When is a tax not a tax? Carbon taxes vs. carbon prices

There seems to be a certain amount of confusion across the land about the idea of a “carbon tax” and whether it deserves to be called a “tax” or not (e.g. here). Proponents of such a scheme – myself included – have taken to calling it a “carbon pricing” system, in order to emphasize the dissimilarity between a carbon tax and more conventional taxation schemes, such as the income tax or the GST (and also to avoid getting caught up in the “all taxes are bad” dragnet currently being thrown by the right). This has led opponents of the scheme, including the current federal government, not to mention their lackeys in the right-wing press, to insist that it is a “tax.” Indeed, the Minister of the Environment never misses an opportunity to repeat the government’s mantra, that a carbon pricing system would be, not just a tax, but a “tax on everything” (and the previous Minister claimed that “carbon pricing in any form is a carbon tax.”)

Underlying this insistence is actually a very deep misunderstanding of the basic principles of a market economy. As I will try to show, carbon pricing really is a pricing system, not a tax. People who deny this are either confused or else deliberately sowing confusion. Typically, it’s because they are confused. And typically the reason they are confused is that, despite having spent years getting all fussed up about taxes, they have never stopped to think carefully about what prices are.

So I’d like to start by taking things back to first principles, to talk about what prices are, and why we have them, before moving on to the question of what deserves to be called a tax. The existence of prices is an immediate consequence of the two fundamental building blocks of a market economy: property and contract. The central characteristic of classical property rights is that they are exclusive – which is to say, they give the owner the right to exclude others from use or enjoyment of the good over which they are exercised. So, for example, when a piece of land belongs to me, I have a right to keep others from walking on it, when a car belongs to me I have the right to stop others from driving it or damaging it, when a cup of coffee belongs to me I have the right to stop others from drinking it, spitting in it, and so on.

What happens if someone else really wants to walk across my land, or drive my car, or drink my coffee? They have to persuade me to let them, typically by offering me some inducement, such as the use or enjoyment of a piece of their property. Hence the principle of exchange, governed by contract. I let you do something that would normally count as an infringement of my property rights (such as drinking my cup of coffee), and in return you give me something that I want – which is to say, you pay me. This is where prices come from – they represent the terms under individuals agree to waive, or transfer to others, their property rights.

Now it’s important to note that the state plays a pretty important role in all this. Individuals determine prices, in the sense that they are free to strike whatever bargain they like. But if you agree to pay me a bag of carrots for my chicken, and after I give you the chicken, you fail to hand over the carrots, then I can go to the state to force you to pay. Similarly, if you trespass on my land and kill my chicken, I can complain, and the state may force you to pay me “damages,” which is basically a judge or jury’s best guess of how much you would have had to pay me, in order to get me to let you kill my chicken. So all prices are “artificial,” in the sense that they are the product of a legal system that enforces the relevant property rights and contracts.

At the heart of this entire arrangement is an extremely important moral idea, which is that individuals, when deciding what to do, should have to take into consideration the consequences that their actions have for others. If I’m using a piece of land, it means that other people can’t use it. If I eat a carrot, it means that other people can’t eat it. Dividing up the world into property is a way of ensuring that these effects must be taken into consideration. The fact that I have to pay for the land, or the carrot, is a reflection of the fact that others would like to use it, or eat it, and the amount that I have to give up, in order to get it, is a direct function of how much unhappiness it will cause in others, when I use or consume it. The “optimal” price – in standard welfare economics – is one in which the amount that the individual pays exactly matches the “social cost,” which is to say, the unhappiness caused in others by the individual’s ownership or consumption.

This way of thinking about markets gives rise to what I call the “apology” model of pricing – that when you pay for something, you should think of it as apologizing to everyone who has been inconvenienced by your consumption.

Next time you buy a cup of coffee at Starbucks, imagine yourself saying to the barista, “I’m sorry that you had to serve me coffee when you could have been doing other things. And please communicate my apologies to the others as well: the owner, the landlord, the shipping company, the Columbian peasants. Here’s $1.75 for all the trouble. Please divide it among yourselves.” (Filthy Lucre, p. 160).

The way I wrote this makes it sound like a joke, or a weirdly Canadian way of thinking about economics, but it’s not. It actually expresses exactly how prices function in a market economy, as well the central moral underpinnings of capitalism.

Starting with these simple principles underlying the price system, it is easy to see that environmental regulation represents only a small extension of the same principles. Suppose that you have some garbage that you want to get rid of, and you would like to dump it on my land. This would reduce my enjoyment of the land, and so naturally I can exercise my property rights in order to stop you. As a result, you will have to pay me to dump your garbage on my land. But now suppose that you get clever, and instead of dumping the garbage, you decide the burn it. As a result, acrid smoke now drifts across my land, diminishing my enjoyment by an even greater degree. Unfortunately, my property rights do not protect me here, since I do not “own” the atmosphere over my land. And yet there is no moral principle underlying this limitation on my rights, it is a purely contingent matter – it’s easy to build a fence around a piece of land, much more difficult to fence off a piece of the atmosphere. The basic moral principle, however, has not changed – before acting, you should have to take into consideration the costs that your actions impose upon others. If you are reducing my enjoyment of my land, you should have to pay me. As a result, I can take you to court and force you to pay damages – which, again, will represent the judge’s best guess of how much you would have had to pay me, in order to get me to let you pollute the air over my land.

What happens if, instead of just drifting over my land, the smoke you produce takes the form of a thin haze that settles over the land of many different people, perhaps contaminating the soil? We could organize a “class action” lawsuit, and force you to pay damages. But there may be significant costs associated with organizing such a lawsuit, not to mention litigating it. And so the state may decide to act preemptively, by simply imposing a charge on you – and anyone else who wants to burn this sort of garbage – that reflects the “social cost” of the pollution generated. The crucial point here is that, in so doing, the state is pricing the activity. It is just a different way of achieving the outcome that a less imperfect system of markets, and of private property, would have achieved (a point that was made, famously but somewhat indirectly, by Ronald Coase).

There is one other point worth noting. What the state does with the money is irrelevant. The core principle of the price system is that when individuals make decisions, the costs that they face as individuals, when contemplating their various options, should reflect the social cost of these options. This is what generates the form of socially optimal decision-making that we value in markets. Imposing a price on pollution achieves this, regardless of whether the state subsequently uses the funds to make whole those who suffer the losses or not.

What about taxes then? According to current conservative talking-points, anything that raises revenue for the government is a “tax.” This is obviously too broad a definition. When the state sells bonds, it is not imposing taxes. Similarly, if the state owns land, which it decides to sell off, the fact that this sale generates revenue does not mean that the person who buys it is being taxed. On the contrary, when the state sells the land it is pricing it. Similarly, right-wing governments will sometimes cut taxes, but then increase user fees in order to make up the shortfall in revenue – claiming then that they have stuck to their promise of not raising taxes. (So, for example, the price of swimming lessons at municipal pools may rise, in order to keep property taxes low. But this isn’t really a tax increase, since the state is just selling swimming lessons, the way any private company would.)

So what is it that makes a tax a tax? The most important characteristic of a tax, it seems to me, is that it is imposed with the objective of raising revenue, but not with the objective of changing behaviour. The income tax is the best example – the objective here is not to discourage people from earning income, the goal is just to raise revenue. Similarly with consumption taxes. Indeed, the reason economists spend so much time worrying about the “distortionary” effect of taxes is that the incentive effects of taxes typically run contrary to some socially desired form of behaviour, and so the goal of an efficient taxation scheme is to minimize this as much as possible. This is why the economist’s ideal tax is a “head tax” (or a lump-sum individual payment), because there is nothing a person can do to minimize or escape it, and so it raises revenue without changing behaviour. Also favoured are taxes on “economic rent,” such as luxury taxes or resource royalties, because again they raise revenue without changing behaviour (although it’s a bit complicated to explain the details of why this is).

One can see here why conservatives are in general hostile to taxes, but not user fees or prices. Those on the moderate right oppose taxes because of the efficiency losses created by their distortionary effects. Those on the hard right oppose them because they represent the mechanism through which the state raises revenue, and they are opposed to state spending in principle. (Typically this is a based on a strong aversion to any sort of redistribution, or “undeserved gains.” So while it’s okay for the state to charge me for swimming lessons, because I pay for the services that I receive, it’s not okay for the state to impose property taxes on me, because there is no guarantee that the municipal services I receive – police protection, road maintenance, snow removal, etc. – will be exactly what I paid for. There will always be the suspicion that some of the money is being siphoned off, and being given to some undeserving person. Apparently many conservatives would rather do without the service than contemplate the possibility of anyone enjoying such an unmerited gain.)

The objective of a price, by contrast, is precisely to change behaviour. It’s intended to stop people from doing things (consuming things, using things, excluding others from the use of things, etc.) unless they really need to – unless the benefit to them is great enough to outweigh the loss to others. This is why we let the prices of most goods be determined by the market – because competitive markets are the institution most able to set prices at the level that equates private benefit with social cost. Now this may sound a bit weird, because when I sell you carrots, my intention is just to make money, not to equate private benefit with social cost. But this is the wrong way of thinking about it. What I intend does not matter. The question is why individuals are free to set their own price for carrots – why there is not, for example, a legislatively fixed price for carrots. The answer is that, by letting individuals set their own prices for carrots, we are more likely to get to the price that equates private benefit with social cost.

Similarly, when the state sells off a piece of land, its objective is to make money – to raise revenue – not to equate private benefit with social cost. So doesn’t that make it a tax, according to my definition? That depends, I would argue, on what price it sets. If it tries to calculate a competitive market price for the land and asks for that, then I would say it is merely pricing the land. If, by contrast, it were to take advantage of its monopoly position, restricting the supply of available land in order to sell it at incredibly high prices – the way that the government of Hong Kong does – then I think it could plausibly be said to be “taxing” those who buy it (e.g. developers). When the government sells the land at a “market” price, by contrast, the fact that this raises revenue is somewhat incidental. Even if the proceeds from the sale were to be given away the next day in a lottery, there would still be a strong argument for selling the land at that price – in order to ensure that the land goes to the person able to make the best use of it.

This may seem like a somewhat subtle point, but when one turns to the environmental case it has obvious and more direct application. Producing carbon dioxide emissions is the perfect example of a type of behaviour that imposes costs on others (through the mechanism of global warming), but where people’s property rights do not protect them. Thus the classic mechanisms of property and contract will not give rise to a price. And yet, if you think of it in terms of the “apology” model of pricing, it is clear that you should have to apologize for all those who are inconvenienced by your atmospheric emissions. The fact that you don’t is due to an arbitrary limitation of the system of property rights, which is that we have no way of exercising property over the atmosphere.

Furthermore, it would be unreasonably costly for individuals to get together and seek compensation from those who are emitting the carbon dioxide. Thus a tort solution is going to be no more effective than a “property” solution. It falls upon the state then to determine how much people would have to pay, in order to get others to let them emit greenhouse gases. So the government commissions a cost-benefit analysis (such as the Stern Review), aimed at determining what the market price of carbon would be, if the people who wanted to do the emitting and the people who were affected by those emissions were to get together to negotiate an agreement. It then imposes this as the price of carbon – or what we call a “carbon tax.”

Again, the idea that it is a price is a reflection of the fact that the revenue it raises is of secondary importance. Even if the state were to take all the money raised by the carbon pricing scheme and give it away in a lottery, the policy would still be worth implementing – in order to create a state of affairs where, when people make decisions, they are forced to take into consideration the full cost that these decisions impose upon others. Indeed, this is why the Liberal party “Green Shift” proposal, put forward several elections ago, involved the imposition of a carbon tax combined with an equivalent reduction in income taxes, so that the entire program would be revenue neutral (that’s why it was called a “shift”). The purpose of it was to create a more efficient system of economic incentives, not to raise revenue. It was, in other words, an attempt to price carbon.

This is why economically sophisticated conservatives suffer from enormous bad faith on this issue, if they choose to toe the party line in opposing carbon pricing. They know that if you accept the basic principles underlying a market economy, and you believe the scientific consensus on anthropogenic climate change, then there is simply no coherent basis for opposing a policy like the “Green Shift,” or carbon pricing in general. The fact that the Conservatives do oppose it is an exercise in crass political opportunism – much like their support for dairy supply management – a position that violates fundamental free-market principles. They have, unfortunately, painted themselves into a corner on this issue, making it impossible for them to deliver good policy.

All that having been said, it wouldn’t be a bad idea for someone with a knack for these things to come up with a better name for the charge that the state imposes when it is trying to adjust prices (i.e. for Pigovian taxes). With road pricing schemes, for example, we call it a “toll” – more accurate than calling it a “tax.” With a trade restriction, we call it a “duty” instead of a “tax.” Perhaps calling it a carbon “levy” is the way to go, but it would be nice to have a term broad enough to encompass all these different forms.


When is a tax not a tax? Carbon taxes vs. carbon prices — 7 Comments

  1. If we are shifting language from “tax” to “pricing”, I think it would also be helpful to eliminate “global warming” in favour of “climate change”. Both terms were used in the post, but conservatives and climate change deniers are always quick to jump on the warming part of global warming whenever there is a cold winter or blip on a graph. This semantic trick works well on the public, so it would be best to avoid global warming altogether at this point.

  2. You could start calling it a carbon “indemnity”. Captures the idea of the public as a creditor in the transaction, I think.

  3. Perhaps one of the distinctions between an income tax and a price is that one is (legally) mandatory and the other, in theory, (legally) avoidable. When you tack consumption taxes onto goods and services they look a lot more like prices (and act like them in the line of thought above).

  4. Simon: I was thinking about this, because a more standard way of thinking about taxes is that they are a compulsory payment, whereas a price is optional (you choose to buy). This is what underlies the classic libertarian aversion to taxes — that they restrict freedom, in a way that prices do not. But I think there are lots of cases where that distinction breaks down, because there are lots of taxes you can avoid paying just by avoiding the thing that is taxed (if you don’t want to pay property tax, don’t buy a house). Only a head tax would be truly unavoidable. Also, libertarians get the non-coerciveness of prices just by helping themselves to property rights, but in fact the reason that you have to pay for things is that you’re not allowed to steal them, and ultimately the reason that you can’t steal them is because of the coercive power of the state.

  5. Interesting stuff.

    Here is a question: how do paternalistic “taxes” fir into your scheme?

    Say, the state wants people to smoke less for their own good and thus puts a heavy “tax” on tobacco. Now, this is not a tax, according to your definition, because the intention is to change behaviour. But, the scheme being paternalistic, it is also not a price, because the state is not trying to approximate the social cost of the behaviour.
    So what is it?

  6. The voluntariness distinction itself breaks down under conditions of – shall we say market capitalism – for both prices and taxes, so it doesn’t to my mind get us much further to what a tax is. We can’t choose not to work and for middle and lower income brackets, we cannot chose to avoid most of our consumption, and so for both we cannot avoid paying the price and tax attached to each activity.
    compare the after-tax position of both, you see renting is actually much more tax inefficient than buying. You could choose to do neither, but it wouldn’t be so sustainable come winter.)

    In that sense earning prices and taxes (income and consuming) are both unavoidable. This is I think the retort to the libertarian position (I have vague memories of a M Friedman – CB MacPherson debate along these lines).

    The internalization of costs – carbon pricing is the example above – is very interesting, it seems to just highlight the conventionality of our thinking about what constitutes a price and I suppose a tax (and the value-laden vocabulary of discussions of tax versus price, e.g., “tax burdens”). When we talk about prices as the “social cost of a behaviour” I get equally queasy, it seems an abstract way to understand what prices are, how they get formed, what they “represent”. Lots of prices fail to properly internalize their true costs and (as just mentioned) lots of prices are not voluntary in any market exchange sense. It almost seems as if we have given up the (concrete and paternalist Toryism?) of discussing imposed costs or imposed taxes as the way we pay for “things to be done right around here”, in favour of a more abstract market-oriented vocabulary that itself is less offensive to libertarians but otherwise equally unsuited to or distracting from what we’re trying to achieve through good public policy which is only to ensure the cost of an activity is properly recognized.

    As an aside on the two reasons you cite for imposing taxes, raise revenue or influence behaviour, quite right, raise revenue. You have probably come across this in your reading, tax policy is typically evaluated with three criteria, administrative efficiency/simplicity (self-explanatory), neutrality (minimize impact on underlying behaviour) and equality (similar taxpayers treated similarly in similar circumstances). So one of the objectives of a tax system is not to influence behaviour, but seeking to avoid that. Of course, one of the objectives of some tax expenditures is precisely to influence behaviour of some social policy purpose (query whether this will likely lead to administrative intensity, but… .)

  7. ooops, correction to the comment: “(Take the house example you gave. You can choose to rent instead of buy, but compare the after-tax position of both, you see renting is actually much more tax inefficient than buying. You could choose to do neither, but it wouldn’t be so sustainable come winter.)

    Sorry about that.