More on Revenue Neutrality

     Since my last post I've been trying to make sense out of the idea of revenue neutrality and why anyone would think it a desirable quality in any tax, let alone one like a carbon tax which is intended to provide an active incentive to shift away from fossil fuels. I have found two ideas plausible.

     The first is that someone has co-opted the concept of revenue neutrality from its original context. There are, after all, situations in which you want a particular set of options to be revenue neutral. 

     For example, suppose you run a small business as a corporation of which you are the owner and sole employee. You have a couple of options as to how you might take your compensation. You can have the company pay you a salary, which is deducted from the company's revenues as an expense so the company doesn't pay corporate income tax on it, but it means you have to pay personal income tax on your salary. Or, you can have the company pay you no salary as an employee, but issue you as a shareholder dividends on its profits. (Or you can use some mix of the two methods.) There may be all sorts of considerations you take into account in deciding which way to go. Maybe you want the company to buy some equipment, or maybe you expect to be able to sell the business to someone else in a couple of years, or maybe you need to establish a particular salary to qualify for a credit card or something. But your choice of method shouldn't make a big difference to your tax bill: we want the choice between paying a salary and paying a dividend to be revenue neutral in that respect. 

     There are a whole lot of similar scenarios in which we don't want tax consequences to  unduly influence a person's decisions, and so we need to design our tax regime to be revenue neutral with respect to those sorts of decisions.

     Notice, though, the context in which revenue neutrality of this sort applies. It doesn't apply to overall revenue, just the revenue consequences of a particular set of options for a given taxpayer or group of related taxpaying entities. Presumably, the government would be happy if the business prospered, made more money and ended up paying more taxes as a result. Indeed, that's part of why these particular choices should be revenue neutral; for the business to prosper, it should be making its administrative decisions on solid business reasons, rather than trying to figure out the best way to keep more of the money it's already earned. Encouraging it to favor dividends over salary or vice versa doesn't really help it to be more productive in the future. If you want to encourage them to invest more in new equipment or hiring more staff, it makes sense to give them those incentives regardless of whether they're paying dividends or salaries. There shouldn't be rewards or penalties for doing things that make no difference to the state's interest in promoting prosperity. So making these sorts of choices revenue neutral in the immediate instance is arguably part of a policy to increase revenue overall in the future.

     So I suspect that the term "revenue neutral" derives some of its appeal from the fact that it's often used in discussion of this sort of tax policy problem. And, as a term perhaps vaguely remembered as something tax policy experts treat as a desirable feature, it makes the objection that a carbon tax is not revenue neutral more informed and credible than just complaining "it makes you pay more taxes!" 

     The other way in which revenue neutrality might make some sense in the context of a carbon tax is when it's structured simply as a complete internalization of the externalities. As I argued in the previous post, the harmful impact of carbon fuels on climate is a cost that is paid by everyone, while only the consumer of the carbon fuels enjoys the benefit; that cost is external to the balance sheet of the consumer, and doesn't really factor into their buying decision. The carbon tax is intended to make the consumer pay a price that more accurately reflects that externalizer cost, thus encouraging them to use less carbon. 

     But that's only half of the externality equation. Ideally, the revenue from the carbon tax would be going to compensate those who are affected by climate change, in proportion to their losses. Failing that, it could go to funding efforts to reduce or avoid the damage. In an ideal world, the carbon tax would raise exactly enough money to make it all work out, either fully compensating the victims or fully preventing the damage. And, of course, if the costs of remediation or compensation are exactly equal to the revenue raised by the carbon tax, then in principle it's revenue neutral.

     If you see the entire purpose of a carbon tax, then, as redistribution of the costs of carbon emissions back to the people doing the emitting, then ideally, yeah, it should be revenue neutral as a broad first approximation. Person A inflicts an externality of $50 on person B, so government taxes person A $50 and gives it all to person B. Obviously there will be some administrative costs along the way, so it might not be perfectly revenue neutral, but close enough.

     The reason I reject this argument, though, is because it ignores the value of the shared resource itself: the carbon sink, our planet's capacity to absorb our carbon emissions without harm by growing plants or forming the calcium carbonate shells of sea creatures or whatever. A person who releases carbon into the atmosphere has a responsibility to ensure they don't thereby cook the planet, and ideally can use a little bit of the carbon sink to do that. But the sink can only absorb so much carbon in a given year, and so it's a scarce resource, one that can be rationed the same way we ration most other scarce resources: by pricing it appropriately. 
     A private owner of the carbon sink would be justified in charging a fee for its use, and earning income on that asset. A prudent manager would reinvest some of their revenue in efforts to preserve the asset's usefulness in the future, but there is no reason why that private owner should be expected to structure their fees to be revenue neutral. Of course, the carbon sink does not belong to any one person, but it is a valuable and scarce resource nonetheless, and one that the Crown therefore ought to manage on behalf of its collective owners (i.e. everyone). And our collective interest in it is no less than that of any single private owner would be: we should want to earn as much profit as we sustainably can from it. So we should want the government to charge a carbon tax on it that generates lots of revenue from it.
     Importantly, this principle applies independently of the whole externality concern; if the price of carbon is kept high enough that carbon emissions are kept low, there is no need to compensate those who don't suffer the consequences of a climate change that never happens. If we had started charging an appropriate fee for the use of this scarce resource many years ago, we could have avoided our current peril. 

Some Invalid and Irrelevant Criticisms of the Carbon Tax

     An ad opposing Canada's carbon tax came across my Facebook feed the other day, sponsored by the Fraser Institute, and I'm going to unpack it here. This is the original image:

     As you can see, the ad objects to the carbon tax on four criteria: that it's not revenue neutral, that it doesn't replace existing regulations, that it doesn't reduce other harmful taxes, and that it doesn't fund subsidies to alternative energy sources. These are all silly and irrelevant objections, which I'll address in turn. 

Revenue Neutrality

     Whenever there's talk of a new tax or indeed any change to the tax system that isn't a straight up tax cut, the anti-tax crowd likes to insist that it should be "revenue neutral", meaning that it shouldn't change the total amount of revenue collected by the government, as if somehow the government is currently making exactly the right amount of revenue and should avoid disturbing this perfect balance.

     The carbon tax is a new tax on fuels that emit carbon dioxide into the air. The basic idea is that emitting carbon creates what economists call an externality: a cost of an activity that is not reflected on the balance sheet of the person choosing to engage in the activity. Someone else ends up paying the cost. In the case of carbon emissions, someone who chooses to burn a fossil fuel enjoys the benefit of the energy, but the cost (in terms of increased greenhouse effect and the resulting climate change) is borne by everyone, and not equally. In economic terms, the problem with an externality is that it distorts the decision-making process; the agent making the decision doesn't have a full measure of costs and benefits on their balance sheet.

     So the purpose of a carbon tax in this case is to change that calculus by making the price of carbon a little more reflective of the true cost, with the hope that people will shift their purchasing choices accordingly. Just like you might find yourself eating more bread if the price of potatoes goes up.

     What, then, would be the point of making a carbon tax revenue neutral? None, really. If a blight makes potatoes scarcer and thus more expensive, the grocery store does not reduce the price of bread for the sake of revenue neutrality. Potatoes just get more expensive, and so people start buying more bread instead. That's how markets work, and incidentally that's why the carbon tax is generally preferred by economists as a more free-market-friendly approach to the problem.

Replacing Existing Regulations

     There's a certain amount of sense here, if you consider the regulations in question to be straightforward restrictions on how much carbon you're allowed to emit. After all, ideally the increased price of carbon fuels should encourage people to use less simply out of economic self-interest, with no need for minimum fuel-efficiency standards.

     Except that regulations exist for a whole lot of reasons besides simply encouraging fuel efficiency. There are regulations requiring, for example, that diesel and gasoline pumps be clearly marked and identified as such, because you can do a lot of damage putting one in a vehicle designed to use the other. I suppose if you're paying more for fuel you might be extra careful not to waste money buying the wrong kind, but it seems unrealistic to hope that might be enough.

     It's entirely possible, of course, that there are regulations which are indeed rendered unnecessary by a carbon tax, and of course such regulations probably should be repealed. But that's only a valid criticism of the obsolete regulations, not the carbon tax itself. It's not the fault of your new refrigerator that you can't be bothered to take your old one to the dump.

Reducing Other Harmful Taxes

     I feel like this particular complaint is just a sneaky way of counting the first one on revenue neutrality twice, because the only way to make the carbon tax revenue neutral is to reduce other taxes accordingly. But let's pretend it's an independent argument, one that doesn't try to pretend that current revenue levels are ideal.

     Let's agree, for the sake of argument, that other taxes are indeed harmful and should be reduced. (In general, I do not think taxes are such a terrible thing, but I'm sure there are some which really should be cut or even eliminated.) With respect to the carbon tax, though, so what? Why is it the responsibility of the carbon tax to address these other inappropriate taxes? There are all sorts of important and pressing problems that the carbon tax utterly fails to remediate. It doesn't improve literacy scores. It does nothing about electoral reform. It doesn't prevent bank fraud, drunk driving, shark attacks or plagiarism. SO WHAT? Neither does brushing your teeth.

     Want to reduce other harmful taxes? Fine, have at it. But you can do that whether or not there's a carbon tax in place to try to combat climate change. Sheesh.

No Subsidies to Alternative Energy Sources

     Of all the criticisms, this is the one that actually makes the most sense. Yes, it actually would be good if some of the proceeds from the carbon tax went to either subsidize alternative energy sources, or to compensate the people most affected by climate change, the people paying the true cost of the externality. (In fact, the Alberta provincial carbon tax does fund programs aimed at facilitating the transition to other energy sources, but let's pretend it doesn't for the sake of argument.)

     But this is not an argument against having a carbon tax. A carbon tax is a carbon tax; what you spend the revenue on is a separate question. The tax end of the equation works regardless of what you do with the money, because it encourages people to shift their consumption away from fossil fuels by raising the price. Indeed, that in itself is a kind of indirect subsidy of alternative energy sources, because it makes them more price-competitive.

     I can't help but feel there's something a little disingenuous about the Fraser Institute objecting to a carbon tax for failing to offer subsidies to alternative energies. The other three (two) criteria are all consistent with their ideological concerns of reducing taxes and regulation, and it seems to me likely that if someone were to propose, independent of any carbon tax, that we should subsidize wind or solar power, they would object. And they'd object to adding a carbon tax to pay for it, since apparently they think a carbon tax ought to be revenue-neutral.

     It doesn't really seem like they're arguing in good faith.