Do climate policies have a budget 'black hole'?

Outgoing Secretary to the Treasury, Ken Henry, concluded major tax reform packages mustbe 'purchased'. That is, they must cost the Budget a reduced surplus if reform 'losers' are to be compensated (eg, via tax cuts), to make packages politically acceptable.

Having participated in the tax reform process in Australia since 1984, I think Ken is right. Does this also apply to greenhouse gas abatement policies?

I don't know Ken's opinion, but I think the answer is 'yes'. Climate policy is effectively about tax reform packages, whether it's 'direct action', carbon prices or emissions trading schemes (ETS). Global warming benefits of climate policies would accrue far into the future, not the next few years. The case for 'purchasing' reforms reducing greenhouse gas emissions is stronger than for 'conventional' tax reforms.

Ross Garnaut now suggests linking introduction of a carbon tax with broader Henry Review tax reforms. Does this imply carbon tax revenue can 'purchase' not only climate policy but also other tax reforms?

I don't think so, without a new round of Budget savings. A practical revenue-neutral carbon tax cannot maintain real consumption spending, let alone increase it via net tax cuts.

So, to 'purchase' climate policy (and other?) reforms, where's the money coming from? We don't have a lazy $5 - $10 billion or so Budget surplus at present. We might need new savings of that order just to get back to surplus (in a 'headline' sense, not a 'structural' sense).

This applies whether policies target national emissions production or consumption, and use an ETS, carbon taxes, or so-called 'direct action'. Consider some examples.

Assume a 100% effective climate policy stopping all emissions targeted. This would require impossibly detailed information, and be administered by an Omniscient Being rather than fallible politicians.

This policy maximises cuts in greenhouse gas emissions – the object of the exercise. Policy costs – whether regulation, purchase of abatement commitments, or an emissions tax – would be charged to the Commonwealth Budget and/or increase costs to energy producers and users.

Taxes, and/or energy prices would rise. Budget savings would also 'cost' those affected. (See Panel A in Figure 1.)

This 'perfect' climate policy can't be 'purchased' from revenue it raises. There is none.

Alternatively, assume imposition of an ETS or a carbon price that is 100% ineffective (eg, the price is too low). Economic activity continues with the same emissions. Revenue collections are maximized, because emitters now pay for their emissions.

If we cut GST revenue by an amount exactly offsetting revenue raised from the carbon tax, average consumer prices might change little. Real incomes and consumer spending might be unaffected in total.

But this policy isn't costless. It requires more revenue to cover administration plus compliance costs.

Only some carbon tax revenue (ie, net of administration costs) could be used to finance 'compensation' for consumers. Real after-tax incomes will be reduced a bit, even if prices on average don't change. Revenue-neutral income tax cuts puts average consumers further behind because average prices rise.

Climate policy (and other tax reforms?) can't be 'purchased' in this case either.

Real-world policies will probably be partly effective, partly ineffective:

• Partly ineffective ETS or carbon price policies collect some revenues, but not enough to maintain real after tax incomes or consumption (Panels A plus B in Figure 1).
• Partly ineffective 'direct action' initiatives add more to Budget costs. No revenues are collected at all (Panels A plus C in Figure 1).

Can politicians sell an effective policy without 'purchasing' its acceptance by massaging the hip pocket nerve? Can they sell an ineffective policy that just 'churns' resources through the Tax Office with no environmental benefit, no scope to increase real after-tax incomes, and increased administration and compliance costs? Either way, I doubt it.

What to do?

First, choose the most cost-effective way to reduce greenhouse gas emissions. This requires independent assessment, currently off the agenda.

Second, secure more Budget savings to 'purchase' an effective climate policy. Is this even being considered? These savings are additional to those already needed to 'make room' for skilled labour demand, etc., expected from the mining boom and natural disaster reconstruction.

Ross Garnaut's proposal to finance other tax reforms as well just adds to the savings needed.

Without 'purchasing' cost-effective climate policy in a fiscally responsible way, it's harder to 'sell'.

Without money for the 'purchase', will politicians opt for ineffective climate policies (eg, a very low carbon price) to maximize revenue collections? Will we see an 'emissions watch' climate policy?

That would be an efficiency-sapping 'con job' – very bad for a productivity-challenged Australia.

There's more. Climate policies plan to increase emissions costs substantially over time. Emissions 'caps' will be reduced, real carbon prices increased, and purchases of emissions cuts rise, pursuing more ambitious emissions reduction targets.

Must we 'purchase' these increased costs, too? Where's the money coming from?