The clean energy plan: compensation or redistribution?

A major component of the government’s clean energy plan is a package of assistance measures to compensate households for higher prices. The government will provide assistance through increases in pensions, allowances and family payments, as well as through income tax cuts. From a political and social perspective, the adequacy and credibility of this compensation will be of crucial importance.

The ideas underlying the compensation package have been around for a long time, as compensation for higher carbon prices is exactly analogous to compensation for the introduction of the GST.  This has been the topic of research and analysis in Australia since the debate on tax reform following the Draft White Paper in the 1980s .  (Similarly, in the 1990s, the then Conservative government in the United Kingdom imposed VAT on household fuel and power for the first time – as a way of cutting CO2 emissions – but also introduced a special compensation package for pensioners and people with disabilities.)

The price impact

Treasury modelling estimates that on average household expenditure is expected to increase by $3.30 per week due to higher electricity prices and by $1.50 per week due to higher gas prices. Most items in consumer budgets will increase by less than 1 per cent; the average household is expected to spend only an additional $0.80 per week on food, for example.

In total, average household spending is expected to increase by a bit less than $10 per week under a $23 carbon price, which means an overall increase in consumer prices of 0.7 per cent in 2012–13. By 2015–16, carbon pricing will have raised consumer prices by an estimated additional 0.2 per cent, for a total effect of 0.9 per cent.

It is worth noting that these effects are small compared with the effect when the GST was introduced in July 2000, increasing consumer prices by 2.5 per cent. They are also small compared to historical movements in consumer prices from year to year.

Averages vs. distributions

In assessing the compensation package it’s important to go beyond these averages and look at the distribution of impacts and the patterns of expenditure within different households. While lower-income households spend less in dollar terms than higher-income households on energy costs, for example, these costs are a higher proportion of their overall budget.

For a single pensioner household in the poorest 20 per cent of the population the average price impact is estimated to be 1.0 per cent in 2012–13, but for a one-income household with no children in the richest 20 per cent of the population, the average price impact is estimated to be 0.6 per cent. In relative terms, costs will also vary with the composition of households – higher for those with children, lower for those without. At any income level, some households will also have higher needs for energy, because of medical conditions, for example.

Compensation vs. redistribution

Overall, it appears that the direct price impact of pricing carbon is slightly regressive – (although some argue that the effect is very regressive) – so any compensation package would need to be at least slightly redistributive to offset this regressivity.

But how redistributive is the package?  The Opposition Leader has been quoted as arguing that this is “redistribution [pretending] to be compensation…” Others have gone further and argued that the package shows that the Government’s priority is on fundamentally reshaping the redistributive nature of the Australian tax system.

The government plans two rounds of income tax cuts as well as increases in pensions, allowances and benefits. The centrepiece of the income tax cuts is an increase in the income tax threshold from $6000 a year to $18,200 next financial year and $19,400 in 2015–16.  Increasing the tax threshold potentially gives all taxpayers with incomes above $18,200 a tax cut of $1830 a year; instead of paying a tax rate of 15 per cent on income between $6000 and $18,200 they will pay zero over this income range in future.

The situation is a bit more complicated, however, because currently low-income taxpayers benefit from the targeted low-income tax offset (LITO), which raises their effective tax threshold to $16,000 a year. The offset is income-tested and currently reduces by 4 cents in the dollar starting at taxable incomes of $30,000 a year, so that it is completely extinguished at incomes of $67,500. Raising the basic tax threshold means that part of the offset will be unnecessary, so it will be reduced to $445 next financial year and $300 in 2015–16. The higher basic threshold plus the $445 offset means that, in effect, the tax threshold for lower-income earners will rise from $16,000 to $20,542.

An increase in the tax threshold is very expensive, however, since the vast majority of taxpayers – including those with very high incomes – potentially get the same tax cut as low-income earners. The government considers that higher income earners can deal with the impact of higher energy prices without compensation, and so plans to increase the first tax rate above the threshold from 15 per cent to 19 per cent and the second rate, on incomes over $37,000 a year from 30 per cent to 32.5 per cent and then to 33 per cent. The rate at which the reduced LITO is income-tested will also be reduced, so that in combination the new effective tax rate will be the same as the previous effective marginal tax rate over most of the same income ranges. However, effective marginal tax rates will fall in some ranges and rise in others.

Overall, single people with taxable incomes under $80,000 a year get an income tax cut, while those above this income level will have no real change in their tax bills. On the other hand, when you factor in the higher prices to be paid, the break-even point – where the income tax cut is equal on average to the increased spending – is closer to $50,000 for single people.

Apart from fully or partly compensating individuals below $80,000 a year, the increase in the tax threshold will mean that more than a million people will no longer need to file a tax return. Someone on the minimum wage will be able to work for about 25 hours per week before being liable for income tax. The government argues that this will simplify life for low-income earners and boost incentives to work.

To compensate people in the social security system, who generally don’t pay income tax, it is necessary to increase rates of pensions, allowances and family payments. These people will be paid a lump sum by June 2012, just before the introduction of the carbon price. This is necessary to make sure that they’re not out of pocket when prices start to rise, since normal indexation provisions mean that pensions don’t rise until at least three months after prices increase.  (Although compensation paid at the end of this financial year will also not appear in next year’s Budget bottom line.)

Compensation will subsequently be provided as a separate regular indexed payment, and people with exceptional expenses will be entitled to an extra $140 assistance under the Essential Medical Equipment Payment.

This compensation for pensioners and beneficiaries is intended to be more than sufficient to offset the projected increase in prices. For single pensioners with no other income, the price impact is expected to be $204 in 2012–13, and they will receive a pension increase of $338. Because there will be variability around these average price impacts, this over-compensation is intended to guarantee that no pensioners will be disadvantaged.  If there was less “over-compensation”. then it would be more likely that some low income individuals with unusual expenditure patterns might find themselves worse-off in practice.

Pensioners and self-funded retirees will get up to $338 extra per year if they are single, with a combined $510 per year for couples. Families receiving Family Tax Benefit Part A will get up to an extra $110 per child and single-income families with children will get up to $69 extra in Family Tax Benefit Part B. And allowance recipients (the unemployed and young people) will get up to $218 per year for singles, and $390 per year for couples.

Details of winners and losers can be found on the clean energy plan website (and are also provided by Peter Martin).

Does compensation undermine incentives to reduce energy consumption?

One of the criticisms of the compensation package is that it will reduce the impact of the carbon price and undermine incentives to reduce energy consumption. But economic incentives can act in two ways – through the income effect and the substitution effect. Full compensation means that the income effect is potentially not relevant – if households have enough additional money to offset the increase in prices then if they so choose they can spend this additional income on electricity, for example, and not directly reduce their carbon consumption.

But the substitution effect will still operate. Households will face changes in relative prices, with goods made with fewer emissions becoming relatively cheaper. By choosing less carbon-intensive goods and services, and taking simple actions to improve energy efficiency in their daily lives, households will be able to save money. Higher-income households who don’t receive compensation will have stronger incentives to economise, as both the income and substitution effects will operate.

It is also worth noting that Treasury’s analysis of impacts on households overstates the effect of carbon pricing on consumer prices because it assumes emissions costs to households are passed on fully, based on fixed consumption patterns. The true change in the average cost of living is likely to be lower than this, as households shift to lower-emissions goods and services.

For example, Treasury also projects that around half of the increase in prices of emissions-intensive goods and services will be offset by lower consumption of those products. The effect on average consumer prices is also likely to be overstated because the model assumes production technology is not adjusted. As John Quiggin points out, businesses in particular will have stronger incentives to invest in more energy-efficient technologies.

The degree of overstatement of price impacts is likely to be greatest for higher-income households, which are more able to shift consumption towards less emissions-intensive goods through product substitution. Because households that can change their consumption patterns will face lower price impacts than households that cannot, some households that appear to be “losers” under the package will not necessarily be as strongly affected as the calculations suggest.

Taking account of these effects means that the compensation package is likely to be somehat less redistributive than it appears to be on the surface.  However, even on the surface the package is not particularly redistributive, particularly by the standards of recent tax changes. For example, a single age pensioner will potentially gain about $130 a year in over-compensation.  In contrast, the tax changes under the Howard Government – confirmed by the Rudd Government – gave the richest 20% of households the equivalent of a an average $3,000 a year cut in income taxes.

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14 Responses to The clean energy plan: compensation or redistribution?

  1. Oh my goodness! an incredible article dude. Thanks Nonetheless I’m experiencing difficulty with ur rss . Don’t know why Unable to subscribe to it. Is there anybody getting an identical rss problem? Anybody who is aware of kindly respond. Thnkx

  2. benjamin says:

    Should businesses shift to lower emmision technology what funds will be available to compensate consumers?

  3. Peter Whiteford says:

    Indexation of pensions, benefits and family allowances is automatic and will protect social security recipients from ongoing price increases. We don’t index the tax scales in the same way, but the practice for the last 25 years has effectively involved giving tax cuts every 2-3 years that gives back the effects of fiscal drag.

    I suppose the issue is what will be the price impact of shifting to lower emission technology. It seems to me that lower emission technologies reduce the revenue for compensation, but they also reduce the need for compensation.

  4. Mark Heydon says:

    All the numbers seem to be modelled on the basis of no behaviour changes.

    If behaviour changes do reduce the amount of CO2 emissions (as intended), won’t that reduce the funds collected by the carbon tax/ETS?
    At the same time, the compensation is unrelated to CO2 emissions – income tax and additional social security payments will go ahead regardless, as will the welfare going to many industries [with the possible caveat that the PC review at least holds out the possibility of reducing future industry welfare payments, if they are found excessive].
    There is already a modelled deficit of revenue over compensation of some $4bn over the first 3 (4?) years (I am going from memory here, so could have some details not quite accurate).
    Has the possibility of a significant and growing deficit in the whole carbon tax scheme been canvassed anywhere? If so, I have not seen it.

  5. Peter Whiteford says:

    Mark

    As I mentioned in response to Benjamin it seems to me that any such shift reduces the revenue for compensation, but also reduces the need for compensation.

  6. Benjamin says:

    I guess I was thinking in a more marginal sense. If the tax is $23/ton but complete mitiation is $22/ton marginal analysis says do it but the increased costs will still be passed on to consumers without a revenue base to fund compensation.

  7. Mark Heydon says:

    Peter
    My point was that the compensation will flow independent of the need for it. This appears to lead to the situation where if the carbon tax works as it is designed to, i.e. it reduces emissions and therefore need for permits, an increasingly large deficit will be generated.

  8. Peter Whiteford says:

    Mark

    I think of the introduction of the carbon price as being like the introduction of the GST. This leads to an upward shift in the price level around the time the price is introduced and as it works its way through. This means that you need compensation when it is introduced.

    If the price of carbon continues to be increased then you need ongoing compensation – as you would if we had an ongoing increase in the GST rate.

    But if people shift to less carbon intensive consumption and businesses shift to less intensive production, then the impact on price increases is reduced, so the cost of automatic indexation is reduced.

  9. Richard Tsukamasa Green says:

    Great work as always Peter.

    I believe Mark’s point is that the compensation in the form of reduced income tax is set regardless of the schemes efficacy. In the event that the scheme is highly successful, reduced income from income tax will not be offset by revenue from Carbon.

    I would downplay the importance of this though given the income tax revenue foregone is more minor compared to the indexed welfare payments where the effect is self cancelling.

  10. Peter Whiteford says:

    Richard

    I have not seen any commitment to index the tax scales, so unless the government did this, inflation would gradually wind back the income tax cuts (although this happens all the time).

  11. Richard Tsukamasa Green says:

    Peter – I actually meant to write that in the second paragraph, I’m not sure why I didn’t.

    It does highlight the value of non indexed tax thresholds to the political economy of good policy.

  12. Peter Whiteford says:

    Richard, I agree – it gives governments flexibility – although I know of a few people who would consider that a bad thing!

  13. Pedro says:

    ” In contrast, the tax changes under the Howard Government – confirmed by the Rudd Government – gave the richest 20% of households the equivalent of a an average $3,000 a year cut in income taxes.”

    Not taking so much of your money is now redistribution? Sheesh.

  14. Incurious and Unread says:

    Peter @8,

    Mark and Benjamin are correct. Because carbon emissions are price elastic (as they must be: a carbon tax would be pointless if they weren’t), there will be a “deadweight loss” from the imposition of the tax, and so it is not possible to compensate everybody for the cost increases caused by the tax.

    This is rather different to the GST, which was designed to cause minimal behavioural change.

    That is the distinction between a conventional tax (designed to minimise changes in behaviour) and a Pigovian tax (designed to cause specific changes in behaviour).

    As I understand it, those not fully compensated are higher income households, and domestic business that is unable to fully pass its cost increases through.

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