The price is right

One of the most persistent myths in Australian politics has been that providing household assistance undermines the effect of imposing a carbon price. If the prices of carbon-intensive products rise by $10 and you give me $10 in assistance, aren't we back where we started?

If there was only one product in the world, the answer would be yes. If there's only one thing I can buy, you can be sure that's where every dollar in my wallet is going to go. So if you put the price of that product up and increase my income, I'll carry on exactly as before.

Yet the one-product world is a far cry from the vast plethora of options facing modern consumers, who can spend on anything from a ballet lesson to a bunch of bananas, a train fare to a television. And here's the insight from modern economics: when you have choices, changing relative prices changes behaviour.

While we're sometimes coy about it, government policies change relative prices all the time. When we raise the first homeowner grant, house sales go up. When we cut tax rates on superannuation contributions, more people put money into their retirement accounts. When we raise cigarette taxes, fewer young people take up the habit. And when we tax alcohol, fewer people buy it.

Yet here's the other thing: all these taxes and subsidies also affect government revenue. All taxpayers help subsidise homeowner grants and superannuation, and all of us share the revenue from alcohol and cigarette taxes. But the revenue impacts don't undermine the price changes.

In understanding how carbon pricing works, there's no more critical distinction than the difference between prices and incomes. Indeed, it's this distinction that should make us optimistic about moving to a low-carbon economy. If some supermarket prices rise, but you have more money in your wallet, you have a choice: you can either buy the same amount of the high-carbon products, or make a switch to a low-carbon product.

One of the great things about a market economy is that we can leave it up to people to decide what's best for themselves. For example, some might decide to turn off the beer fridge, so they can spend the household assistance on a new surfboard instead.

This will parallel the choices being made inside the 500 largest emitters, where managers will look for creative ways to cut CO₂ emissions in order to save money for the company. Indeed, when the US introduced an emissions trading regime in the 1990s to tackle acid rain, firms found so many innovative ways of reducing emissions that the eventual cost was just one-third of what the boffins originally anticipated. Anyone who thinks companies will shut up shop rather than find creative ways of reducing carbon emissions underrates the ingenuity of Australian businesses.

To see the fallacy in the 'money-go-round' argument, just think back to recent increases in households' disposable incomes. When economic stimulus cheques were sent to millions of households during the global downturn, did families spend it all on high-carbon products? When the single pension was raised by $65 a fortnight in 2009, did pensioners put it all towards goods that produced carbon pollution? And when tax rates were cut in recent budgets, did taxpayers spend all the money on carbon-intensive commodities?

In each case, the answer is no. If you increase disposable incomes, we spent the money on the next thing we're hankering after: a nicer brand of coffee, a new book, a visit to the cousins. The same principle holds for tax cuts and pension increases that will be delivered as part of the clean energy future plan.

By pricing carbon, we're encouraging a shift to a cleaner economy. But assistance offers a simple guarantee to most Australian households: if you want to keep buying the same things, you'll be able to do so. Indeed, some groups will receive a buffer – such as full rate pensioners, who will get a 1.7 percent increase in their pensions to compensate for a 0.7 percent price rise.

Since Tony Abbott has called economics 'boring', it's perhaps not surprising that he is in complete misinformation mode on this point, describing tax cuts to assist households as 'a con'. Yet language sometimes reveals. When universal superannuation was introduced in the 1990s, Abbott told parliament that it was 'a con'. Let's see how long he's able to rage against good economic policy this time around.

Andrew Leigh is the federal member for Fraser.