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Carbon tax will stoke inflation and hurt productivity

By Henry Thornton - posted Thursday, 4 August 2011


Inflation and productivity are the terrible twins of Australia's economic policy.

The eurozone remains in crisis, with frantic attempts to stave off the falling dominoes of sovereign debt default. The latest news from Washington suggests the US may avoid a "financial Armageddon" but there is a lot of work needed to produce a viable long-term deficit reduction plan to limit exploding US government debt.

China is grappling with serious inflation and may by accident, or design, reduce its growth, at least for a time, to an extent that hurts Australia's terms of trade.

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The Reserve Bank should not alter interest rates while global uncertainty is high. But goods and services inflation for the June quarter was again in excess of expectations and the mining boom is on track to make inflation worse. RBA governor Glenn Stevens has drawn attention to the way Australia's productivity performance has stalled. Strong inflation and stalled productivity are the key twins of economic policy. As with any twins, there can be interactions between them, for good or ill.

Stalled productivity creates inflation as cost pressures do not get offset by rising productivity. And if cost pressures rise, as they must as the mining boom gathers strength, inflation will become a larger problem. The many costs of inflation work against productivity, creating a vicious cycle of rising inflation and falling productivity, with stagflation the inevitable outcome. Sensible reform of industrial relations could help break this ugly cycle, but this will not be seen from the Gillard government, whose predecessor Labor government so enthusiastically re-regulated the labour markets.

Instead, what is on offer in the name of reform is a great big new carbon tax, intended to reduce CO2 emissions in the supposedly most efficient manner. Australia's economists almost to a man support this tax, arguing that it is efficient by definition in its supposed use of a price mechanism. The fault in this logic is that no other country has such a system.

A tax of $23 a tonne for the CO2 emissions of Australia's 500 greatest polluters will severely handicap Australia's most productive industries. Production, jobs and emissions will be shifted offshore to countries and competitor producers less concerned than the Australian government about the supposed costs of greenhouse gas emissions.

This is action guaranteed to reduce the productivity of Australian industry, increasing the strength of the stagflationary forces already evident.

As the Productivity Commission noted in its recent report to the government, "no country currently imposes an economy-wide tax on greenhouse gas emissions or has in place an economy-wide ETS". What is more, the same PC report noted that Australia's current policies, both in terms of effort to reduce emissions and in terms of abatement achieved, place us around mid-range among the countries analysed, rather than falling behind as the government claims.

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This was despite the government omitting, from the selection of countries it asked the PC to examine, key competitors such as Indonesia, South Africa, Russia and Brazil, none of whom are acting on climate change.

As noted in the speech by Tony Abbott at the Economic and Social Outlook Conference in Melbourne on July 1, other countries are rapidly increasing emissions and moving away from putting in place economy-wide emission trading schemes. For example, the US has abandoned all moves towards a national cap-and-trade scheme; and at the same time as our 5 per cent emissions-reduction target would see us cut annual CO2 by around 50 million tonnes per annum by 2020, relative to current levels, China is projected (on the government's own figures from Ross Garnaut) to increase its emissions by over 100 times as much (over 5000 Mtpa), on top of an increase 50 times as large that has already happened over the five years to 2009. The silence of most economists at the conference in response to Abbott's speech was noticeable and deeply disturbing.

This effect of getting ahead of the world will be exacerbated by the uses to which the tax will be put. One use will be to pay officials to administer what is sure to be a complicated money-go-round, clearly unproductive.

A second use will be to overcompensate "battlers" who may just be encouraged to maintain old consumption habits in the face of higher prices for the products of Australia's 500 "greatest polluters".

If the government is really serious about changing behaviour, it must rely on income effects as well as relative price effects yet, with the proposed policy, income effects will be fighting relative-price effects. This is a severely compromised "price mechanism", whatever economic theorists might say.

The third use of the additional tax is a fund to support research into alternative-energy generation mechanisms. This government gave us the pink batts debacle, the education revolution spending (in reality highly inefficient handouts to construction companies), and has made a massive bet on current best-in-class broadband technology.

Can the voters of Australia have any real confidence that the Gillard government will pick winners from a bunch of technologies, all of which are currently far less efficient than coal or gas-fired electricity generating plants? Even if sensible choices of new technologies are made, it is extremely unlikely that the relatively small investments Australia can afford will create the necessary breakthroughs.

This policy is a remnant of Kevin Rudd's misplaced aspiration to lead the world in solving what he called the "greatest moral challenge of our times". Australians became suspicious when he was left alone and friendless in Copenhagen and his closest cabinet colleagues told him to abandon his ETS plan. The same colleagues then called time on his prime ministership.

There are various aspects of the government's financial arrangements that suggest there is a growing budget hole in the overall carbon tax-and-spend plan, and this issue will eventually become a serious embarrassment.

We can also be certain that there will be fraud and mismanagement in any carbon trading scheme, as already alleged to be the case in the only two such schemes currently running, in Europe and the United Nations.

Abbott's alternative direct-action plan has been widely criticised, despite its promise to provide "incentives rather than penalties; to rewarding positive action rather than punishing Australian families, households and businesses". Its costs to the budget would be far lower than the government's plan. Equally important, it avoids all the major costs to productivity and competitiveness of the Gillard plan, as enumerated above.

There is one very important final point, which was made by the head of the Productivity Commission, Gary Banks, in a speech in March. "It will not be efficient from a global perspective (let alone a domestic one) for a carbon-intensive economy, such as ours, to abate as much as countries that are less reliant on cheap, high-emission energy sources . . . Modelling aside, it's commonsense that achieving any given level of abatement is likely to be costlier in a country with a comparative advantage in fossil fuels."

A carbon tax, starting at $23 a tonne and (according to Treasury modelling) rising quickly to $37 a tonne by 2020 will do nothing to help the global or Australian environment. Instead, it will send jobs and emissions offshore; it will produce a large and growing fiscal hole; it will be rorted; and it turns companies into supplicants to the government, having to beg for relief from the impact of the carbon tax.

Rather than creating certainty, all this has added hugely to uncertainty for business and, coming on top of the government's actions over other issues such as the mining tax and live cattle exports, has turned sovereign risk into a serious issue for business for the first time in many decades.

This is not the work of Adam Smith's famous invisible hand. Instead, it is quite obviously the work of politicians and bureaucrats who desire to strut the world stage, be seen to be doing something and resort to the very visible hand of a new tax and a new money churn whenever confronted with what they perceive to be a problem.

Australia cannot afford the frolic of a carbon tax. We should be improving productivity, not weakening the competitive position of Australian firms.

The world is too competitive for us to burden our industry with a tax no other country has embraced. The government's carbon tax will strengthen both the terrible twins of inflation and productivity.

The Reserve Bank will be forced to respond by raising interest rates higher than with no carbon tax, causing great and unnecessary pain to Australian businesses and households.

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This article was first published in The Australian on August 2, 2011.



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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at www.henrythornton.com.

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