The free-market argument for a carbon tax

I wrote the following as an opinion article for a general audience.


Following the release of the Garnaut Report, it seems that everybody wants to talk about climate change.

Clearly, climate change is an important issue. Last year the International Panel on Climate Change (IPCC) said they are more than 90 per cent certain that humans are contributing to global warming. Computer models suggest a temperature increase of about 2-4 degrees over the next 100 years and many people are worried about the possible impact. But there is an important difference between having good intentions and introducing good policy.

At the moment, both major parties and most minor parties are pushing a carbon trading system and billions of dollars of subsidies towards alternative energy. This looks good, but it is bad policy. Australia would be better served by introducing a revenue-neutral carbon tax.

Government’s are notoriously bad at “picking winners” in any industry, and there is no reason to believe that politicians will correctly predict the future of the various alternative energy options. I don’t know which option is better between solar, wind, hydro, nuclear, ‘clean’ coal, hot rock, bio-fuels or any other option, and neither does Kevin Rudd, Brendan Nelson or Bob Brown. The best alternative energy source might not have been invented yet. If we want to shift away from ‘dirty’ coal then the best option is to put a price on carbon emissions and let the market decide.

We can get a price on carbon in two ways – carbon trading or a carbon tax. There are several reasons for preferring the tax option. A tax is more transparent, provides certainty in the carbon price and it allows  greater flexibility in the face of changing economic circumstances. In trade theory it is well understood that tariffs are better than traded quotas. Similarly, a carbon tax is actually more flexible and efficient than the trading system.

A carbon trading system may involve “picking winners” if there is an allocation of carbon credits, which adds another element of inefficiency. It also involves compliance costs (search, negotiating, approval and insurance costs), potentially significant administration costs and wasteful rent-seeking behaviour. Many of these problems are already apparent in other trading systems, such as the European Union’s carbon trading system – which has been criticized for its highly variable carbon price (from e1 to e30), it’s “state aid” (ie corporate welfare) to energy producers and the perverse incentives that it has created (eg encouraging high emissions in the “base” year so as to get a higher allocation of carbon credits).

Another benefit of a carbon tax is that it raises a consistent and guaranteed amount of revenue for the government, which can be used to cut other taxes, and therefore reduce the potential economic costs of climate change policy. Indeed, depending on the details, a modest carbon tax and matching tax cuts may have no net negative economic effect.

A tax of $15/tonne of co2-e (carbon dioxide or equivalent) would raise enough money to increase the tax-free threshold (TFT) from $6000 to $10,000. Alternatively, the revenue could be used to cut the top marginal tax rate down to 30%. Both of these would be significant and beneficial reforms.

If we increased the carbon tax to $30/tonne then the government could afford to increase the TFT and cut the top marginal tax rate, or they could increase the TFT to $15,000.

There is another, more controversial, option that deserves consideration.

Australia already has an environment tax on fuel and diesel. The transport sector currently emits 94m tonnes of co2-e per year and pays a high tax rate (petrol tax is 38.143 cents per litre, excluding GST), while the stationary energy sector emits 306m tonnes of co2-e and pays no environmental tax. A $30/tonne carbon tax could be introduced as a replacement of the fuel tax – effectively reforming our environment tax so as to have a lower level on a broader base. Such a policy could be seen as good tax policy, irrespective of the environmental arguments.

The real-world consequence of this would be more expensive electricity, offset by cheaper petrol prices.

The impact on the budget would be roughly neutral. The impact on economic efficiency would be roughly neutral, as both taxes create a similar level of behavioral response. The impact on equality would be roughly neutral, as the policy replaces one regressive tax with another regressive tax.

One complaint against a switch from a fuel tax to a carbon tax is that the lower emissions from electricity generation will be offset by higher emissions in the transport sector. While this is true, it confuses the means with the ends. The goal of a climate change policy should not be to reduce the use of electricity or transport (both of which have brought significant benefits to society), but to create an incentive for people to research and invest in alternative energies so that we become less reliant on ‘dirty’ coal. A switch from a fuel tax to a carbon tax provides that incentive in a way that is relatively harmless to equity, efficiency or the budget.

Climate change is becoming an increasingly important part of Australia’s political debates. But if we are serious about tackling the challenges of climate change in an intelligent way, we need to get past the easy promises of just “doing something” and work out which policy approaches provide the most benefits and least costs to Australian society. As a free-market economist with a passionate belief in low tax and small government it pains me to say this – but the best option we have is the introduction of a modest revenue-neutral carbon tax.

5 thoughts on “The free-market argument for a carbon tax

  1. London to a brick the tax revenue gets diverted into subsidies, but you are right that it should go to the TFT, and matching welfare increases and then off the balance of the tax rates.

    I suppose the tax needs to be set to make existing alternatives immediately competitive or nearly so, otherwise there is too much lag in the emissions reductions.

  2. When I looked into alternative energies it seemed that they were getting more price competitive as time went on. I think it would probably be better to set the tax so that the alternatives weren’t quite competitive yet and give ourselves 10-20 years or so to make the transition. This way we aren’t immediately writing off millions of dollars worth of infrastructure.

    $30/tonne co2-e is about right I think. That puts a few alternatives (eg nuclear) within striking distance… but not quite as cheap as “dirty” coal.

    The big difference between “tax & spend” and “tax & tax-cut” isn’t a distributive issue… but an efficiency issue. All taxes create inefficiencies. By linking a new tax with the reduction/removal of an old tax, this helps offset the efficiency problem.

    I like the carbon-fuel tax swap in part because it is not a regressive tax swap (as a carbon-income tax swap would be). And as transport & electricity both contribute to the underlying costs of everything else, a carbon-fuel tax swap will not feed through as generally higher prices.

  3. Freud Lives On…

    By getting an economist to propose a system to combat “global warming”, we are being pulled into accepting the whole thing – without discussing it directly. Sales people call this “involvement” i.e. “Mary, which room would become your bedroom?” They haven’t decided to buy the house yet, but the salesperson won’t let that stop the sales process.
    How come nobody (except 1 comment that someone posted) remembers Ice Age(s)? Even after 3 (three) movies with this name in the last 4 years! During the last Ice Age more than half of Europe was covered by ice sheets – not some snow in the middle of winter, but serious ice sheets – like over some of Greenland and Antarctica today. And then, about 10,000 years ago, all that ice melted. That was one hell of a global warming, wasn’t it? And not a single factory on the whole planet. Not one car to blame it on. What caused that global warming?
    Is it not possible that same/similar forces of nature are at play again?
    The climate is changing – as it always did! Do we need to prepare and/or adjust for the changes? I think it is a great idea. But not by way of redistribution of wealth through either trading or carbon tax.

    What’s that got to do with Freud? Watch the 4 part doco series “Century of the Self” on Google Video.

    We are being sold something that we do not need.

  4. Sigh. Yes Andre, we know the climate always changes.

    But do you know that the government has been acting on the potential threat of AGW for 10 years already. And they are certain to do more. So you can hold hands and sing kumbaya, waiting for the messiah… but some of us would like to contribute to the real debate and argue for a relatively more free-market (and low-cost) action.

    The carbon-fuel tax swap would have a roughly neutral impact on the economy, on distribution, and on revenue. It is pretty much a “no-regret” policy.

  5. Pingback: Mangled Thoughts » Centre for independent studies demands imposition of Co2 taxes

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