Carbon tax compensation: too complex, too costly, or both?

The carbon tax debate is shifting towards compensation questions, whether for trade-exposed industries or households. Businesses are ramping up their demands for special treatment.

Minister Combet's Press Club lunch address last week suggests the Government's 'holding' compensation response at present is long on assurances and short on detail.

Those involved in the debates about Paul Keating's 'Option C' tax reforms (1985), John Hewson's Fightback! tax reforms (1991-93), or John Howard's New Tax System reforms (1998-2000) see a familiar feature emerging with the proposed carbon tax. This is the 'tax mix switch'.

For past tax reform exercises, the tax mix switch involved increased revenue collections from indirect taxes like the GST, and reduced income taxes. Household compensation for the effects of a revenue-neutral carbon tax seems headed down a similar path.

Such compensation needs careful design. Direct offsets to increased electricity bills, or petrol excise reductions to offset higher fuel costs, aren't sensible. They destroy the very price signals a carbon tax is supposed to send.

A carbon tax is intended to change consumer behaviour, assertions to the contrary by John Daley (Grattan Institute) notwithstanding. It does so by changing relative prices. Emissions-heavy product prices rise more than others. Taxing producers won't alter this reality because these imposts are shifted to Australian consumers, one way or another. Legal and actual burdens of taxes are very different.

Emissions cost subsidies offsetting emissions cost increases are just an inefficient way of doing nothing at all. But attempting to maintain total income purchasing power while shifting relative prices is sensible. That was a key feature of the three tax reform exercises noted above.

If a carbon tax increases the CPI, maintaining total income purchasing power requires an increase in the tax-free threshold for personal income taxes, and reductions in the tax rates sitting above that threshold.

There's a very precise formula prescribing these adjustments, summarised in Table 1 below for three illustrative assumptions about the net effect on the CPI of introduction of a carbon tax.

This formula is based on the price-increasing effects of any carbon tax. It has nothing to do with the revenue it might (or might not) raise. Tax cuts different from those in Table I aren't carbon tax compensation at all. They are income redistribution.

Table 1. Income tax compensation for net CPI effects of a carbon tax