The new carbon tax – is it really?

By Dr. Sirimewan Dharmaratne 

Taxation is in general an inefficient way to raise revenue. It causes a ‘deadweight loss’, which is a net loss of economic benefits to the society. This is why free market economies have an aversion for excessive taxation and generally looking for ways to bring down taxes.

Despite this, taxation remains the most common and socially acceptable way to redistribute income and finance essential public goods. Another important purpose of taxation is to correct market failures. Pollution, caused by carbon emissions is one such major market failure. The emissions from fossil fuel impose an additional cost on the society that is not borne by fossil fuel uses. In Sri Lanka, to the umbrage of the motorists, this wrath has fallen on them. 

Most countries impose a tax on fossil fuel, commonly known as a carbon tax. The UK imposes a tax based on EU’s Emission Trading System (ETS). In Ireland, the carbon tax is $ 20 per ton of fossil fuel. Similar charges are present in other developed and developing countries such as Chile. Correcting for all other factors, UK carbon emissions have reduced by 25% from 2010 to 2016 and Ireland has experienced a drop of 15% since 2008, due to the carbon tax.

The purpose of carbon taxation is to change behaviour and dampen demand for fossil fuels. If producers absorb the cost of the tax, their profits go down and they will look for alternative sources for energy production or improve technology to reduce carbon in fossil fuels. If the cost is passed on to the customer, the price of fuel will go up. This will increase the marginal or additional cost of each km of travel. Simple demand theory tells us that this will eventually lead to a reduction in travel and emissions. Sri Lanka’s recently implemented carbon taxation system is based on the age and engine capacity. For a motorist this simply a fixed cost and will not have an implication on how much they travel. If the objective is to reduce carbon emissions, then any policy measure should have an impact on the variable cost of travel. On the other hand, if this is simply a revenue raising mechanism masqueraded as an environmental policy measure, there are more straightforward taxation options what will significantly reduce the admin burden on both the Government and the motorists. 

Sri Lankan Carbon Tax

The currently implemented carbon tax will not have an effect on reducing carbon emission due to the following reasons.

Firstly, this policy ignores the primary economic principal in changing behaviour – that is changing the additional or marginal cost of travel and not the fixed cost. Once the tax is paid, it becomes a sunk cost to the motorist and does not have an effect on the running cost. In fact, each additional km costs less in terms of taxation as they travel more. It is obvious those who pay higher road tax or registration fees for a more expensive car, do not travel less because of that cost. This tax simply adds to that overall cost of keeping a vehicle.

Secondly, notwithstanding the above fact, this policy assumes that older cars in total generate more carbon compared to newer cars. While older cars may be less efficient and emit more carbon per km of travel, they may also travel less. Newer cars on the other hand, although may emit less per km, may travel more. Therefore, the underlying assumptions of this policy is quite arbitrary.

Thirdly, the policy does not give any incentive to reduce emissions. The motorists have no recourse to change the level of their emissions as changing the age or the engine capacity is not an option. There will not be a huge shift towards people ditching older cars and going for never models. For owners of older cars, who are likely to be the less well off, this is simply not an option, as the cost of the change far exceeds current and future taxes. Even for those who can, the difference in taxes is not significant enough to make the switch. In either event, the total pollution will remain unchanged and the total stock of cars and the total number of km driven are unlikely to go down.

Finally, this policy unjustifiably singles out motorists. Other fossil fuel uses such electricity producers, industries and such emitters are inexplicably excluded. This leads to a ‘Government failure’, where the Government fails to effectively correct the market failure and create further inefficiencies.

It is disingenuous for the Government to frame this tax as a ‘carbon tax’, which is one of the more respected and universally accepted environmental taxes. This taxation will cause reduced emissions, in fact if that is the objective. On the other and if this is simply a revenue raising measure, then in the pretence of framing this as an environmental tax, the Government has not only contrived a rather convoluted process to make yet another raid on motorists, but in the process will create further inefficiencies and distortions.

(The writer is a Senior Analyst, HM Revenue and Customs, UK and could be reached via email at: [email protected].)