Is the 'great big new carbon tax' a good idea?

I am using that emotive description of the new tax because I have previously suggested on this blog that a great big new carbon tax might not be a bad idea if it replaced other taxes that are having adverse effects on economic incentives. So, how good is the carbon tax package announced by the prime minister yesterday?


The first point that needs to be recognized in assessing the package is that it only makes sense if it is viewed as a signalling exercise. By itself this package will have a small impact on carbon dioxide emissions in Australia, a tiny impact on the world-wide emissions and an almost negligible impact on the stock of global emissions and global climate. Its impact depends almost entirely on the extent to which it may help to encourage people in other countries to take similar action to reduce their carbon dioxide emissions. If there is sufficient action by other countries more investors may come to expect that development of more efficient alternative technologies is likely to become a profitable venture.

The incentives that the tax provides for development of more efficient alternative technologies are the critical factor in whole exercise. If the world community ever gets serious about making substantial reductions in global emissions, the economic cost will be massive unless low-cost technologies are developed for energy generation and/ or removal of carbon dioxide from the atmosphere. Unfortunately, the proposed tax is unlikely to induce many people to rush into investing in development of new technology.

The tax cannot credibly be claimed to be anything other than a modest step by a small country. The longer term promises about the extent of reductions in emissions that are aimed for have little credibility. At best, the proposed carbon tax provides a weak signal of Australia’s willingness to participate in global action to reduce greenhouse gas emissions. The signal would be stronger if there was bipartisan support for the tax – but even if it is introduced and remains in place it will not amount to much in a global context.

Why don’t we hear the government arguing that ordinary people should be prepared suffer some pain in order to save the world from a climate disaster? The government is not talking about pain. It seems to have reasoned that since it will be obvious to almost everyone that the contribution of the tax to saving the world will be extremely modest and contingent on similar action by other countries, the tax can only be justified to Labor’s traditional voters if they suffer no pain. The package is being sold to the government’s traditional supporters as a redistribution measure that will actually improve their lot at the expense of the big polluters. And it is all being done in the name of ‘tax reform’!

Could anyone object to a new tax being used to fund reforms that will make the overall tax system more efficient? I imagine that such a proposal would have widespread support. The question that must be asked, however, is whether the proposed increase in the tax-free threshold should be viewed as a reform.

My concern is that the proposed tax relief will do very little to improve the work incentives faced by people with low incomes because it will leave effective marginal tax rates largely unchanged. The government has missed an opportunity to undertake some meaningful tax reform that might raise productivity. If this carbon tax package can be sold as economic reform, then the meaning of economic reform has changed beyond recognition and new words will have to be found to describe policy actions that will raise productivity.

Postscript:
In proposing to raise the tax threshold the government can claim to have followed a recommendation of the Henry review.
However, there is a strong case that greater tapering of welfare benefits would be a better way to tackle poverty traps.The relative merits of increases in the tax free threshold and greater tapering of welfare benefits as means of reducing poverty traps was discussed by David Ingles in a paper for the Australia Institute last year. Ingles suggested:  'In general, the recommendations of the Henry Tax Review are a slight improvement on the current situation but they do not address really fundamental issues and lack a coherent underlying rationale'.
In my view, Ingless goes too far in suggesting that the recommendations of the Henry review lack a coherent underlying rationale, but I can't see a coherent rationale in the way the government is cherry picking the recommendations of that review.

Why not think up a new political system?

Shona has a suggestion for a new project for me. Regular readers of this blog will remember Shona as the person who wrote some guest posts about volunteering. Shona suggests that I should invent a new political system.


This is what Shona wrote:

I just had my meeting with our local MP. Actually, Bruce was a ‘no show’ so he asked his minion to talk to me. I wouldn’t have minded talking to the minion if that is what Bruce had asked me to do originally. I was surprised that Bruce had asked me to talk, although I did write a very long email to him a few months ago. The appointment was set up 5 or 6 weeks ago and clearly his schedule has been overrun with his new responsibilities.


Bruce’s new responsibilities involve looking at social policy. His focus is on social issues that have become institutionalized (with groups representing them) and not the broader picture. That is a big mistake in my opinion.


In my discussion with said minion, I suggested that it didn’t matter what party was in power, we have people who don’t know anything about a subject leading policy. And there is no long term strategic thinking.


It makes me wonder whether this political system we have ever satisfies anyone. Are there any good examples of political systems anywhere in the world? Our political system is based on the British system which is hundreds of years old. If we were to start from scratch, what sort of system would we establish? It also strikes me as very bizarre that a head of a government agency has to be qualified to do that job, but a politician who directs and takes responsibility for the agency doesn’t have to have any qualifications! Shouldn’t there be some sort of competency system for politicians?


I am appalled by current politics. I don’t want to be forced to choose between existing political parties or leaders. Maybe you could invent a new political system from scratch for discussion – a system to perpetuate our happiness, and then perhaps compare it with what we have now. You could write thoughts on everything from competency criteria for politicians to voting systems. We could come up for a great name for it - the Winton System rather than the Westminster?

My immediate response was to start thinking up reasons why it is not a good idea to start from scratch in thinking about what kind of political system we should have. I don’t think it is possible for anyone (not even me) to understand how some political system that they thought up from scratch would work in practice. It is difficult to predict how politicians, judges, the media, interest groups and the public might respond to the incentives we might seek to incorporate in a new system until we actually see how they respond. Many people may tend to be less self-interested in their role as citizens than in normal market behaviour, but few are angelic. It is probably much easier to predict how people would respond to changes to a system in which norms of behaviour have already been established.

The suggestion of looking around the world to borrow ideas that work is sensible. I understand that is what the Americans did when they had the opportunity to start from scratch to invent a new political system. Australians did the same thing in developing a new constitution at the time of federation.

My starting point in thinking about political reform is to acknowledge that the Westminster system has one very good feature – it usually enables governments to be held accountable for their actions and to be voted out of office if they become unpopular. I think some of the argy-bargy that many people dislike about politics is an inevitable result of the role of the opposition and media in holding governments accountable. But the system does not reward politicians who are seen to offer unfair criticism. Politicians run the risk of losing votes if they are seen to be excessively negative or unnecessarily destructive

Added to the normal argy-bargy, some of the bad odour associated with federal politics in Australia at the moment seems to me to stem from the unusual situation in which we find ourselves. It is difficult for voters to hold the government accountable for the policies it is adopting because there was no clear winner after the last election. That means that the policies that the government has been implementing are the result of negotiations with minor parties and independents, rather than policies that it took to the people at the last election, or even policies that it can honestly claim to be in the interests of the community as a whole.

My next point is that in thinking about political reform we need to recognize that politics has inherent limitations as a way of getting things done. A lot of the disappointment about outcomes in a wide range of areas seems to me to stem from attempts to achieve things through the political process that would be better left to the private sector or voluntary co-operation. Why take money from people in order to provide them with services when they could obtain better value for money by buying them privately? The only answer that makes any sense is to make the distribution of services fairer – but governments do not need to be involved in actual provision of services in order to do that. As far as I can see there is no more reason to think that governments would be good at running schools or hospitals than farms, shopping malls or chook raffles.

A major problem inherent in politics as a way of getting anything done is that it involves giving some people the power to push other people around. People don’t mind when the pushing is obviously justified. There are not many people who mind being required to obey laws to respect lives and property of others, or being required to pay taxes to defend the country against potential foreign aggression. Politics becomes particularly objectionable when people get pushed around in order to provide benefits for some group that happens to be politically powerful.

In order to enjoy politics you have to either enjoy pushing other people around or enjoy pushing back. I think our main priority should be to contain politics to those aspects of life where it is actually necessary – so the pushing and shoving doesn’t intrude into aspects of life where it is unnecessary.

So, rather than start with a blank piece of paper I think it is probably better to look at the political system we have and to consider how it could be improved. The competency of politicians might be a good question to consider first. Should politicians be required to meet competency standards?

Does economic growth help people to thrive?

Yes! The proportion of people who are thriving tends to be higher in countries that have experienced greatest economic growth over the longer term. It may take several decades, however, for economic growth to be fully reflected in subjective measures of well-being. The proportion of people who are suffering also tends to be lower in countries that have experienced greatest economic growth, but there are quite a few countries that do not fit that pattern.


These observations are based on the definitions of ‘thriving’ and ‘suffering’ used in the Gallup World Poll. Gallup classifies respondents as "thriving," "struggling," or "suffering," according to how they rate their current and future lives on a ladder scale, based on the Cantril Self-Anchoring Striving Scale, where the bottom rating is ‘the worst possible life’ and the top rating is ‘the best possible life’. Further information on the survey and classification method is available here.

The following charts show the percentages of people who are thriving or suffering in 122 countries relative to per capita GDP levels in those countries. It is clear that the percentages thriving tend to be higher and the percentages suffering to be lower, in countries with relatively high per capita incomes i.e. those which have experienced greatest economic growth in the past.

The countries that do not fit the general pattern are interesting. Several former communist bloc countries are outliers in terms of lower percentages of the population thriving and a higher percentages suffering than would be expected on the basis of per capita income levels. Some African countries have much better outcomes and some much worse than would be expected on the basis of income levels. The outcomes that are worse than expected can be explained by factors such as civil unrest. Better than expected outcomes for African and Latin American countries in studies such as this are often attributed to national characteristics, such as a positive outlook on life (but that is not necessarily irrelevant to emotional well-being). The lower than expected percentages of people thriving in China, Singapore, Hong Kong and Taiwan might also be attributable to some extent to a more reserved outlook on life by Chinese people.

Another factor relevant to considering China, Singapore etc. is the rapid economic growth of these countries. As discussed in my last post, to the extent that well-being is affected by wealth (reflected in quality of housing, financial assets, human capital, public infrastructure, social capital etc.) as well as current income, countries with relatively high growth rates could be expected to have lower levels of well-being than other countries with similar per capita incomes. Regression analysis, comparable to that reported in my last post, suggests that growth prior to 1970 makes a substantially greater contribution to the percentage of people thriving than does growth in the periods 1970 to 1990 and 1990 to 2009. The results provide support for the view that is that it takes time for economic growth to be translated into forms of wealth that enhance well-being, rather than for the ‘unhappy growth’ hypothesis which I have discussed previously. The unhappy growth hypothesis implies that the estimated coefficients on growth in the most recent period could be expected to be negative, but I found the estimated coefficients on growth to be positive in respect of all periods. (The estimated coefficient for 1990 to 2009 is not significantly greater than zero at the 95% significance level, but the standard error is smaller than the estimate. Anyone who would like to see the results is welcome to email me.)

It would be appropriate to round off this discussion with a profound statement stressing the importance of economic growth to reducing human suffering and allowing more people to thrive, while acknowledging that wealth does not guarantee that anyone will thrive. However, I’m not in the right mood for writing profound statements.

How long does it take for GDP growth to be reflected in higher well-being?

In a paper written while he was at the World Bank, William Easterly found that changes in quality of life are surprisingly uneven as per capita income grows, despite the fact that a remarkable diversity of indicators shows quality of life across nations to be positively associated with per capita income. This finding might deserve to be called Easterly’s puzzle. (Bill Easterly is probably better known for his observation that foreign aid frequently fails to promote economic growth – but I don’t think that qualifies as a puzzle.)


One possible explanation, discussed briefly by Easterly, is that there may be ‘long and variable lags’ in the relationship between quality of life and economic growth. A related possibility, that is supported by some simple analysis I have undertaken for OECD countries, is that well-being is affected by wealth (reflected in quality of housing, financial assets, human capital, public infrastructure, social capital etc.) as well as current income. In this post I want to explore this possibility for a wider range of countries using the Legatum prosperity index. As noted in my last post, the Legatum prosperity index is highly correlated with the OECD’s well-being index.

To the extent that well-being is affected by wealth rather than current income, countries which have experienced rapid economic growth in recent decades could be expected to have lower well-being levels than those with similar income levels which have a longer history of relatively high per capita incomes. The following table provides results of regressions in which the Legatum prosperity index and various components of this index are explained by the log of per capita GDP in 1970, and the change in log per capita GDP from 1970 to 1990 and from 1990 to 2009. If the component of current income reflecting relatively recent growth has a similar coefficient to that reflecting income in 1970, it would be reasonable to conclude that capital stocks are not relevant to current well-being. (There are 92 observations in the regressions; 18 former Soviet block countries had to be omitted because of lack of lack of comparable per capita income data. Per capita GDP data is from Penn World Tables – the rgdpl measure.)

The results are consistent with the view that well-being is affected by wealth as well as current income. For the index as a whole, the estimated coefficient on the variable reflecting relatively recent growth is substantially lower than that on the variables reflecting past growth experience. The results for some components of the index also support that interpretation.

Economy: The estimated coefficient on relatively recent growth is actually higher than that on the variables reflecting previous growth experience. That result is to be expected because the economy variable is derived from a range of indicators of recent economic performance.

Entrepreneurship and opportunity: The low estimated coefficient on relatively recent growth is to be expected because an entrepreneurial culture takes time to develop. I usually think of causation running in the opposite direction – from an entrepreneurial culture to economic growth – but success often breeds success.

Governance: It may not appear to make a lot of sense to view low levels of corruption as a consequence of economic growth, rather than vice versa, but some of the indicators covered (e.g. political rights and regime stability) could reflect a build-up of institutional capital that has been fostered by economic success.

Education: As expected, the estimated coefficient on relatively recent growth is lower than on previous growth experience, reflecting the time it takes for improved education of young people to be reflected in the stock of human capital. Some of the indicators covered in the education variable reflect current enrolments rather than education levels of the population.

Health: Reasons for the low estimated coefficient on relatively recent growth would include investment required to improve sanitation and water quality, and the time required for training of health professionals.

Safety and security: As expected, countries with a long history of relatively high per capita incomes tend to have less violence. Low violence is conducive to economic activity and economic opportunities reduce the incentive to engage in criminal activities. The relatively low estimated coefficient on the recent growth variable suggests that economic growth has a greater positive impact on safety and security when it is sustained over a couple of decades.

Personal Freedom: Civil liberties, satisfaction with freedom and tolerant attitudes are strongly associated with a history of relatively high per capita incomes. The results do not shed much light on the effects of more recent growth experience.

Social Capital: Again, relevant indicators such as trust and perceptions of social support are associated with a history of relatively high per capita incomes, with greater ambiguity in respect of recent growth experience.

The regression results also indicate that the relevance of per capita income to explanation of the various components of the index varies considerably. Income history seems to be much more relevant to education and health outcomes than to personal freedom and social capital. Performance in relation to factors such as social capital helps to explain why some countries (e.g. New Zealand) have higher overall index scores while other countries (e.g. Greece) have lower overall index scores than would be predicted on the basis of income history.

Finally, to answer the original question, the results reported here suggest that it can take two or three decades for GDP growth to be fully reflected in higher well-being levels.