– Professor Richard Holden

The Prime Minister, Julia Gillard, recently announced that petrol would be exempted from Australia’s forthcoming carbon tax (sorry, “price on carbon”.) She declared, “Families, tradies, small business people do not have to worry about a petrol price increase.”

No doubt much will be said about the politics of it, but let’s talk about the economics of it. They’re not good, either.

There is a basic tradeoff here—an all too familiar one. A carbon tax internalizes externalities. That is, it forces people to make choices that take account, in this instance, of their impact on the environment. Why is this necessary? Because there are some things that aren’t part of the price mechanism, yet drive our economic choices. Pollution stemming from manufacturing is often not factored into the price of consumer goods, the price we pay for car registration typically doesn’t take into account traffic congestion, and so on.

What does a carbon tax do? If properly implemented, it internalizes these kinds of “externalities”—things that are not naturally part of the price mechanism. It makes people face the true prices—and hence consequences—of their individual decisions. Sounds perfect, right?

Not so fast. Some people will not be hurt very much by such a change, but some people will be hurt quite a lot—at least relative to their current incomes and expenditures. If there is suddenly a large tax increase on petrol and I walk to work, then that’s no big deal for me. If I drive a lot for my job (or for recreation), then that is a big deal. The Prime Minister apparently hears the pain of the latter group and has acted. That’s reasonable, in principle. There are distributional consequences of a carbon tax and she wants to mitigate them. Fair enough, no?

Too bad, then, that she has chosen the worst possible instrument with which to try and help. The whole reason for having a carbon tax is to change behavior—make people face the real price of their actions. Ms Gillard has chosen to exempt a large number of people from doing exactly that. It will significantly damage the effectiveness of the policy.

What she could have proposed, instead, was compensation for groups most likely to be affected by the carbon tax. Give them lump-sum compensation like a $1000 annual tax credit. Isn’t this the same thing? No, it’s not. Compensating people helps alleviate the hardship imposed, but still gives them the incentive to make personal choices about (say, petrol) consumption faced with true prices. The downside is that we can’t compensate everyone perfectly with tax credits. And there’s the rub. If you exempt the very users of something that isn’t priced then a tax has zero effect. If you don’t compensate the users to some degree, then they get hurt.

One might worry that compensation like this could be taken back in the future, but so could the proposed exemption. And moreover, Australia has proven very effective at maintaining compensation once in place when it’s the right thing to do.

There is an inherent tradeoff between economic efficiency and distribution. We shouldn’t fail to acknowledge it. And we shouldn’t inflict significant harm on certain groups—like tradespeople and farmers—simply because it is “economically efficient”. But we also shouldn’t enact a compensation scheme that undoes the whole point of pricing socially costly activities in the first place. That’s clearly bad economics, but it’s also bad politics.

Richard Holden is Professor of Economics at the Australian School of Business, University of New South Wales.

A version of this opinion piece appeared in the Australian Financial Review 11 July 2011.