Economics Report

Markets began the new financial year tentatively. The Australian share market suffered its fourth negative month in succession, with the ASX200 index falling by 4%. The US market again did better, with the S&P500 index down by 2.1%.

Over the course of the month, the eurozone debt issue worsened as Italy and Spain seemed likely to get sucked into the vortex, but then improved when a further bailout package was agreed for Greece. As I write, the US debt issue—the raising of its debt ceiling—is ongoing. Politicians there are playing a very dangerous game. The Republicans want to raise the ceiling only slightly, so that the issue continues to hang over the US economy next (election!) year. Some resolution will be reached within a week, but this should all have been sorted out long ago. The issue now is that, even if an agreement is reached, the future cuts to the deficit that will be part of the agreement may not be enough to satisfy the ratings agencies, so US government debt may be downgraded anyway. This is, of course, a far more serious issue than a Greek default, for example. It would guarantee further turmoil in markets for some time.

The debt-ceiling impasse reflects the fact that US politicians are quite prepared to put their own or their party’s agenda ahead of the national interest. Thank God that could never happen in Australia! A default on US government debt remains a small possibility. This will not be good for markets if it does occur.

An Economist’s View: A Tax is the Best Form of Defence

In the past month, Australia got its first detailed look at the proposed carbon tax. I have refrained from writing about this before now because it has become such a political football and because we did not have the full details.

Here’s my view. If you believe the science—and almost all of the scientists do—then the world is warming up, human activity is at least partly responsible and the long-term consequences are catastrophic. This suggests that we should do something about it!

This issue is right out of an Economics textbook. In a free market, we get “too much” pollution simply because the polluter does not pay all of the costs some of them are borne by others. The way to fix this market imperfection is to internalise those costs (make the producer of the pollution pay). This is what a carbon tax does. Economic theory is very clear on this. If the objective is to reduce emissions of carbon dioxide (or, more generally, greenhouse gases) then far and away the cheapest (most efficient) way to do this is by means of a per unit tax (or, more correctly, a licence).

Of course, the pollution producer may pass on the cost to the consumers of the product, who are thereby worse off. But the revenue from the tax can compensate consumers (on average) for their loss of welfare. Consumers don’t have to be made worse off to reduce their energy-intensive consumption it’s the relative price (substitution) effect that persuades them to do so.

That’s the theory. It’s a no-brainer. In the real world, of course, it all gets far more complicated. There is a range of issues that must be dealt with. In the short run, what does one do about the capital losses from electricity-generating plants that need to be shut down? What about workers in areas such as the Latrobe Valley? If we proceed at a different pace from the rest of the world, what do we do about trade-exposed industries?

This is not intended to be a detailed critique of the Government’s proposal, which does at least address these issues. None of them is easy.

There is one thing that I would have done differently. I would not have excluded petrol (nor, for that matter, agriculture). Petrol is relatively cheap in Australia, mainly because it is taxed much less than in most developed economies. While fuel taxes frequently have other purposes, they are relatively efficient at reducing emissions (about 40% as efficient as a carbon tax per se). I understand the argument that we all drive, that an increase in the fuel tax won’t make much difference to consumption in the short term and that hence almost everyone will need to be compensated. The belief that nothing will change may be true in July next year it won’t be true 40 years from now. Over the years, we will move towards more fuel-efficient cars (and alternative fuels) we will change our driving and commuting habits, and even make different decisions about where we live and work. A multi-decade problem requires a multi-decade solution.

There has been much focus on the costs of reducing emissions. Official estimates of our costs of meeting the 2050 target is lower growth of income per capita of about 0.1 percentage point a year. OECD estimates for the global costs are similar. This is not a trivial amount. But what is always omitted from this calculation is the cost of inaction—higher sea levels, widespread crop failures, more extreme weather events etc. And even with lower growth, incomes are still expected to be significantly higher in 2050 than they are now world GDP is expected to increase by about 250% over the next forty years.

The fact that we are dealing with a global problem makes the issue that much harder, particularly since it affects the relationship between the developed and the developing nations. The latter have been responsible for most of the growth in emissions in recent decades as they have out-grown the developed world. The general view is that it is inequitable to hold them to the same standards in terms of proportionate reductions in emissions from the current level, since this would severely limit their ability to continue to catch up. But what then is equitable?

The other international feature is this: if the aim is to limit global emissions, then the most efficient (cheapest) way to do this is via a global market for emission permits. What this means is that, having committed to contribute a certain amount to the global reduction in emissions, Australia will purchase some of this reduction from overseas. Indeed, it is expected that about half of our commitment will eventually be bought from abroad. This immediately raises a red flag clearly the international policing mechanism will need to be strong.

There are two arguments against a tax that I find particularly specious. The first is that we are so small that whatever we do will make so little difference that we shouldn’t bother. While we are small, we have a relatively big global footprint, in part because we use brown coal heavily in the generation of electricity. More importantly, we didn’t use this argument when we committed troops to the World Wars, and nor should we have used it. Having a programme in place will at least give us some moral authority in the international negotiations that will continue on this issue.

Second, we are told that it is costly to us to move ahead of the rest of the world. But we are not doing this. More than 30 countries have an emissions trading system in place already, or are in the process of developing one. And more than 190 countries signed the (admittedly non-binding) Cancun agreement last December endorsing co-ordinated international action to address the issue.

Global warming—it’s a matter of degrees

Note that the worldwide emission reductions consistent with the Cancun agreement, and with the current Australian plan, will not halt global warming. It is estimated that they will only be enough to limit the further rise in temperatures to 2 degrees Celsius over the next 40 years. But this will be a lot better than otherwise!

Working to reduce emissions has a lot in common with saving for retirement. At age 25, the threat is distant and there are current costs in the shape of forgone consumption. But we all know it’s better to start then the costs only go up the longer one waits.

Chris Caton
Chief Economist

The views expressed in this article are the author’s alone. They should not be otherwise attributed.

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