Distributional implications of a carbon tax

This post was written by Richard Tol

In a paper just published in the ESR, Verde and Tol study the implications of a carbon tax across the income distribution. The paper by and large confims previous work (Callan and others being the most recent). A carbon tax is markedly regressive. It disproportionally hits poorer households. That said, the scale of the carbon tax is modest (euros per week) and small relative to income taxes and benefits. That means that the distributional damage can easily be repaired (should our dear leaders be so inclined).

The paper adds to previous research by also quantifying the indirect effects of a carbon tax. (This was last done by Cathal O’Donoghue for 1987.) A carbon tax increases the price of energy (direct effect) and thus of everything else (indirect effects). The paper shows that the indirect effects are small relative to the direct effects, and thus hardly affect the regressivity of the tax. The paper also shows that a carbon tax abroad would have a similar impact on Irish households again.

16 Responses to “Distributional implications of a carbon tax”

  1. Paul Hunt Says:

    @Richard,

    Many thanks to you and your colleague for this very useful research. My principal concern is that, since this is a tax on a “bad” (CO2 emissions) and the objective, presumably, is to reduce the production of this “bad”, this tax is unlikely to achieve this objective - and in your analysis I note you have assumed no impact on demand or supply. My understanding is that this means that the impact on CO2 emissions will rely totally on how the net revenue generated (once distributional impacts are addressed) will be applied to abatement. It is also my understanding that lower income households tend to have higher energy intensity per capita - presumably because they lack the wherewithal to invest in energy consumption reduction. Therefore there seems to be a strong case for applying the net revenue generated in energy consumption reduction investments among the lower income deciles.

    I am sure you recognise that, in these straitened times, there is a risk that the Government will see this tax as a purely revenue raising exercise and that, even if some effort is made to address the distributional effects, there will be a reluctance to apply the net revenue to energy and carbon reduction initiatives - which appears to the principal way this “bad” will be reduced.

    In addition, while energy prices appear to be much higher than those of Ireland’s major trading partners, I have my doubts about the sense of imposing an additional tax until the reasons for these differentials are addressed, as they comprise implicit taxes on enerhy. These excessively high prices provide consumers who can afford to do so every incentive to reduce energy consumption and, thereby, their CO2 emissions. And the implicit taxes on energy include an implicit tax on carbon. Do we need an additional explicit tax when there is no quarantee that the net proceeds will be used to abate carbon emissions?

  2. Sean Lyons Says:

    @ Paul

    The basic argument for a carbon tax is not simply that it will reduce emissions of CO2, but that it will reduce them by a socially efficient amount, in the least cost way. If the tax is set at a rate that leads to households and firms facing the full social cost of their energy use, the resulting emission levels will be economically efficient. This argument does not require recycling of tax revenues into efficiency subsidies; in fact, the economy will probably be better off if most recycling offsets labour taxes or VAT.

    The case for public support of efficiency programmes rests on other market failures, such as imperfect information about energy saving options, credit constraints or other impediments to investment that may affect some households (e.g. the fuel poor or those in public housing). There has been little research on how significant these market failures are in an Irish context.

    The Tol & Verde paper does not focus on the question of what CO2 reductions will result from the tax; they are interested in its distributional effects. I’m sure the authors would agree that a carbon tax will reduce emissions to at least some extent. Demand for energy tends to be inelastic, but households and firms will respond to higher prices. However, you are right to say that the level of other energy taxes is relevant in assessing both the impact of tax policies on CO2 emissions and the extent to which externalities of energy use are appropriately priced.

  3. Brian O' Hanlon Says:

    I didn’t know where to link this, but it is an article worth reading in any case. It is sort of relevant to this thread, as Fintan O’Toole compares our proposed investment in a dead Anglo Irish bank, which has no relationship with the ‘real economy’ to a proposed investment in telecommunications infrastructure and a green-er economy.

    http://www.irishtimes.com/newspaper/opinion/2009/0922/1224254981979.html

    O’Toole asks some interesting questions for the Green party to deal with, in their conscience.

  4. Paul Hunt Says:

    @Sean,

    I fully accept the validity of the points you make - I can do no other since they make perfect economic sense, but, in the context of energy pricing in Ireland, they are valid only if one assumes that the current pricing arrangements are consistent with, and lead to, economically efficient outcomes. Then, and only then, will a carbon tax lead to a socially and economically efficient outcome.

    My contention, specifically for gas and electricity, is that the current pricing and outcomes are far from efficient - and are, in fact, damaging and dysfunctional. I have provided Richard with evidence of the impact on gas and electricity prices of gloriously inefficient financing of network investment to which, unfortunately, he has not responded. Other factors also contribute to these inefficient outcomes and, while these are more contentious, sufficient evidence exists to demonstrate their malign impact.

    The de-integration of vertically integrated businsses and reductions in the market shares of previously dominant players are generally accepted as necessary to facilitate efficient and effective competition in electricity and gas, but the scale and size of the relevant markets is also important. When the relevant market has insufficient scale and size - as I would contend is the case for the all-island electricity and gas markets - the accepted process of liberalisation frequently bumps up against inherent economies of scale and scope and, for electricity, beneficial plant portfolio effects. A failure to take these into account - or to incorporate them in market design - inevitably leads to higher costs for consumers. And this, I would contend, is the case in Ireland.

    The relevant markets for gas and electricity are the markets on the islands of Ireland and Britain - as a precursor to further integration into the larger regional markets in North West Europe.

    In addition, even though a formal process of de-integration has taken place (separating electricity networks from generation and supply and gas networks from supply), the revenues of the electricity distribution network and of the gas networks are not ring-fenced - they flow into one corporate pot. There is no formal restriction on the subsidisation of unregulated activities from regulated activities. For example, BGE is able use surplus network revenues to subsidise its penetration of the electricity market, thereby penalising all gas consumers to subsidise the much smaller number of electricity consumers who switch.

    Finally, for the gas networks, the second gas interconnector (IC2) has little use and the entry of Corrib gas and LNG will render IC2 and, possibly, some of the capacity on the first (IC1) largely redundant. Gas consumers are paying, and will continue to pay, for this sequence of imbecilic investment decisions.

    All these factors comprise the implicit taxes to which I refer - and not the explicit taxes to which you refer.

    Until these implicit taxes are stripped out it makes no sense to impose an explicit carbon tax - however economically justifiable it may be.

  5. Sean Lyons Says:

    @ Paul

    Facilitating competition in energy markets is worth doing, but there is still scope for improving the efficiency of the tax system as things stand. The effects of a carbon tax relate to gas, oil and coal used in home heating and petrol/diesel used in transport. Electricity generation will be exempt. I doubt that the retail price effects from imperfections in gas markets could outweigh the benefits of switching from taxes on labour to taxes on CO2 externalities. A carbon tax will improve the match of relative prices on these different fuels to their relative social costs. We can still reap benefits if the relative prices of gas to the other fuels are not perfectly aligned, as long as they are better aligned than they were before.

  6. Richard Tol Says:

    @Paul
    I agree (and I’m sure Sean does to) that regulation of the energy sector could be much improved, and the same holds for transport. I also agree that imposing a first-best instrument on a second-best world may well lead to unexpected and undesirable outcomes.

    That said, the Irish tax system needs to be broadened and steadied. A carbon tax is a useful element in that.

    The current taxes etc on labour do much more damage to the Irish economy than a carbon tax can. A shift from labour to carbon tax would be a welcome stimulus to the economy.

    A carbon tax will also, in time, help rid the energy sector of a range of silly subsidies.

  7. JeromeK Says:

    @Richard

    “A carbon tax will also, in time, help rid the energy sector of a range of silly subsidies.”

    The main subsidies I am aware of are for the non-carbon generators such as Solar, Wind and Bio-fuel…

  8. Paul Hunt Says:

    @Sean, Richard,

    Many thanks for taking the time to engage on these issues. I take the point that gas, alone, is at the intersection of our posts, but, even if electricity is already covered by the ETS, the use of the ESB’s windfall in one year to reduce prices and its subsequent withdrawal is an absolute farce and there are genuine concerns about the extent of effective competition in the solid and liquid fuels markets.

    I am not contesting the requirement for, or the benefits of, a carbon tax - even if my preference is for the greater use of market mechanisms, but under tighter policy and regulatory control. Since the tax will be related to the traded price of EUAs I think we can have both/and.

    What baffles me is that the significant costs of inept policy, misguided and subverted regulation and ineffective competition do not get the research attention that I believe they deserve. It appears that this is left to “voices crying in the wilderness” like myself, who have no possibility of making any impact. Perhaps it has something to with the sources and allocation of research funding?

  9. Richard Tol Says:

    @JeromeK
    There are indeed subsidies for some renewables, but not for others. A carbon tax would level the playing field for all renewables.

    The main subsidies are for building insulation, however.

    These subsidies are all targeted at specific technologies and specific groups, at the expense of other technologies and groups.

  10. Sean Lyons Says:

    @ Paul

    As you probably know, the Competition Authority has commissioned (and done in-house) some research in this area, and there are international bodies such as DG Competition, DG EcoFin and the OECD who have an interest in it. There are certainly some researchers who would be happy to work on the effects/design of regulation if more funding were made available!

  11. Paul Hunt Says:

    @Sean,

    The CA is unlikely to have any impact beacuse the CER very jealously guards its statutory prerogatives. The various EU DGs and the OECD tend to poke their noses in only when something comes to their attention that they can’t avoid or, more usually, when they are invited.

    I suppose I should be pleased to hear that “(T)here are certainly some researchers who would be happy to work on the effects/design of regulation if more funding were made available!”, but the reality is that the major purchasers of consulting and research services in the Irish gas and electricity markets reside in the Quadrumvirate comprising the ESB, BGE, the CER and the DCENR. They have absolutely no interest in addressing the issues I am raising. Insofar as any work or research is commissioned in this area the ToR tends to be so tightly defined that there is no possibility of addressing the key underlying issues.

    This, on a much, much larger scale, is how the banking/regulatory/developer fiasco came about. There are none so blind as those who will not see.

    Good luck in your search for funds!

  12. Stefano Verde Says:

    As co-author of the paper in question, I’d like to emphasize the following (all remarks present in the paper): 1) The analysis does not allow for substitution effects, which implies the actual impact of the tax may end up being smaller than indicated, certainly not bigger; 2) Variability of the tax impact is very high in the first decile, which fact may distort the picture; 3) low income households have wider margins for carbon reductions, to be achieved through the use of less carbon intensive fuels and energy efficiency.

  13. Paul Hunt Says:

    @Stefano,

    I realise you’re trying to pull this thread back on topic. The points you highlight are well-noted, but I still think you and Richard are seeking to apply lipstick to a pig. Most R&C consumers realise that some form or other of price-gouging is being carried on in all of the energy sub-sectors, but, equally, most do not have the interest or detailed knowledge to identify how or why it is happening. Despite the demonstrable benefits of a carbon tax, one needs to be aware that the likely public perception of such a tax is to treat it as just another bit of government-sponsored price-gouging - and, therefore, to oppose it.

  14. Paul Hunt Says:

    For some time I have been somewhat mystified by the reluctance of ESRI staff (who, perhaps, among the staff of all Irish research institutions are most prolific in research on the economic aspects of energy policy) to address what I (and many others) see as major and damaging deficiencies in energy policy and regulation.

    Sean Lyons has indicated that lack of funding is a constraint. I can see why this may be a problem - particularly if one is relying on funding from those who are responsible for these deficiencies (or profit from them).

    However, I remained unconvinced that there wasn’t more to it than funding. My eyes were finally opened when a colleague drew my attention to the notice for an ESRI energy policy seminar next month. One of the papers is titled “Electricity prices in Ireland: are they ‘just right’?”.

    No further comment is required.

  15. Richard Tol Says:

    @Paul
    This borders on slander.

    Had you taken the trouble of reading our work, you would have noted that ESRI researchers are by no means uncritical of the way energy is regulated in Ireland.

    There are a number of reasons why electricity prices are too high in Ireland, and a number of reasons why they are too low. Simple comparisons to other European countries are biased as electricity prices abroad are probably too low.

  16. Paul Hunt Says:

    @Richard,

    The implied threat is not helpful.

    You have to admit that this statement on the ESRI’s web-site: “Energy research, organised in the Energy Policy Research Centre funded by a consortium of industry stakeholders and the Department of Communications, Energy and Natural Resources, [is] focused on the supply of electricity in Ireland” is bound to raise some doubt in the mind of an independent analyst attempting to raise a variety of energy policy and regulatory issues that, so far as it is possible to establish, have not been addressed in a comprehensive fashion.

    I am not, in any way, questioning the professionalism or integrity of ESRI staff - I regret that you have interpreted my comments in that way; I am simply alluding to the possibility that the source of funding may influence (and, perhaps, may constrain) the scope of the research agenda.

    My experience over a number of years suggests that there is little benefit in outlining the wide range of issues that, I believe, deserve attention, so it is probably best to leave things stand.

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