I got 99 problems but a carbon tax ain’t one: The latest evidence on the impacts of a carbon tax on different income groups

A concern often expressed about carbon taxes is that they tend to hit hardest the income groups that spend a bigger proportion of their income on electricity and fuel. This tends to be people in lower-income groups, who normally also have fewer options when it comes to reducing their use of electricity and fuel. For instance, if you’re worried about paying your bills and making ends meet, you’re not likely going to be able to find the funds needed to better insulate your home in order to save on energy costs, or to buy a new more fuel-efficient vehicle. It’s also hard to cut back on luxuries in order to pay higher costs for energy if you’re already spending all your income on things that are necessary.

When a tax takes a higher percentage of income from lower-income people than it does from higher-income people, it’s called “regressive” and most people generally think there’s something inherently unfair about it. In 2011, Sustainable Prosperity released a Policy Brief discussing how carbon pricing (including both carbon taxes and carbon cap-and-trade systems) has the potential to be regressive and how policy-makers could seek to address that through the initial design of the tax, or through mitigating measures.

Interestingly, new evidence shows that carbon taxes have the potential to be “progressive” – meaning they hit lower-income people less than they do higher-income people. A forthcoming article by Yazid Dissou and Muhammed Shahid Siddiqui ("Can Carbon Taxes Be Progressive?," to be published in the journal “Energy Economics”) shows that if you take a wide look at the impact of carbon taxes, such an outcome is possible.

I’m taking a few liberties here in trying to translate economics to real-world language, but the bottom line is something like this: Dissou and Siddiqui argue that we should consider what impacts a carbon tax could have on not just how much people spend on goods and services but also on factor prices (an economic term to mean the costs of inputs into production processes, like the price of capital, the cost of wages, etc.). Changes in factor prices can affect people’s income — generally speaking, lower-income people get most of their income from their wages, while higher-income people get a larger share from their capital investments. Previous research has shown that industries that are more capital-intensive see the biggest negative impact from a carbon tax, which is more likely to affect higher-income people’s income. So we have increases in the price of goods and services affecting lower-income people more, and income decreases affecting higher-income people more.

Dissou and Siddiqui build an economic theory to explain this and then use an economic model to simulate the different impacts of carbon taxes. They find that the two effects are indeed opposite (the goods and services cost element is regressive, the income element is progressive) and that whether or not a carbon tax will ultimately be regressive, progressive or balanced (meaning it does not impact different income groups differently) depends on the level of the tax and the context around it.

As we continue to explore the best ways to implement carbon pricing, we need to keep in mind that everyone is affected by a carbon tax. In the short-run, we could reasonably expect that people in all income brackets will be impacted when a carbon tax comes into effect and prices and incomes change. However, the potential for carbon taxes to be regressive is something policy-makers need to pay close attention to, particularly given the large and widening gap between the wealthy and the poor.

Our success in building support among Canadians for policies like carbon taxes will depend on how well we can address important issues like their potential impacts across different income groups. If we design policy well and are aware of potential impacts from the outset, we can think about the best policies to use to mitigate impacts on those hit hardest and to smooth the transition to a low-carbon future.