If carbon taxes work, why all the new regulations?

Many economists were excited a few years ago when the federal Liberals committed to introducing a carbon tax. Whether they were specialists in environmental economics or not, they knew from their introductory textbooks that emission pricing is a good tool for controlling pollution. And here was a major political party citing economic theory to support its policy plans. How enlightened!

But the specialist literature carried a warning my colleagues largely ignored. As I tried to caution (more than once) emission pricing makes sense if it is used instead of, not on top of, regulation. Because the different policy instrument amplify each others’ costs, if emission regulations are not removed before adding the tax, the outcome can be worse than doing nothing at all.

Unfortunately most Canadian economists were happy to do the light lifting of telling governments why they should introduce a new tax, but very few wanted to help with the heavy lifting of convincing the government they first need to repeal renewable energy mandates, home retrofit subsidies, ethanol mandates, electric vehicle subsidies, appliance efficiency standards, new energy efficiency codes for buildings, new motor vehicle fuel regulations, coal phaseouts, and a host of other fashionable green policies, support for which is nowadays viewed as a litmus test for being a good citizen.

So we have ended up with the worst of both worlds. None of the inefficient policies were repealed, carbon taxes were layered on top and now the government is charging ahead with even more misguided climate regulations. The recent throne speech brings back for the millionth time home energy retrofit subsidies, despite ample evidence (going back to the old CHIP grants in the 1970s) that most of the money is wasted paying people to do things they were planning to do anyway. Even worse is the proposed Clean Fuels Standard, a high cost boondoggle that aims to bring the carbon intensity of fuels down a small amount, at what will be an exorbitant cost per tonne that far exceeds the carbon tax rate.

So if, as the Trudeau government insists, carbon taxes “work,” why all the regulations? The reality is the government never understood or endorsed the economic theory of carbon taxes, they just liked the virtue signalling and the revenue.

Carbon taxes “work” but it’s important to understand what the word means in this context. The tax is supposed to charge fuel users for their estimated contribution to climate change, and to nudge everyone into adopting the lowest-cost emission reductions. If the tax is set at a reasonable amount, it accomplishes both goals automatically, so in that sense it “works.” But when costly regulations are layered on top both goals are thwarted. It’s the combination of policies that fails.

When critics charge that carbon taxes don’t work they usually mean that emissions don’t fall by much in response. This may be true, but it doesn’t mean the tax didn’t work, it just means that the fuel to which it applied has an inelastic demand, i.e., people don’t adjust their purchases by much in response to a price increase. This doesn’t mean regulations would work better; if anything it implies that they will impose much higher costs than people would be willing to pay if given the choice.

Still, there is a valid version of the “carbon taxes don’t work” argument—if governments make a promise that we can reach the Paris climate targets easily and painlessly by implementing a carbon tax with rebates or tax cuts so most people come out ahead, then no, in that sense carbon taxes won’t work. To get to Paris-level emission cuts will require a carbon tax at a high enough level that it will shrink the rest of the tax base by more than the carbon tax brings in. Revenue-neutrality for governments will require other taxes to go up, not down.

And that’s in the rarified world where carbon taxes are used in isolation. Throw inefficient regulations into the mix and the costs go even higher. Sadly, we have a government in Ottawa that seems determined not only to set unrealistic emission targets, but also to use an inefficient mix of instruments that inflate the costs even further. Carbon taxes can work, but not the way Canada is using them.