Carbon Tax: A Few Thoughts on Implications for Economic Growth and Clean Energy Investment Policies

(Written in response to article on thebreakthrough.org site: "Should We Swap Energy Subsidies for a Carbon Tax?")  

A carbon tax will impact the economy, with the directionality and extent conditional upon alternatives available to energy consumers, and the allocation of carbon tax receipts by the government.  In addition, increased taxation reduces the velocity of money in the economy, which reduces economic activity.     

The impact of a carbon tax on energy consumers depends on available alternatives and opportunities for switching.  In the short term, a carbon tax would have a negative effect on the economy, diverting financial resources away from household budgets, reducing discretionary spending, and reducing profits for businesses.  The effect of a tax on gasoline for consumers, for example, results in reduced driving, or reducing other expenditures.  Wealthy consumers can offset increased gasoline costs by purchasing a hybrid car, overcoming the increase in gasoline taxes.

Over time, leveraging market forces to identify and source lower carbon alternatives can be the most effective means to obtain the greatest return on deployed capital and resources.  If there are no lower cost forms of energy available, or capital for improving efficiency is limited, then the overall effect of a carbon tax will be reduced economic activity. 

A carbon tax is regressive, as economically disadvantaged people do not have the capital and resources to acquire lower cost alternatives, resulting in their otherwise being stuck with a higher cost life.  This points to the need for the government to dampen the negative impacts of the carbon tax. 

The choice of what the government does with carbon tax receipts is critical, informed by the potential economic pratfalls associated with instituting the carbon tax.  Overcoming the dampening effect of a carbon tax is accomplished by making lower cost energy resources available as well as loosening up capital resources to accelerate investments in improving energy efficiency and productivity.  A 5% carbon tax, for example, can be overcome by a 7% improvement in energy efficiency, for example, with the added 2% to cover capital costs. 

A 5% carbon tax may encourage certain switching behaviors, but as an incentive, is not sufficient to encourage investment in alternative energy technologies that have larger price/performance gaps.  For example, there was a time when wind turbines were three times more expansive than what is needed to compete on the grid.  A 5% carbon tax would really not be enough to encourage investment to bridge a 200% price/performance.  Hence, there is a reason for governments to participate implement policies targeting closing the price/performance gap on emerging clean energy technologies.  Wind and solar technologies, for example, have both benefited from favorable financial policies on the part of governments.  As such, in certain markets around the world, both wind and solar power technologies are achieving grid parity economies.  These cost reductions have been achieved by the government priming market demand, resulting in scale economies and continuous movement down the learning curve. 

In summary, it is not a question of swapping energy subsidies for a carbon tax.  It is recommended to have both policies, with receipts from a carbon tax providing energy subsidies to encourage lower cost alternatives, encouragement of investments in energy efficiency and productivity, as well as addressing regressive nature of the tax.