All of us boneheaded economists are convinced that there should be a price on carbon. This is such basic economic theory that there is not much room to argue. Almost all of us think a carbon tax would be better than a cap and trade system. Most of us think that a very well-designed cap and trade system could do as good a job as a carbon tax.
So most economists thought at first that the proposed Ontario cap and trade system might work , providing it was very well designed. Here is why most economists will end up thinking the the Ontario Climate Plan was born dead.
To work, the price on carbon has to be high enough to change behaviour a lot. “A lot’ means the price is high enough to convince most people to stop using gasoline cars and stop using natural gas for heating. Transport and heating release something like 2/3 of the CO2. The price needed to significantly change behaviour is over $100 per tonne of CO2. The starting point under the Ontario Plan may be as high as $18 per tonne.
That level is totally ineffective. Worse yet, it sets public expectation that the price will stay low. For a price signal to work it is absolutely necessary to tell consumers that the price will reach $100/ tonne SOON. People wills start planning to buy an electric car, start thinking about insulating their houses, start thinking about installing a heat pump WHEN THEY KNOW IT IS GOING TO MAKE A BIG DIFFERENCE FINANCIALLY soon. The government has to announce that the prices of carbon fuels are going up a lot and it will happen soon. Without that announcement the Climate plan will not change behaviour nearly enough, and it will not work.
It is not enough to SAY the price will go up. The government has to be believable. The government has to COMMIT to raising the price to to a shocking level. There is only one way that the government can make a CREDIBLE commitment to raise prices on such an important set of commodities so much that it transforms the market.
The government has to give the money back to the people.
Only by returning all the revenue to consumers can the government avoid a huge public backlash. If the money does not go back to people, the government will not be able – read that as will not have the political backbone – to raise the price enough.
Giving all the revenue from a carbon tax back to the taxpayers is the only way to get the political room needed to push the tax to the level we need.
If the money goes back to taxpayers will actually make many better off. To show why, we need some of those infamous indifference curve diagrams that we economists find so revealing and most others find so obscure. The basic argument is pretty simple, though. If we raise the price of gas and keep all the other prices the same you are really poorer. If we give you the gas tax back, you would be able to buy just as much gas as you bought before the tax was imposed. By this argument, if we give the tax back to you, you cannot be poorer. You can buy the same bundle of goods you bought without the tax.
But stop and think for a moment. Now gas is relatively more expensive and other goods are relatively cheaper. You might want to cut your spending on gas and buy more other goods. It would be your choice, but if you changed your consumption bundle it would be because your thought the change would make you better off.
There are several other good economic reasons why a high carbon tax returned to the people makes the people of Ontario better off, but let’s save the rest of the economic analysis for another day.
The point is that people will complain about the carbon tax, but they won’t suffer from it. That makes it relatively easy to keep the tax in place or even raise it. Furthermore, once the money is handed back to taxpayers, it is nearly impossible to cut the carbon tax. Writing the first carbon dividend checks locks the government in. It provides a credible commitment that the government will not back out.
The Ontario government decided to start with a very low and very incomplete carbon tax (with a very expensive collection system called cap and trade). It will have very little effect. Then the government decided to spend the money it collected. I doing this it painted itself into a corner. It will find it very hard to raise the carbon price. It will find it impossible to say we will go to $100/tonne (or higher. In other words the Climate Plan has already failed. Ontario cannot get to it needs to be with this “Plan.”