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The Progressive Economics Forum

CGE models and carbon tax incidence

A colleague of mine pointed out a relatively new paper about the distributional impacts of BC’s carbon tax. In my work, we look at actual energy expenditures by different household groups, and because lower income groups spend a greater share of their income on (carbon-intensive) energy, any carbon tax is regressive. But that regressivity ultimately depends on what you do with the revenues, and can be compensated with a credit. In BC’s case, when the carbon tax was instituted, there was a decent low-income credit that made the overall regime progressive, but as the tax increased from $10 to $30 per tonne, the credit did not keep up, and the current regime is regressive. Not massively so, but it is important to get the details right before scaling up.

The authors take issue with my work in the area for only looking at the direct effect of the carbon tax, and not a range of economy-wide impacts that then feed back into distribution:

Recent research in other contexts, however, has found that the incidence of energy and carbon taxes is dictated by general equilibrium responses and not well approximated by partial equilibrium studies such as Lee (2011) and Lee and Sanger (2008), which only consider the distributional effects resulting from households’ consumption of the taxed fuels and other carbon-intensive products.

It’s certainly an interesting argument, and they come up with a startling finding:

Using the model, we find that the existing BC carbon tax is highly progressive even prior to consideration of the revenue recycling scheme, such that the negative impact of the carbon tax on households with below-median income are smaller than that on households with above-median income. We show that our finding is a result of welfare effects of a carbon tax being determined primarily by the source of a households’ income rather than by the destination of its expenditures.

The model in question is a Computable General Equilibrium (CGE) model, which should raise some alarm bells. To assess the impact of trade agreements and tax changes, some economists have used CGE models, which develop a system of equations to model the economy, then shock it with a policy change to look at impacts once everything settles. Unfortunately, CGE is a deeply flawed approach that incorporates all of the market fundamentalism of neoclassical economics. Moreover, they give the appearance of making empirical estimates when really what is being generated is a function of the assumptions being made. Here’s The Economist magazine on problems with CGE models:

[T]he results of CGE models flow from the presuppositions of their authors. Most empirical exercises confront theory with numbers—they test theories against the data; sometimes they even reject them. CGE models, by contrast, put numbers to theory. If the modeller believes that trade raises productivity and growth, for example, then the model’s results will mechanically confirm this. They cannot do otherwise. In another context, Robert Solow, a Nobel prize-winner, has noted the tendency of economists to congratulate themselves for retrieving juicy plums that they themselves planted in the pudding.

In this particular paper, what assumptions are notable? “The model is based on the principles of general equilibrium theory. It combines microeconomic detail to project agents’ behaviour with the requirement of market clearing” and “Markets for all factors are assumed to clear perfectly (i.e., there is no friction in any of the factor markets). Labour is treated as mobile between sectors in each region but immobile between regions, as is conventional.” Also: “For each region and each sector, nested constant elasticity of substitution (CES) cost functions describe the price-dependent use of capital, labour, energy and materials for the production of commodities other than primary fossil fuels. Producers choose to substitute between different inputs (labour, capital, different types of energy and materials) to maximize profits.”

With those whoppers as starting points, they shock the model with a simulated carbon tax, then conclude on distribution: “To sum up, the progressive character of the carbon tax is mainly caused by the greater decline in real wages compared to the relative increase in real capital earnings. Households in the higher income deciles are more dependent on labour income than households in the lower deciles, which means they are hit harder by the drop in real wages.”

So higher energy prices cause diminished economic activity and associated wage reductions, which disproportionately affect high-income earners, according to the model. For such a change in prices, however, it may also be the case that other low-carbon sectors are stimulated. Indeed, we know that capital investment in renewables generates more jobs per dollar as that invested in fossil fuels. And as a general note, there are both income and substitution effects for any price change, and these move in opposite directions. So it’s not obvious that the overall impact of a carbon tax is being modeled properly – there is a lot we do not know. But I suspect these results are an artifact of the assumptions in the model.

On the breakdown of income, transfer income is relatively more important to low-income households, capital income is relatively more important higher up the distribution. Some of the gain is attributed to transfer income being indexed to the CPI, compensating for higher energy costs. While this may be true for federal transfers like OAS and CCTB, it certainly is not the case for social assistance in BC, a transfer most relevant to this analysis.

But the real distributional problem is on the expenditure side: it’s hard to get around the prima facie empirical case that low-income households spend a greater share of their income on energy, and therefore get hit with a higher share paid in carbon tax. This paper seems like a lot of hand-waving to me. Given the track record of CGE models, a quasi-empirical approach that is highly driven by the assumptions being made, I suggest some skepticism. And such a paper can be problematic to the extent that it endorses carbon pricing initiatives that allow proponents to ignore distributional impacts.

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Comments

Comment from Ron Waller
Time: November 25, 2014, 8:38 pm

Progressive activists and economists better prepare for the latest right-wing assault on society that’s coming down the pike: it’s called EcoFiscal. It’s a neo-con think tank under a green banner. First neo-cons were climate science deniers. Now they embrace the environment and see pollution taxation as a means to slash corporate, income and investment taxes.

This think tank is headed by the most odious of Canadian free-market fundamentalists: Chris Ragan, Jack Mintz and Preston Manning. Preston Manning is being lauded in the social media for standing up for the environment despite attacks from Sun News. But what most Canadians don’t realize is that there is progressive green and regressive green. Neocons are just as dangerous in terms of living standards and inequality espousing their version of environmental policy as they are in their version of economic policy.

Here are some of the slogans that @EcoFiscal (#EcoFiscal) has been polluting the social media with: “EcoFiscal policies generate revenue that can reduce harmful taxes”. “We need a better fiscal [read: tax] system, not bigger government”. “$760-million — the amount that income and business tax cuts exceeded carbon price revenues in BC”.

The last slogan emphasizes my point that EcoFiscal is trying to win over right-wing ideologues by showing them that carbon and pollution pricing is a way to cover up big tax cuts for the rich that also creates deficits and forces governments to cut spending — aka “starving the beast”.

It should be noted that matching pollution taxes with tax cuts is always regressive. The top 20% makes 52% of the income and pays 60% of income taxes. Therefore they get the lion share of any income tax cuts. Corporate and investment tax cuts only benefit the wealthy who possess an even greater share of investment wealth and income.

Small government is the problem. It’s the reason we’ve had 30 years of falling living standards and skyrocketing inequality and debt which culminated in economic collapse. Small-government green will make things much worse.

Comment from Ron Waller
Time: November 25, 2014, 8:38 pm

BTW, carbon pricing will not nearly be enough to reduce carbon emissions. For example, economists, politicians and pundits believe that if Canada adopts national carbon pricing it will enable us to export more bitumen and help accelerate development of the tarsands. As this chart shows, rising emissions from the tarsands are wiping out all the hard work provinces have done reducing carbon emissions. So any green policy that doesn’t at least freeze tarsands output is a sham.

Second, disincentives for dirty energy use must be met with incentives for clean energy use. That way people have an alternative choice. (Neo-cons simply want to make energy a scarcity.) Since the electricity grid is our main source of clean energy, it would be absurd to raise electricity prices as a green policy (which the Ontario Liberals fail to realize.) The goal is to make the electricity grid greener and have people and businesses use electricity instead of fossil fuels.

Take for example the transportation sector responsible for 24% of carbon emissions. The goal is to get rid of combustion engines (20% efficiency) and replace with electric engines (85% efficiency.) To make the transition we need to make electricity cheaper than dirty energy and we also need regulations and other incentives that get people and businesses to switch over. (On the regulatory front, all extremely dirty coal-fired power plants must be banned. They are 30% efficient compared to gas-fired plants: 60% efficient.)

We also must subsidize green energy projects in the electricity grid with taxpayer money, not ratepayer money. (Another fact the Ontario Neo-Liberals fail to realize.) This will ensure green energy is funded progressively not regressively. (The top 20% pays 60% of income taxes and their electricity bills are a miniscule percent of their incomes, where as they are burdensome to low and middle income. So clearly green energy subsidies from tax revenues are progressive — from ratepayers very regressive.)

Only Keynesian big government policies will work in creating a sustainable progressive economy/society. Since the 1990s we have cut taxes by $90-billion a year. This is absurd. We need that money to invest in green infrastructure: green energy, mass transit and ultra-high-speed internet (wired and wireless) which will reduce need for high-energy-consumption travel.

Comment from Ron Waller
Time: November 26, 2014, 12:28 am

Last: exposing the neo-con and neo-liberal MO. These people advocate regressive tax policy that gives the rich the biggest break: raise carbon, pollution & consumption taxes; cut income, corporate and investment taxes. These tax efficiencies will create innovation, prosperity and jobs they tell us. Of course, after 30 years of these policies and we’ve seen living standards, productivity growth and GDP growth plummet while inequality and debt has skyrocketed.

They advocate pay-as-you-go everything: higher prices on home electricity (but lower for business use), higher cost for water use (absurd for a renewable resource — and, of course: exclude the tarsands’ 3 barrels of water for 1 barrel of bitumen), higher eco-fees, higher consumption taxes. The pay-as-you-go conservative model gives the rich the biggest break because they consume the smallest part of their income.

These policies have measures for the poor thrown in to claim they are “progressive.” So they end up gouging a shrinking middle class. Of course, the tax cuts create deficits, which create budget crises. Then governments implement the “silent cuts” — cuts to the poor (given little coverage by the corporate media) that were supposed to make these neo-con/neo-liberal policies “progressive” in the first place.

So progressives better get their ducks in a row. A new wave of neoclassical blight is coming our way: regressive green.

BTW, here’s a link I forgot that shows neocon economist Stephen Gordon heaping praise on the Harper Government for “starving the beast” — aka bankrupting democratic government. Given the Trudeau Liberals cite Gordon (and Kevin Milligan) as the experts behind their EI corporate tax cut scheme to “create jobs,” Canada is facing a dismal future.

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