon tax was corralled down the road to taxation by minority members of the governing coalition. Is taxation the ‘best’ method for controlling greenhouse gas emissions?

The range and the combination, of instruments available that can be used to reduce and control greenhouse gas emission is only limited by the ingenuity of those charged with developing the policies. However, as has been amply demonstrated in the real world, boundaries are established that effectively limit the choice of instruments. These boundaries may be the result of political principles such as equity and social welfare, or they may be the result of design principles.

Historically the choice of instruments available for the control of environmental threat have been described using variants of a pendulum analogy that assigns one extreme of the arc to command and control instruments, indicative of socialist ideology, with the pendulum swinging through various gradations to the other extreme of economic instruments, indicative of free market capitalism. Using this analogy the point of the arc from which instruments are chosen is dictated largely by the prevailing political principles.

With the passage of the Gillard government’s carbon pricing legislation it is clear that the government is focusing a great deal of effort in taxes and charges. At the same time the opposition has has vowed to repeal the legislation if they are elected and replace the taxes with direct expenditure. I would like to put forward my thoughts on the comparative merits of the two approaches.

Firstly, taxes and charges are a form of financial mechanism. Financial mechanisms are generally considered to represent a more economically efficient means of achieving policy objectives because of the greater flexibility in responding to the task of GHG emissions reductions. The arguments to support this position often focus on the inefficiencies of command and control regulations in pareto efficient market places, however it needs to be recognised that such ideal markets are very rare. A further point to be noted is that financial mechanisms are a comparatively recent inclusion in environmental policy and there is only limited evidence of their actual outcomes. Consequently outcomes are predicted from economic models which in themselves have uncertainties.

Taxes and charges can be levied on either resource use or on emissions. It is generally held that the closer to the source of the pollution the more effective the tax will be in effecting behaviour of the polluter (this was first raised by Pigou in 1920, and has largely stood the test of time as an economic principle and is widely quoted in most textbooks of environmental economics). Taxes are intended to encourage the emitters to reduce the level of emissions by forcing the internalisation of the environmental costs of the emissions. The main strength of taxes as a policy instrument is that this encouragement continues to exist even below a set standard of emissions, i.e. it encourages continual improvement. However the effectiveness of the tax is dependent on the level at which it is set and how responsive the market is to changes in cost. If the tax is set too low then there is little incentive to reduce emissions, and the result is merely that the consumer pays a bit more for the same emission pattern. Consequently several iterations may be necessary to determine the right level of taxes.

Secondly, direct action. Government expenditure can occur as direct investments, grants and subsidies, bounties, fees and commissions and favourable administration. The strengths of government expenditure are that it is a strategy with low direct costs to the industry and public. It allows activities that because of their high threshold costs would not otherwise be available to SME’s or the public, to occur. This is especially relevant with research and development actions. It is also relevant to education programs wherein the expenditure can be used to improve the efficiency of the market by improving knowledge and awareness, which are key requirements for market efficiency.

It has also been noted that one of the strengths of direct government expenditure, such as subsidies, is its ability to act as a catalyst or ‘circuit breaker’ for change. A government contribution can tip the balance in favour of an action that may otherwise be uneconomical or politically unacceptable. There are many examples from buses in Hong Kong to wind generators in Sacramento where, once established with the assistance of government expenditure, economies of scale allow low emission products to compete favourably with emission intensive products.

Opportunities exist for reducing emissions from the transport and stationary power sectors by introducing subsidies or favourable administrative conditions to upgrade equipment machinery and vehicles. However this has two main threats. The first is that government would have to draw from limited available resources to fund the actions. The second threat is to equity in that it provides a reward, in the way of financial assistance, to those with dirtier or older facilities while ignoring those who have made investments in cleaner technologies.

The agriculture sector appears to offer the best potential for results from direct expenditure. In this sector there are many diffuse sources of emissions representing nearly a quarter of the Australian total. An expenditure of research and development into agricultural practises has the potential to achieve significant reductions if coupled with an awareness program.

 

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