By Eoghan Murphy (Economics- Graduate Diploma)
[This essay was written for the Government, Welfare and Policy third-year undergraduate module. Students were tasked with writing a blog-style essay on a topic linked to a group poster project. Topics were chosen by students and reflect their own interests. The essay gave them experience of writing content in an engaging style for a non-expert audience. What you see below is one of this year’s top-marked blog-style essays. Christa Brunnschweiler]
How to tackle climate change efficiently and fairly
The need for meaningful action on climate change is increasingly urgent, as the Paris 2015 target of 1.5C warming looks like slipping away. Yet climate policy merely inches forward, held back by the fossil fuel lobby and political opportunists stoking public reticence about the cost of the ‘green transition’. Every proposed solution is decried as wasteful or unfair.
Can there be a climate policy that is effective, efficient, and equitable? Simple answers to complex problems are rarely, if ever, valid. However, there is a market-based, transparent, and fair solution to the existential challenge of climate change – a carbon tax and dividend.
The concept of a carbon tax is well-established but often unpopular, which is why the novel idea of returning its proceeds to taxpayers by way of regular dividends, universally, has gained increasing attention among policymakers, media and academics.
Economic efficiency and market failure
But wouldn’t economists reject government intervention on climate change, in favour of the ‘Invisible Hand’ of the market? Economic theory does indeed hold that the market will allocate resources efficiently. This is well-known. However, less well-known is the accompanying caveat – that the market will produce the optimal resource allocation only in a “first-best” economy. That means an economy characterised by perfect information, perfect competition, complete markets, rational behaviour, non-distortionary taxation, no public goods, and no externalities. Where one or more of these “first-best” assumptions doesn’t hold, there is said to be a ‘market failure’, and a case for varying degrees of government intervention can be made on the grounds of improving economic efficiency.
This brings us to climate change, which has been described as the ultimate market failure. This failure arises because carbon dioxide (CO2) emissions are a prime example of a negative externality – their environmental/social costs are not reflected in the market prices of goods and services. This allows companies, governments, and consumers to pollute freely, as their private cost of production or consumption (as the emitter) is less than the true cost (climate change). Therefore, faced with a clear market failure, government intervention is not only fully supported by economic theory, but is also compelled, considering the scale of that failure. The only question concerns the form this intervention should take, whether finance (taxation/subsidy), regulation or public production.
Government intervention – the case for carbon tax
The optimum approach to dealing with externalities is to impose a tax in place of the place of the cost not accounted for by the market. This is well-established in the taxation of tobacco and alcohol, for example, which are often subject to specific taxes to account for their negative societal spill-overs, further acting as a disincentive to consumption. In the case of CO2, a carbon tax – levied on each tonne emitted – would represent the missing price.
When compared to the alternative forms of intervention, a carbon tax has the advantage of comprehensiveness, speed, and predictability. For instance, subsidies and regulation face design challenges and monitoring/enforcement costs, while also lacking a consistent price signal and creating uncertainty for business (e.g., time-limited subsidies, ambiguous regulations). As such, they risk distorting incentives or even capture by special interests through lobbying. Public production, meanwhile, is not feasible given the breadth of industries that emit CO2.
If we finally settle on taxation as the means of intervention, we must consider whether the costs of intervention outweigh the benefits. Unsurprisingly, the answer is a resounding no. While a carbon tax may cause a slowdown in economic activity, this would be a short-term phenomenon and of modest scale where the tax revenues are recycled into the economy. By contrast, given what is at stake, the benefits of effective action to reduce CO2 emissions are immense. For an illustration of this, we need look no further than the latest report from the Intergovernmental Panel on Climate Change: “The cumulative scientific evidence is unequivocal: Climate change is a threat to human well-being and planetary health. Any further delay in concerted anticipatory global action on adaptation and mitigation will miss a brief and rapidly closing window.”
Carbon taxation and equity concerns
So, the justification for a carbon tax may be clear, but what about the proposed carbon dividend? If an economic case is to be made for redistributing carbon tax revenues on the basis of social justice, it needs to be established whether there are valid equity (fairness) concerns, and if they are serious enough to warrant government intervention.
Carbon taxes already exist in many countries, often in the form of taxes on transport fuels, and are generally perceived to be inequitable. It is true that carbon taxes are generally fully passed onto consumers, whether through higher prices or lower wages/profits. However, we must look closer to understand whether this tax burden is distributed fairly.
Who bears the burden of carbon tax?
Vertical equity
The fairness of a tax policy is typically assessed according to the distribution of the tax burden between income groups (vertical equity). A tax is regarded as progressive where the better-off pay more relative to income, and regressive where the less well-off pay more, relative to income. For carbon tax, this depends on the relative budget shares of carbon-intensive goods, such as electricity, heating fuels, transport fuel and food (especially red meat) for each income group.
A wide range of studies support the notion that a comprehensive carbon tax would be regressive, as the less well-off spend a greater proportion of their income on carbon-intensive products. This has also been shown to be the case with existing carbon taxes in France and Sweden, although the latter is progressive when measured against lifetime income.
Horizontal equity
Divergent outcomes within income groups (horizontal equity) are often overlooked in discussions of equity. However, this is a significant issue with carbon taxes, primarily due to differences in location (e.g., rural versus urban households) and equipment (fossil fuel- versus renewable-powered heating/electricity). Indeed, households living in sparsely populated areas have been found to have a higher relative carbon tax burden.
National characteristics
The equity implications of a carbon tax vary across countries, according to their socio-economic characteristics. The tax is likely to be regressive in high-income countries, where transport fuel is a necessity, but may be neutral or even progressive in lower-income countries, where car ownership is a luxury (see Box 1).
Research has also highlighted a strong correlation between the regressivity of taxes on transport fuels and levels of income inequality (see Graph 1). This is also likely to be the case for comprehensive carbon taxes, such that they would be most regressive in already unequal countries, thereby compounding existing inequities and potentially fuelling social/political unrest.
International equity
These inequities apply between countries too. A recent paper found that an EU-wide carbon tax would be regressive due to inter-country differences, primarily the high carbon-intensity of energy consumption (e.g., reliance on coal) in Eastern European countries such as Poland, Bulgaria, and Romania. Overall, the burden of carbon taxes falls more on average-income consumers in poor countries than on poor consumers in average-income countries.
Intergenerational equity
Finally, while a carbon tax today would disadvantage the current generation as compared to polluters of the past, this burden would surely be less than that set to be disproportionately borne by future generations in the form of climate change.
There can be no doubt then, that a carbon tax raises significant equity concerns, within and between countries. Government intervention for the purposes of social justice is thus entirely justified, but what form should this take?
Government intervention – the case for carbon dividends
The options for equity-enhancing intervention revolve around the use of the revenues generated from the carbon tax. Typical policy choices would include cutting taxes or reducing government debt, but these are generally regressive, with benefits flowing to middle and higher-income taxpayers. Additional public spending, meanwhile is an imperfect (and indirect) means of addressing inequity.
Accordingly, such policies risk undermining support for a carbon tax. By contrast, research has consistently shown that returning the tax revenues to citizens by way of regular, lump-sum carbon dividends, more than offsets the additional burden for low and middle-income households (see Chart 1).
Therefore, an equal dividend for all citizens would have the advantages of simplicity, transparency and, crucially, the potential for broad political appeal. Of course, this design could be refined according to a country’s social and political preferences. For instance, taxing the dividends or linking them to income would improve vertical equity. Addressing horizontal equity is more challenging, but efforts could be made to link dividends to factors such as geographic location or equipment ownership. Alternatively, a portion of the revenues could be retained for targeted public spending, similar to the EU’s Just Transition Fund.
All-in-all, this looks like a winning combination for the climate, and it is no pipedream – Canada is showing it can be done, with the proceeds of its new carbon tax being returned to citizens as quarterly dividends since July 2022. Time to follow Ottawa’s lead.
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