The Prime Minister is wrong when she claims that “street market” logic demands her carbon emissions tax. She’s as wrong as she can be. The contrary is true: markets will ensure her proposal is both futile and damaging.
Her error, in this case, has nothing to do with global warming at all. The reasons that the carbon emissions tax will be futile (it won’t cut global emissions or Australian consumption of CO2 intensive goods and services) and will damage our economy (reducing growth and innovation in our country and elsewhere) is international trade.
Trade guarantees that any price (e.g. on carbon intensive goods) that Australia sets higher than prices elsewhere will be undercut, leaving world-wide demand for carbon-intensive goods unchanged but switching supply from Australian producers to foreign producers. This effect has the fancy name of “carbon leakage” because imports are like a “hole in the dike” (except the PM is not planning to erect any dike around our borders). But it is really just the same as buying from Coles when Woolworths’ prices are higher
The tricky thing about international trade, however, is that it is not like bargaining in a “street market”. A tax on the production, not just the consumption, of tradable goods has much worse consequences…
The biggest losses are due to the impact of the tax on the mechanisms of our gains from trade (‘comparative advantage”). If we tax the production of valuable goods that are relatively cheap to produce in Australia, such as coal-powered energy and its products—implicitly subsidising substitutes that are relatively costly to produce in Australia such as low-carbon energy and its products—we will make ourselves and our neighbours poorer forever while still not achieving any overall change in the global output of carbon-intensive goods. We will be poorer because we will have handicapped our own economic strengths and subsidised our weaknesses. We’ll spend way too much on doing things the hard way, robbing ourselves of the opportunity to acquire things we need now and in the future at low prices.
The Prime Minister wants us to believe that she can “compensate” the losses. It’s easy to show why compensation probably won’t offset the first impact of the tax (on prices). For example, Woolworths’ might offer to “compensate” for higher prices on one product by cutting prices on another; but you know that if the higher price is on milk and the lower price on onions, your food bill will still go up. Compensation could work, in theory, but in fact Woolworths wants higher margins overall, so it’s unlikely to be real compensation. The same is true of the carbon tax: the government wants the tax to hurt enough to change behaviour, so it cannot be fully offset.
It’s more difficult to show why you can’t “compensate” a loss of comparative advantage. But the result is even more certain. We don’t have the resources to compensate either ourselves or our trading parters for the loss of economic efficiency (“specialisation” in production) the tax will bring. It’s a bit like the compensation offered to a car accident victim for paraplegia; the money (never enough, anyway) is just not the point. Money is not walking; the loss of function is non-compensible.
David Ricardo’s concept of “comparative advantage” has an inescapable logic that not even the Prime Minister can evade or withstand. She can only imagine she may do so because she hasn’t really understood it.