Angry in the Great White North

Liberal Party leader Stephane Dion wants Canadians to pay a tax on carbon usage.  The carbon tax will encourage us to use less fuel, but we'll be compensated when Stephane Dion lowers income taxes:

Dion is clearly hoping his carbon tax will capture public imagination, and answer an inchoate longing for bold, positive leadership. His success will partly depend on the details of his plan, to be released in June. All we know is that it is supposed to be revenue neutral - all the money raised will be returned through income tax, or other reductions.

How does this help the environment?  It doesn't if I keep consuming the same amount of fuel.  Now there is a carbon tax, so I am penalized for using carbon, and rewarded for not using carbon.  If I reduce my carbon usage, the amount I pay in carbon tax goes down.  I have more money in my pocket and I have a smaller carbon footprint.  See?  It's so obvious.

Maybe too obvious.  I've been thinking about the carbon tax and the notion of being "revenue neutral" and the implications of that.  It seems less obvious to me just how this is supposed to work.

First, off, revenue neutral means neutral for the government, not for people paying the tax.  I might pay $100 extra in carbon tax, and the government returns an additional $100 to Canadians, but not necessarily to me.  Indeed, an increase in government spending by $100 might be "revenue neutral" too, if you assume $100 in government spending results in $100 in value-added services to Canadians.  Nevertheless, let's be optimistic and assume that Stephane Dion will cut taxes so that, overall, the government collects $100 less in corporate and income tax.

For simplicity, let's only consider income tax as the tax being reduced.  Now play along with a few made-up numbers.

So let's pretend that the government collects $100,000 in carbon taxes in the first year.  It also collects $500,000 in income taxes.  To be revenue neutral, it cuts the income tax rate in order to collect only $400,000 in income taxes next year. 

How does this save the environment?  I'm still using carbon at the same rate.  But now I see a way to keep more of my own money by cutting my carbon use.  I pay less in income tax and less in carbon tax.  I win because I have more money, and now I'm using less carbon. The Earth cools, and polar bears increase in number and roam free through the streets.  Yay!

Let's say that in the next year, we all cut carbon usage and so the government only collects $50,000 in carbon taxes.  The government already cut income taxes in order to return the carbon tax collected in the previous year, so in this year, the government collects a total of $450,000 in taxes, compared to the total of $600,000 the year before.  To be revenue neutral, the government ought to have collected and kept $500,000 (assuming no changes to the tax code unrelated to carbon taxes) from all tax sources.

Faced with a $50,000 shortfall, the government has to (1) increase the carbon tax significantly in order to collect even more carbon tax money even though carbon use has gone down, (2) collect less in carbon taxes so as to return less income tax in the next year, or (3) increase income taxes to fill up the room left by my environmentally-friendly efforts to reduce carbon use.

The problem with (1) is that carbon usage has gone down, so the tax has to be raised dramatically higher in order to recover the revenue from a smaller carbon tax base.  That would look bad for a government.  People would be upset that all their efforts to benefit financially from reduced carbon usage was just wiped out.  And it's a vicious cycle, if as the environmentalists assume, the carbon tax can drive carbon use downward indefinitely.

The problem with (2) is that it essentially is a movement back to the old status quo.  It's perverse.  The government would ease up on the carbon tax in order to encourage more carbon usage and so recover the lost revenue.  Why bother going down this path in the first place?

The problem with (3) is that it is hard to explain to Canadians how increased income taxes added to a new carbon tax is revenue neutral.  My revenue seems to going in reverse and fast.  As I said, though, revenue neutral refers to the government and not to you and me.  But a new carbon tax followed by increased income taxes?  The distinction will be lost on most people.

Really, the goal of revenue neutrality only works if the balance between income tax revenue and carbon tax revenue remains fixed.  That would work if carbon taxes remained fixed, but the whole point of this exercise is to see carbon usage go down over time. If carbon usage goes down, carbon tax revenue goes down, and the government has to recover the cash from some other source in order to maintain neutral cash flow.

But that messes with whole point of the carbon tax, which is to shift taxation from income to carbon usage.  My income tax goes down, and I'm encouraged to lower carbon usage, which means my carbon tax goes down.  I pay less overall tax, and I'm happy.  The government, on the other hand, is taking a big hit, having shrunk income taxes and now seeing carbon tax revenues shrink, and is no longer revenue neutral.

So which is it?  Revenue neutral, which means I pay a tax either here or there but always somewhere?  Or revenue shrinkage as a result of a shrinking carbon footprint, which is a measure of success for me, but also means the government has to shrink too?

Addendum: Wait, you say, what about increased spending?  I have more money in my pocket from lowered income tax and my smaller carbon footprint.  I use money to buy stuff.  That generates revenue in sales taxes.

Yes, there would be some joy there.  But is it enough to compensate for the reduced revenue?  You can compel people to pay taxes, but you can't compel them to spend money.  What is the right level of GST to make up the difference?  Is it higher than 5%?  Would the Liberals bring a carbon tax and then increase the GST in the following year?  Does the GST become the tap the government adjusts to maintain a neutral revenue flow?  Increasing the GST and applying a carbon tax is a brake on spending, which hurts GST revenues.  But then that's good for the environment.  When you buy stuff like cars and houses and such, you're increasing your carbon footprint.  Indeed almost any spending has a carbon price attached to it.  Remember, I wanted to reduce my carbon footprint.  One way to do that was to reduce spending. A carbon tax will encourage me to spend less, even as lowered income taxes encourage me to spend more.  Honestly, I'm not sure one can balance the other.

Stephane Dion wants to drive down carbon usage but maintain government cashflow.  I think the dynamics of the situation are so tricky and the elements so interconnected that I can't see how it could be made to work.

Ultimately, I'm not sure how you make something good for the environment and good for the government when you are forced to make it revenue neutral at the same time.  Well, I guess you can, by making it really bad for Canadians.

Addendum: The real answer is that we reach a new stable point.  Carbon usage stabilizes, and government revenues stabilize as well, presumably with new stable income tax and GST rates.  The government is still revenue neutral, which means we're all paying the same overall tax as we were before all this started.  Resigned to a lifestyle of reduced heating during cold winters (colder now that Stephane Dion's carbon tax has fixed the global warming problem), Canadians stop trying to reduce carbon usage, and the government stops encouraging them by leaving the carbon tax rate alone.  Then the real question becomes at what point do Canadians just give up and stop chasing the carbon reduction dream?  If there is a follow-on to the Kyoto Protocol and there are new demands for even lower emissions (because, really, do you think it'll ever stop?), does Stephane Dion tell his environmentalist friends that Canada is comfortable with emissions just the way they are?