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Markets can’t tackle climate change on their own

Canada’s new Ecofiscal Commission, chaired by McGill University macroeconomics professor Chris Ragan, has a mandate to propose reforms to the fiscal system that reduce pollution and environmental damage while also increasing economic efficiency.

The core idea is to move towards a polluter-pay approach, whereby environmental costs are reflected in the market prices of economic activities. By taxing polluting activities, eco-fiscal policies incentivize actions that reduce harm to the environment and generate new revenues that could be used to reduce other taxes.

The commission is composed of 12 leading mainstream economists, advised by a board that includes prominent former political leaders (Paul Martin, Jean Charest, Mike Harcourt, Preston Manning, Bob Rae); several business leaders, including Suncor Energy CEO Steve Williams, and environmentalists such as Peter Robinson, CEO of the David Suzuki Foundation.

The fact that such a prominent commission has been launched is certainly good news from a progressive perspective. It puts the key principle of polluter-pay squarely at the heart of the policy agenda, and may break a political taboo in Canada when it comes to talking about pricing carbon in particular.

That said, the first discussion paper launched by the commission shows excessive faith in the power of markets alone to solve environmental and economic problems. It merits a critical but constructive response.

The commission’s discussion paper quite appropriately recommends “incorporating environmental costs into market prices … thus spurring firms and households to find innovative and cost effective ways to reduce pollution.” It provides a number of successful examples and case studies of this concept at work. British Columbia’s carbon tax, for example, has significantly reduced greenhouse gas emissions compared to other provinces while its economy has grown at about the same rate since its introduction.

The paper, however, has a strong and questionable overall bias towards recycling the proceeds of polluter-pay taxes towards matching cuts in personal and corporate income taxes that are alleged to discourage paid work and investment. Such recycling of revenues, the paper claims, simultaneously promotes both economic and environmental gains: “Ecofiscal policies can generate revenue that creates space for governments to reduce costly taxes on employment, income and profits.”

It is noted in the report that polluter-pay revenues could be recycled into subsidies to promote reduced pollution and positive environmental change, and into public investment and supports for infrastructure and new technology. However, the assumption is that tax changes along polluter-pay principles are generally sufficient to drive innovation and change through the market — without the need for government intervention. Regulation is seen as appropriate only “when critical thresholds or extreme damage from pollution exist.” Subsidies are also frowned upon because they are seen as a more expensive means of reaching the same goal.

Summarizing the overall approach, the paper states that: “Ecofiscal policies use market forces to align economic and environmental objectives, creating incentives for conservation. They also enable reductions in other, more distortionary and growth-retarding taxes. For both reasons, ecofiscal policies are more cost-effective than other policy approaches such as direct regulations and subsidies.”

While the strong endorsement of the polluter-pay principle is welcome, the commission places excessive faith in the power of markets and unduly minimizes the key role that must be played by governments in the needed transition to a more equitable and environmentally sustainable future.

The claim that personal income tax and its progressive rate structure discourages work is not well-founded — as indicated by the very high proportion of Canadians who participate in the paid work force and by the fact that many part-time workers are seeking full-time work. While personal income tax rates are higher in Canada than in the United States, the employment rate here is also much higher. The key labour market problem in Canada today is high levels of unemployment and under-employment in insecure and low-paid jobs — not supposed disincentives to work flowing from income taxation.

Marginal tax rates on top incomes were cut significantly in the 1990s, particularly through generous tax treatment of capital gains income, and are far below their levels in the 1950s and 1960s when growth was much more rapid. Thomas Piketty and others have argued that there would be very little economic cost arising from significant increases to top personal income tax rates.

Similarly, the claim that current corporate tax rates discourage investment flies in the face of the fact that rates have been deeply cut in recent years, with no corresponding increase in corporate investment that remains below pre-recession levels. High after-tax corporate profits have been used to increase dividend payouts to shareholders and have led to the accumulation of more than $600 billion of “dead money” in corporate cash reserves.

The argument that all revenues from polluter-pay should be used to cut personal and corporate taxes is not well substantiated in the paper, and ignores the reality that governments badly need additional resources to fund already inadequate social programs and public services. This is especially true in the context of an ageing society and in those provinces still running significant deficits. The International Monetary Fund, for example, has suggested that environmental levies such as carbon taxes can be used to generate significant new revenues so as to avoid spending cuts to deal with high levels of public debt.

The principle of revenue neutrality by recycling polluter-pay revenues to tax cuts would, if implemented, undermine the fiscal base that is needed to fund major new public investments undertaken as part of an overall environmental policy. Instead, some significant part of polluter-pay revenues should be used to finance related environmental investments. In a poll conducted last year by the Broadbent Institute, a clear majority of Canadians were in favour of paying a new yearly tax if the proceeds were used to fight climate change.

Most serious attempts to develop a policy framework to deal with climate change, for example, stress the need for a combination of carbon pricing, public investment and regulation, rather than exclusive reliance on the former. See, for example, Part III of therecent 2014 assessment report of the Intergovernmental Panel on Climate Change (IPCC) regarding the mitigation of climate change, and one of the final reports of the National Round Table on the Environment and the Economy (NRTEE), ‘Framing the Future’.

For example, it is clear that the reduction and eventual elimination of carbon-based sources of electricity generation involves a major shift to renewable sources of energy such as wind and solar power. While carbon pricing can play a considerable role in making coal, oil and gas less competitive in the market for sources of power, in practice the development of alternatives has involved major government investments in new technologies, as well as interim measures such as favourable feed in tariffs and direct subsidies to producers of alternative energy so as to give them an initial market.

As Mariana Mazzucato argues in her book The Entrepreneurial State, government support in Germany has allowed wind and solar to scale-up rapidly and significantly reduce costs over time. Such a major change in energy systems never would have happened without major government intervention in the market going far beyond just sending a price signal to producers and consumers. Change would have been much less rapid if it were based on carbon pricing alone.

The oilsands industry itself, in fact, was the beneficiary of strategic government investment and massive subsidies, and many now argue a similar activist approach from government is needed to make Canada a clean energy power.

To give another example, a carbon tax levied at the consumer level would raise gasoline prices and thus create an incentive to purchase more energy efficient vehicles and cut back on unnecessary travel by car. But a major transition also would require investment in public transit on a massive scale. Households are more likely to accept a carbon tax if transit alternatives are available as gasoline prices begin to rise significantly, which means that the investments must be made in advance of a large tax increase. Similarly, few consumers will buy plug-in or hydrogen-fuelled cars until there is a basic infrastructure for refuelling in place to allow for a reasonable level of mobility.

The key point, then, is that major economic and environmental transitions — such as a shift to renewable energy and to more energy-efficient forms of personal transportation — will require significant new public investments that must be financed from borrowing or from taxes, including environmental charges. Governments have an essential role to play in shaping and creating markets of the future.

The IPCC and the NRTEE reports also suggest a more significant role for subsidies and regulations than does the discussion paper of the Ecofiscal Commission. Most experts would agree that vehicle fuel efficiency requirements and energy efficiency standards in building codes have helped reduce the carbon footprint of automobiles and home heating respectively. Higher fuel prices alone will not necessarily drive significant behavioural changes — especially if the initial price change is small and consumers lack knowledge about the alternatives. The federal government’s eco-energy retrofit program was successful in prompting consumers to refurbish homes for greater energy efficiency since it gave them access to subsidized expert assessment and advice.

Environmental tax measures alone may have limited impact if the resulting revenues are directed to tax cuts, rather than to the needed subsidies and investments that support environmental transition.

One of the problems involved in following two different priorities at the same time — polluter-pay and tax cuts — is that policy-makers may avoid environmental taxes that generate only modest revenues and promote those that generate the most revenues. But is has to be borne in mind that an environmental tax that raises significant revenues is likely to be one that is having only a limited impact on pollution. Conversely, an environmentally-effective tax will generate little revenue. If we tax some specific pollutant such as carbon so heavily as to result in very little consumption, tax revenue will be negligible, whereas it will be most significant if there is little or no reduction of high levels of emissions.

Good environmental policy must involve some combination of polluter-pay, regulation, subsidies and public investment. This means that the preferred option should be for any polluter-pay revenues to be directed to the funding of new public expenditures rather than to cuts in existing taxes. This is particularly the case when it comes to carbon reduction, where there is a clear need for very rapid and major changes to energy systems, industrial processes and the built environment (houses, buildings and roads).

Turning finally to the equity dimension of ecofiscal policies, the commission paper argues that environmental tax revenues can and should be recycled in part so as to protect vulnerable populations against the impact of price increases. While this is entirely appropriate, it raises the broader question of who should be protected.

Some parts of the population obviously will be worse off in terms of their ability to consume since the commission proposes to cut corporate and not just personal taxes. Their call for a recycling of revenues to personal income tax cuts could be interpreted as support for a cut to effective tax rates across the income spectrum, coupled with some narrow targeting to the poor.

The question is whether higher-income earners should be cushioned against environmental charges to any significant degree, since resources are limited — and since those higher-income consumers account for a disproportionate amount of the consumption that drives pollution in the first place. The carbon footprint of the rich is much greater than that of the poor and the middle-class. A better general principle to adopt would be that polluter-pay taxes and any changes to other taxes should, as a combined package, diminish rather than increase income inequality. Indeed, given the high levels of public angst regarding income and wealth inequality, correctly positioning the commission’s eventual recommendations with respect to this issue will be critical.

The Ecofiscal Commission plans to launch a discussion of how to bring the principle of polluter-pay to bear on economic and environmental policy in Canada. They are right to underline that environmental taxation and charges can play a major role in moving us forward. A rational discussion of carbon pricing is particularly important if we’re to grapple with the pressing issue of climate change.

But progressives must be critical of the view that revenues from environmental taxes should be recycled almost exclusively into personal and corporate tax cuts, given the need for a major scaling-up of public investment to deal with such pressing issues as inequality and the associated need to expand public services and social programs. Effective environmental policy will require a combination of tax measures and government investments that will have to be financed.

Economist Andrew Jackson is senior policy advisor to the Broadbent Institute

This article originally appeared at

Photo: senor_codo. Used under a Creative Commons BY-SA 2.0 licence.