2.4 Incidence of costs
Who will pay the costs of climate change policy is not immediately apparent. There are four critical points here:
- Who actually bears the cost is independent of who legally pays the tax or holds the permit.
- The incidence of cost and wealth transfers is exactly the same in a smoothly operating permit system with auctioned permits as in a tax system.
- Taxes are borne by those who engage in activities or consume goods that are associated with high emissions.
- Taxes are borne by those who demand products for which total demand is inelastic.
2.4.1 Who actually bears the cost is independent of who legally pays the tax or holds the permit
This is a standard result in public finance where markets operate smoothly. For example, suppose a wholesaler pays the tax. The wholesaler is unable to reduce the amount of carbon in its fuel and it faces competitive international and domestic markets in fossil fuels. It has to pass on the full amount of the tax to its purchasers. If the purchaser is a business facing a competitive market with a fixed price (set by an alternative producer who does not use carbon), it is not able to raise its price to consumers who can buy the same good from other non-fossil fuel using suppliers at the old price, and the purchaser will absorb the entire price rise on the fossil fuel it uses.
Alternatively, suppose the business must pay the tax on every unit of fossil fuel they purchase. If they reduce their demand for fossil fuel it will not alter the price offered by the wholesaler though it will reduce their total tax burden. Similarly, they are unable to pass on a price rise to their consumers. Again they bear the full cost of the tax on each unit of fossil fuel they use.
If the consumer was required to pay the tax on the amount of carbon “embodied” in the product, and they face substitute products without carbon, they will only buy the product if the price is the same as before and therefore the business must again absorb the tax.
The business will of course reduce the amount of tax it must pay by reducing carbon use until the cost of reducing carbon emissions by one more unit is the same as the tax.
2.4.2 The incidence of cost and wealth transfers is exactly the same in a smoothly operating permit system with auctioned permits as in a tax system
If permits are auctioned, every time a wholesaler extracts or imports a unit of carbon (in fossil fuel or other sources), she must buy one permit. The price of this permit will be equal to the tax that would lead to the same level of total emissions. Thus paying for the permit is exactly equivalent to paying the tax and the conclusion from the previous section, that the incidence does not depend on who must buy the permits, holds.
If permits are not auctioned, once they are allocated their effect is still like a tax. If a business emits one more unit it either needs to buy a permit at the market price or it forgoes the opportunity to sell a permit. Either way the emission costs them the same amount as the tax and they will pass part of the cost on and / or increase abatement depending on their elasticity of supply and the elasticity of demand they face.
The allocation of permits by a system other than auctioning is simply a wealth transfer and has no effect on incentives to abate and hence no effect on efficiency. It makes no economic sense to allocate permits to wholesalers who can pass on the costs and hence pay little of the tax or permit cost. This is particularly true when many wholesalers are foreign owned.
2.4.3 Taxes are borne by those who engage in activities or consume goods that are associated with high emissions
The incidence of a tax falls upon those who consume goods or services that ultimately required emissions to produce. Kerr (2001) demonstrates this for a petrol tax where she finds that those in middle income ranges will bear the highest tax burden.
2.4.4 Taxes are borne by those who demand products for which total demand is inelastic
In a tax system (and hence equivalently a permit system) when a business or individual faces a higher price due to the tax they can reduce their demand for the good and / or pay a higher price. If enough buyers can reduce their demands significantly, if for example there are close substitutes, the seller of the good will be concerned about losing their market and will be unable to raise the price as much. For example, if an electricity company faces higher input costs due to a rise in the price of coal they could try to increase the price of electricity but this may encourage people to be more energy efficient or switch to gas for heating and cooking. Thus the electricity company may choose not to raise the price too much but may try both to cut down their use of coal and to absorb the input price rise in their profit.
The businesses and people who will bear the highest cost from a tax on carbon are those with high demand for energy, who are unable to reduce their energy demand and unable to change to a less carbon-intensive fuel. If they are a business they will lose profits and may be forced to close down. Individuals may suffer noticeably lower living standards. It is extremely hard to identify who many of these people and businesses will be in the long run.
The costs of the carbon dioxide policy are both the costs of paying the tax and the real costs of abating use of carbon and products produced using carbon. The tax payments (or permit costs) are not a real cost to the economy because they are received by the government as revenue, but they are real costs to firms. The real costs of abatement are the deadweight losses caused by a reduction in the quantity consumed of the products whose production causes emissions.[3]
2.5 Revenue recycling
Both emission taxes and auctioned permits can raise revenue for the government. If the government can raise revenue while achieving an environmental goal it can reduce its need to raise revenue elsewhere. Kerr (2001) explains why reducing revenue raised through taxes elsewhere has efficiency gains for the economy:
Taxes on labour income and on capital cause inefficient distortions in behaviour. For example, with no taxes, wages will be equal to the marginal productivity of the worker (simplistic but roughly true). Each person will work until the value of the extra amount they produce is equal to the extra cost to them of working – their marginal utility of lost leisure. With a labour tax, this decision is distorted because they are paid only a percentage of the value they produce and thus will stop work sooner or choose not to participate in the labour force at all. This is socially inefficient because the social benefit of their work is unchanged, some benefit simply goes to the government through taxes.[4]
The revenue raised through environmental policy should be used to lower overall taxes, or for independently planned spending, depending on the government’s fiscal priorities. Adolf Stroombergen did some work on revenue recycling in New Zealand in 1994, and found that GST or income tax would probably be the best tax to cut.[5] Not claiming the revenue for government use exacerbates the competitiveness impacts of climate policy because the cost of carbon regulation is not partially offset by lower taxes or improved government services. Goulder et al. (1998) estimates that in the United States, if emission reductions are less than 23 percent, grand-parenting all permits rather than auctioning them would double the cost of the regulation because of the lost opportunity for revenue recycling.
For optimal efficiency, revenue should certainly not be used to compensate the sectors that are directly affected, as this would decrease the efficiency of the regulation and lower the environmental benefit. There may be an argument for transitional assistance, but an industry that fails when it faces the full costs of its activities is not economically efficient, and should not be propped up by the government in the long run. The revenue should also not be used to fund other environmental or carbon policies, which should be considered on their own merits and funded out of general tax revenue. This form of revenue is no different to any other and should be treated as such.
Nevertheless, politics may suggest the revenue raised is directed towards climate policies. Public perception of a carbon tax or auctioned permit system may be better if those who pay feel the money is being used for good climate policies. This could be a problem if tax revenue is very high. Under the proposed tax system, net carbon tax revenue from a $15 per tonne tax is estimated to be $660 million per annum. It could be very inefficient to commit such a large amount of money to climate policy. As a compromise, it may be desirable to visibly direct some of the revenue to environmental projects that are desirable in themselves. Some of the revenue could also be used for investments that improve adaptation to climate change.
There may also be a case for transitional assistance and retraining of workers affected by industries that are damaged by the policy. If, for social reasons, there are groups toward which the government would like to direct resources to maintain their standards of living as energy prices rise, such as the elderly, this can be done through increases in superannuation or improvements in health care and other services.
