Flawed federal carbon-pricing plan will hurt economy
Last week the Trudeau government unveiled its updated (and long-awaited) climate change plan dubbed “A Healthy Environment and a Healthy Economy.” The plan includes 64 new measures and $15 billion in climate change-related spending, which is expected to reduce greenhouse gas emissions by approximately 171 megatonnes by 2030. Most of the heavy lifting, however, will be done by a steadily rising carbon tax.
Currently, the carbon tax is set to reach $50 per tonne in 2022. The new plan sets annual increases of $15 starting in 2023 until it reaches $170 by 2030. This is a 240 per cent increase over what the government indicated was the maximum tax it considered just a year ago.
Having said that, we acknowledge that setting a price on carbon is the most efficient (i.e. least costly) way to reduce emissions as it provides the flexibility for individuals and businesses to either pay the price of emitting or find cheaper ways to reduce emissions, rather than mandating one single approach. However, several key conditions must be met for carbon pricing to deliver on the promise of cost-effective emissions reduction. Canada’s national carbon tax features several design flaws and simply increasing the tax to $170 doesn’t solve these deficiencies.
First, a carbon tax should be revenue neutral. Ottawa currently only rebates 90 per cent of the revenues in a form of lump-sum payments to households. The remaining 10 per cent is used to finance grants for energy efficiency projects.
More importantly, the way we recycle carbon tax revenues matters. To improve economic growth, revenues from the carbon tax must help reduce other more harmful taxes such as personal and business income taxes. In this way, economic incentives are improved as a method to increase economic growth. Using the revenues, or most of the revenues from the carbon tax to finance a lump-sum rebate (similar to what the government is doing), does not change the incentives for investment, work, savings or entrepreneurship, and thus does little to improve economic growth.
So instead of issuing lump-sum rebates to households and providing grants for energy efficiency programs, the government should use all carbon tax revenue to reduce business and personal income tax rates.
Second, a carbon tax should replace existing and corresponding emissions-related regulations. The point of a carbon tax is to rely on prices and market decisions to drive reduction in emissions. The price of the carbon tax allows individuals to make decisions about how best to respond to the cost of emissions either by innovating, reducing emissions or perhaps transitioning to different production. Retaining existing regulation prevents some of these decisions, and in other cases changes the effective price people face. In both cases, the regulations short-circuit the price mechanism intended by the carbon tax.
Indeed, the Trudeau government understands this, which is why it narrowed the scope of the Clean Fuel Standard (CFS)—a costly regulation requiring those who produce and import fossil fuels to reduce the carbon intensity of their products. Ottawa originally intended the CFS to cover all fuels (Canada is the first jurisdiction to attempt such broad coverage). But reduced the scope of the regulation to only liquid fuels. However, so far, there has been no GHG-related regulatory reductions following the implementation of the carbon tax. In fact, the federal government is doing the opposite by planning to introduce even more GHG-related regulations such as methane regulations.
Finally, measures to prevent carbon leakage—where firms reorganize their activities or relocate operations outside of the country to avoid the carbon tax—must be part of the design. Many economists argue for some type of border adjustments to be made to imports that have GHG-related inputs and for exported goods subject to the carbon tax.
Indeed, the Trudeau government included a system of compensation payments called the Output-Based Pricing System (OBPS) with the intent of limiting the harm to sectors exposed to trade and competitive pressures, and to thereby mitigate the risk of carbon leakage. However, as shown in a recent study, the compensation system is not tied specifically to factors that determine a firm’s risk of reduced competitiveness.
As a result, some firms that lose significant international market share end up worse off—even under the OBPS compensation plan. And Ottawa has no adjustment for imports that have GHG-related inputs, which means goods produced in Canada (and subject to the carbon tax) are more expensive than similar imported goods.
Overall, Canada’s carbon tax, albeit well-intentioned, has serious design flaws that unnecessarily hurt our economy. The new carbon rate hikes will only exacerbate these flaws. While tackling climate change and reducing GHG emissions is a priority, Ottawa must design and implement a better, more effective carbon-pricing system.