If done right, a reformed carbon tax would beat the alternatives
On April 1, the federal carbon tax rose from $65 per tonne of emissions to $80. Further planned increases will take it to $170 per tonne by 2030. It is widely acknowledged that carbon taxes are the most efficient way to reduce greenhouse gas (GHG) emissions. Our own 2021 study for the Fraser Institute concluded that the carbon tax at $170 would reduce emissions by 25.6 per cent compared to a scenario without the tax.
But the design of the carbon tax is critical. To be cost-effective it must meet certain conditions. The federal government's current carbon tax plan contains serious design flaws that will unnecessarily harm Canada's economy, which is already suffering after a decade of stagnation. We believe Ottawa should reform the carbon tax to reduce its negative economic impacts. Calls to “axe the tax” are understandable but if they mean replacing it with more costly and less flexible regulatory measures or subsidies it will just make things worse.
We believe six important
1 changes are needed.
The carbon tax should be Canada's only carbon policy. For a carbon tax to be efficient, it must replace, not supplement, existing Ghg-related regulations and mandates. But the federal government has simply layered the carbon tax on top of multiple regulations, subsidies and sector-specific mandates, including GHG caps on the oil and gas industry, EV mandates, and marine tanker bans. Existing Ghg-related policies undermine the economic logic of the carbon tax. To restore that logic and enhance the cost-effectiveness of the tax, the government should repeal these
2 other measures.
The carbon tax should be truly revenue neutral. To further minimize the economic harm the carbon tax does, it needs to be “revenue neutral,” meaning the government should return all carbon tax revenues to taxpayers rather than using some of them to fund public expenditures. These rebates should include the hundreds of millions of dollars in GST that Ottawa piggybacks onto the carbon tax every year.
The economics literature shows that recycling carbon tax revenue through lump sum rebates to households is less beneficial than reducing other taxes. In an ideal scenario, the government would achieve revenue neutrality by reducing broad-based tax rates on corporate and personal income wherever provincial pricing systems make that
3 possible.
The carbon tax should reflect the social cost of carbon. How high should the carbon tax be? The level should reflect the “social cost of carbon” (SCC), which is the estimated global damage from an additional tonne of CO2 emissions, expressed in monetary terms. There are, as might be expected, many estimates of the SCC, ranging from small negative amounts (which suggests there may actually be net benefits from incremental emissions) to many thousands of dollars per tonne. The wide variation in estimates results from variations in a few key modelling assumptions, including the discount rate used to evaluate future costs and benefits, as well as estimates of “climate sensitivity” — the warming expected from doubling the amount of CO2 in the atmosphere.
The federal government updated its estimate of the SCC in 2022, raising it to five times the previous estimate of the cost per tonne of Canada's emissions. But these high estimates are based on flawed and unrealistic assumptions about climate sensitivity and climate change's impact on agricultural productivity and mortality costs. The government needs to revisit the revised SCC and set a carbon price based on more reasonable
4 assumptions.
The carbon tax needs to reflect the true marginal cost of public resources. Any tax, including any carbon tax, is going to impair economic activity, especially when it is applied alongside existing taxes on personal and corporate income, retail sales and so on. An optimal carbon tax should therefore correspond to the social cost of carbon deflated by “the marginal cost of public funds,” which measures the total economic burden of taxes.
According to recent estimates, in 2021 the marginal cost of public funds was $2.86 per $1 raised through the personal income tax and $2.02 per $1 raised through federal corporate income tax. Assuming a conservative estimate of $2 for the overall national marginal cost of public funds, the optimal carbon tax should be approximately half of the estimated social cost of carbon.
5 The carbon tax should apply to the widest possible base of economic activity. This means taxing all potential GHG emissions from all fuel types and users at the same rate, regardless of the origin or method of generation. The federal carbon tax currently departs from equal treatment in two main ways.
First, Quebec is exempt from the federal tax because it runs its own tradable emissions permits system, in conjunction with California. But the settlement price for these permits is much lower than the federal carbon price. Second, late last year the federal government caved to political pressure and gave heating oil, which is primarily used in the Atlantic provinces, a three-year exemption from the carbon tax.
To address the first issue, the federal government could create a uniformity rule by, for instance, mandating that the national carbon price equal the lowest price currently in place in any Canadian jurisdiction running a carbon-pricing system that federal guidelines deem acceptable. This “lowest common denominator rule” would prevent any Canadian jurisdiction from gaining unfair advantage in domestic trade.
To address the second issue, the government should resolve not to create new tax carve-outs for political reasons and to remove those that are in place. If the carbon price truly reflects the true social cost of carbon, there is simply no case for exempting some fuels and not others. Any worries that the tax may hit low-income households disproportionately can be addressed through revenue-recycling mechanisms.
6 The carbon tax can't ignore the state of U.S. carbon policy. The carbon tax threatens the competitiveness of Canadian industries with high emissions intensity and significant exposure to international trade. Because the U.S. lacks a national carbon-pricing regime, this is especially a problem for producers competing in the U.S. market, the destination of the great bulk of our exports. “Carbon border adjustment mechanisms” — tariffs on carbon-intensive imports — are one way to deal with this problem, although they would need to be assessed carefully to see if in fact they would yield net benefits to Canada or instead would provide unjustified and anticompetitive protection for given Canadian industries.
To summarize our argument, according to current scientific understanding, GHG emissions are a negative externality generated by the production and consumption of fossil fuels. A carbon tax is the most flexible and cost-effective way to pursue society's climate goals. The federal government should fix the shortcomings of its carbon tax plan and reduce its economic cost. By contrast, repealing the carbon tax while attempting to achieve the equivalent CO2 emission reductions would require more costly measures such as regulations, subsidies and tax breaks, which may be less visible than a carbon tax but are in fact more costly economically and would therefore not serve the best interests of Canadians.
THE FEDERAL GOVERNMENT'S CURRENT CARBON TAX PLAN CONTAINS SERIOUS DESIGN FLAWS.