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

Adjustments may be needed for government transfer payments to various beneficiaries, although those with indexation provisions will automatically be adjusted as CPI effects are reflected in benefit increases.

Given the multiplicity of different benefits and thresholds for them, including different low-income tax-free thresholds, low-income Medicare Levy exemptions, and the like, further adjustments to a large number of concessions will be needed to deliver compensation precisely.

Others may miss out. Those with taxable incomes below the increased tax-free thresholds in Table 1 won't be fully compensated. Self-funded retirees in the superannuation pension phase cannot be compensated via tax cuts because they pay no tax. For those with superannuation investments in the accumulation phase, will contributions and earnings tax rates be reduced?

What about compensation for loss of purchasing power of existing savings? This was largely ignored in 1985, similarly in 1991-93, and only partly covered in 1998-2000. Compensation for savings' loss of purchasing power could be expensive.

The only way to avoid this 'savings compensation' morass is to have a net carbon tax impact on the CPI of zero. One way of doing that would be to use all carbon tax revenue to cut the rate of GST. (I'm not holding my breath.)

Carbon tax revenue can't finance comprehensive household compensation, especially if it reduces emissions – its primary purpose. Budget savings from elsewhere will be needed to do the job.

What about 'compensation' for 'trade exposed' industries as well? We can't even precisely define 'trade exposed' industries (and how much they are exposed) under the CPRS-type policy the Government seems to be pursuing. We can't afford industry compensation as well, without truly swingeing Budget cuts (and forget cuts to company taxes or any other taxes for that matter).

Defining 'trade-exposed' industries with any sort of principle, precision, consistency and equity is only possible if the carbon tax applies to Australian consumption, including imports, and excludes our exports.

This consumption model eliminates the need for messy, expensive and discriminatory 'special deals', demands for which are already increasing apace. It also broadens the carbon tax base, by 'carving-in' imports rather than 'carving out' import-competing industries, in a WTO compliant way. This helps finance household compensation, but only in part.

Carbon tax compensation is complex, but we've done this before. If we stick to household compensation, and design the policy to obviate the need for 'special deals' industry compensation, we'll be closer to a Budget-viable approach.

Even then, 'compensation' won't be cheap. It will leave gaps – notably savings and super compensation – and it will collide with the Government's policy to return the Budget to surplus by 2012-13. We'll need more Budget savings, above those already needed, to finance comprehensive household compensation for any carbon tax.

The Government will have to choose existing Budget commitments that have a lower priority than getting a carbon tax across the line. This will be quite difficult.