Nova workboard

a blog from young economists at Nova SBE

Tax rebate – best way to introduce a carbon tax?

The idea of launching taxes on pollution is far from being a innovation.

Arthur Cecil Pigou came up with this idea in 1920, observing that the market does not take into account the full costs and benefits of production and consumption. There is unintended consequences from market transactions, and they are called externalities. OECD defines externalities by referring “to situations when the effect of production or consumption of goods and services imposes costs or benefits on others which are not reflected in the prices charged for the goods and services being provided”. It is important to refer that third-party that is involved do not choose to incur that cost/benefit, but still has to bear with it.

Pollution is one example of a negative externality, and I will focus specially in one type of gas that causes it. Carbon dioxide (CO2) is the primary greenhouse gas emitted through human activities and scientists say that it is the main responsible for what is being called Global Warming (the steady rise in the average temperature of Earth’s oceans and atmosphere). There are many negative consequences of global warming, and despite the different scenarios that different scientists present to the society, there are no doubts that global warming will and is having social, biological and economical costs.

Therefore, the total costs that the consumption of goods that had in their production process CO2 emissions are not only what the consumer pays for them but it is also necessary to add the cost of the externality. The total costs economists define them as social costs.

What happens when only the private cost is recognized by the market? As consumers, we make our purchase decisions based on the price that is given by the market, and choose to consume more of the good that we normally would consume if its price reflected the social cost, instead of only the private cost. In equilibrium, the society will consume (QP), but if the cost of the externality was reflected in the price, the society would only consume (QS).

                Pigou though that, if there was the possibility to increase (artificially) the price of goods that produce negative externalities to compensate its costs, then the market would reduce the quantities of the good transacted, and the society would be better off. Pigou monetized the externality, and that will be included in the production and consumption decisions!Image

                Although this instrument had been used several occasions by municipalities and regions around the world, its popularity increased in the ninety´s. Environmental awareness increased a lot (Kyoto Protocol was thoroughly negotiated and discussed in that decade, and several international organizations published reports about human influence on climate change). The responsible were the Nordic Countries, for a movement that is called the Green Tax Reform. Sweden was the first one, imposing a carbon tax and reducing at the same time the income tax. Basically, the Green Tax Reform is usually based in the Double Dividend hypothesis. Countries increase the environmental taxes and decrease labor taxes (“tax waste, not work” and “tax bads, not goods”, it’s their moto). Countries lose competitiveness in capital-intensive industries and gain competitiveness in labor-intensive industries, but most of all they force the market recognize the costs of pollution, and by that help society become aware of costs that otherwise each individual would not take into account.

                What happened to the average consumer with the tax rebate (income collected by the environmental taxes being returned to consumers by a decrease in labor taxes) and what he could have happen if there wasn´t a tax rebate?

                If we analyze what happens to the average individual in a static way and keeping in mind that the utility (a measure of well-being) that he think he gets from the consumption of products with negative externalities to the environment doesn´t take into consideration the environmental costs that he is imposing to others and himself in the future, we conclude that the goal of the measure is achieved (the consumption of goods with negative externalities decrease), but with the tax rebate the impact in well-being of the average individual is minimized! Why? Because the other goods are now relatively cheaper than the pollutants, giving the incentive for consumers to switch for environmental friendly products. The final situation is characterized by the letter C, and if there wasn´t any tax rebate the consumer would be worse-off (B). In fact, the consumer in the end can be better off, because the negative income effect caused by the tax is offset by a positive income effect of the tax, leaving only the substitution effect.


               So this measure can be a very powerful tool to introduce to the society a carbon tax. Public opinion would be more favorable to the introduction of the tax, society can benefit by the improvement of the environment, and labor-intensive companies would gain competitiveness in the market.

Bruno Dias, #670


Author: studentnovasbe

Master student in Nova Sbe

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