Date created: 28 November 1996

Last modified: 18 November 1997

Maintained by: John Quiggin

John Quiggin

Myths of the carbon tax debate

Australian Financial Review ,

14 February, 1995

One of the most enduring tensions in economics is between those who claim that a unified model of supply and demand can explain the workings of all markets and all goods, and those who argue that particular markets, for example labour markets or agricultural markets, are special and require a separate theoretical model. At least since the 'energy crisis' of 1973, there has been a widespread feeling that energy is special in this sense. Indeed, there have been attempts to build up entire alternative theoretical frameworks for economics in which energy is the central concept. The notion that energy is special has re-emerged in the current debate over carbon taxes. However, it has emerged not from the ecological fringes but from guardians of neoclassical orthodoxy like the Industry Commission and the Tasman Institute.

One of the central results of neoclassical welfare theory (embodied in the 'welfare triangles' laboriously constructed by every economics student) is that a small tax will have very small welfare costs. An even more fundamental tenet of neoclassical theory is the law of demand, that when the relative price of a good (or an input to production) goes down, the demand for that good or input will go up. (The law can be stated more precisely to take account of income effects, but these are not relevant here). Both of these propositions have been implicitly denied by participants in the carbon tax debate who have claimed that, because of the special role of energy in the Australian economy, a small tax on carbon use will have disastrous economic effects, and that a switch from taxes on labour to taxes on carbon may lead to a reduction in employment.

To show that energy is not special, and that it obeys the normal laws of supply and demand, it is necessary first to explode the myth that changes in oil prices were a primary cause of the economic dislocation of the seventies. The continuing power of this myth is reflected in the ABC's daily practice of informing its listeners of the price of West Texas intermediate crude, a commodity which few of them can ever have had any occasion to buy. Indeed, the breakdown of post-war prosperity is often traced back to four-fold increase in oil prices during 1973-4, which allegedly led to an inflationary surge resulting in double-digit rates of inflation in most OECD countries, including Australia.

In retrospect, however, it may be seen that the process leading to this crisis was well advanced by 1973. The initial inflationary impulse was generated by the unbalanced US fiscal policies associated with the Vietnam War. The key events took place in 1971 and 1972 with the breakdown of the Bretton Woods agreement which had controlled international financial relationships since 1945. US President, Richard Nixon, tried, and failed, to control inflation through a temporary freeze on wages and prices. When the Nixon freeze failed, the world entered a period of inflationary boom.

The success of the Organization of Petroleum Exporting Countries (OPEC) in lifting oil prices in late 1973 was ultimately due to the inflationary crisis in the world economy. All prices were rising, particularly commodity prices. For example, the price of wool rose by nearly 100 per cent in 1972-3, when OPEC was still an obscure grouping of unimportant countries. Oil was initially an exception to the general rise in commodity prices because the oil market was controlled by the big oil companies which had kept prices low for decades. The increasingly strong pressure on prices allowed OPEC to overthrow the buyers' cartel and replace it with a sellers' cartel. The OPEC shock was a consequence, not a cause, of the breakdown in economic management.

The currently popular form of the 'energy is special' argument appears to based on the claim that we should not tax activities, such as energy production, in which we have a comparative advantage. Since at least some activities must be taxed, the effective claim is that we should give preferential treatment to areas of comparative advantage. From the perspective of neoclassical trade theory, this claim is the exact reverse of the truth. The theory of optimal trade taxes suggests that we should apply higher taxes precisely to those commodities in which we have such a substantial comparative advantage as to generate a degree of monopoly power. Indeed, what is OPEC but a device for levying taxes on the one industry in which its members have a comparative advantage?

Advocates of interventionist industry policy do indeed suggest subsidising areas of comparative advantage. However, the claim is not that we should subsidise the areas of existing comparative advantage but rather those in which a comparative advantage can be expected to emerge in the future (hence the standard criticism that this type of policy amounts to 'picking winners'). This line of argument gives much more comfort to those who favor subsidising solar electricity than to those who want to exempt coal-mining from taxation.

John Quiggin is Professor of Economics at James Cook University and author of Great Expectations: Microeconomic reform and Australia, published by Allen & Unwin.

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