Rebalancing Taxes - Eliminating The Carbon Externality

What I term "The Carbon Externality" is that cost being borne by current and future society as a result of greenhouse gas emissions, being produced over the past century or so at a rate that exceeds the capacity of the planet to absorb them without perceptible harm. Externality is an accounting/economics term for any cost that is borne by an external party, and therefore not part of the internal cost analysis. It is the fundamental flaw in Friedman economics and why those calling for small government are missing the point.

Government exists to account for and address externalities. Effective regulation of the market reduces or eliminates externalities so that the costs of doing business are increasingly borne by those who benefit from the business, in the form of reduced profits and higher end-user costs. Taxes are the principle mechanism for this. The existence of a well-educated and healthy workforce is paid for by both employers and the employed through their taxes, which fund health care and education. The same argument can be made for everything else that governments do - national security, policing and justice, the welfare state, transport infrastructure are all paid for through taxes because they provide benefits to people and businesses that they would not otherwise pay for.

So how do we address the Carbon Externality? I am not a fan of piecemeal tinkering at the edges, and ill-aimed taxes that encourage or discourage the wrong things. The fairest taxes are those that impose a flat rate that increases progressively with the rate of accrued benefit.

A recent report, as noted in The Guardian suggested that:

if all taxes on petrol are taken into account, the implicit carbon tax is £220 per tonne of carbon

I don't agree with the report's solution to use the VAT mechanism, but it is worth considering adopting the idea to put a carbon tax on all fossil fuels at source, coupled to an abolition of other taxes on them (including both fuel duty and VAT) and the one remaining direct subsidy (the deep field allowance). The tax should be designed to be revenue-neutral, but with a built in escalator to predictably ramp up the floor price of carbon so that businesses can plan for a carbon-free future.

The impact on petrol and diesel will be to lower the price, initially, which should make the move popular and give a boost to industries struggling under these volatile and rising costs. The continuing price disruption caused by peak oil supply will soon eradicate that incentive to keep driving ourselves to death, and other incentives can be introduced or extended to push forward the electrification of the vehicle fleet.

The costs will show up in gas and electricity bills, and we will need to make them more progressive - at the moment the higher rate per unit is paid for the first few units, with additional units charged at a lower rate. I suggest (not my idea) that we require the utilities to reverse this pricing structure for domestic users, providing the first few units at a lower than cost price, subsidised by higher prices for heavy usage. This will protect the energy-poor and incentivise the wasteful and profligate users to find ways to use less, including early adoption of the Green Deal.

For energy intensive industrial users, they have the scale and security of demand needed to be early adopters of renewable technology. A big rise to their utility bills, balanced by a drop in their transport bills, will give them a strong nudge towards seeking their own renewable supply. There are those that argue that any more energy costs on these intensive industries will drive them out of business at precisely the time we want to be supporting manufacturing. I agree that such industries are vulnerable, so I would suggest additional measures to assist with financing the innovation and investment needed to convert them to zero-carbon energy sources.

It should be noted that as a tax on pollution it is intended that the carbon tax eliminate the thing it is taxing, so revenue will fall over time if it successful, even as the rate at which fossil fuels are taxed rises. Therefore the escalator should be structured so that the tax rate rises in line with anticipated or budgeted emissions reduction under the climate change act, keeping the overall level of revenue static, or falling slowly and predictably.

Finally there is the issue of embodied carbon - imported goods manufactured in places with no mechanism to eliminate the carbon externality. It is not yet clear if it is permitted under WTO rules to vary tarrifs on imported goods for reasons of environmental protection. However, both the US and EU are considering such, and if coupled to an effective carbon tax, a clear price mechanism would permeate every buying decision we make, driving down emissions and cleaning up the global energy supply.