Guest Post by Willis Eschenbach
Over at her excellent blog, Judith Curry is hosting a discussion that in part is about “revenue-neutral” carbon (in reality energy) taxes. This is another example of where being a generalist is an advantage. I’ve started and run businesses, so I know why revenue neutral isn’t neutral at all when it comes to an energy tax.
Figure 1. The money doesn’t always end up where you think it will go.
The reason that energy taxes are not revenue neutral is that although the government does indeed return the taxes to the consumers, there is a hidden effect working under the radar that most folks don’t think about.
A businessman prices any product based on how much money he has in it. A typical rule of thumb for manufactured products, for example, is that your product should sell for around twice what you have directly invested in producing it.
So a typical product cost analysis might look something like this:
Widget Production Cost = $10 materials + $10 labor + $10 energy = $30 total cost per widget
Widget Sales Price ≈ 2 * Widget Production Cost ≈ $60 per widget
The businessman has to do that, he or she has to get a percentage return on the money that they have tied up in the product. So I go in and buy a widget, I pay $60, and go home happy.
Now, remember that the deal with a “revenue-neutral tax” is that the consumer is supposed to get the money back from the government. According to the pundits, this means that a revenue-neutral tax won’t slow down the economy, since the taxes aren’t removed from circulation, instead they’re returned right back to the consumers. We’ll ignore the details on how that is supposed to happen in a fair and equitable manner, although that’s another interesting can of worms. For our present purposes, we’ll leave that worm tin hermetically sealed and just assume that the US Government in its brilliant wisdom has decided to impose a $10 tax on the energy that’s used to make widgets. To balance that out and make it all revenue neutral, they’ll give you that money back as a crisp new $10 bill when you buy a widget. Perfectly revenue neutral. What’s not to like?
Here’s the difficulty. Let’s run the new widget costing numbers including the tax.
Widget Production Cost = $10 materials + $10 labor + $20 energy = $40 total cost
Widget Sales Price = 2 * Widget Production Cost = $80 per widget
So I go in to buy another widget, I give the widget man $80, and the Government gives me $10 and says everything is for the best in this, the best of all possible worlds. It’s all balanced since the tax was $10 and I got the $10 back, so the Government and I are exactly even, shake hands and part revenue-neutral friends …
Except for the part where I’m short ten bucks, and the widget maker has made ten dollars extra for the same widget. The revenue is neutral, but despite that, in the case of energy taxes the net effect is to slow down the economy.
Why will the economy slow? If we have the same amount of goods at higher prices, demand will fall and the economy will slow. It’s basic economics.
And that’s why a “revenue-neutral” energy tax isn’t neutral at all … and more to the point, it’s one reason why taxing energy in any form is a really dumb idea. Even when it’s revenue-neutral it slows the economic cycle, and when it’s not revenue-neutral, it slows it even more.
w.
PS – In addition, an energy tax is a very regressive tax. An extra $10 energy tax for the energy used to commute to work means little to the CEO, but may break the bank of the janitor. Taxing energy is a bad plan for a host of reasons.
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Dear Moderator,
My comment to Willis of more than 1 hour ago is stll stuck in moderation.
Can you free it from the nether gods?
Thanks.
John
vindsavfuktare says:
March 18, 2011 at 1:52 am
You miss an important linkage. Energy is development. Taxing energy is taxing development, which discourages development. Which means people have less food and less medicine and less clothes and less shelter … and why on earth would you want to do that?
You don’t even have to make the choice, since you can decrease pollution without decreasing energy use … why not focus on that instead? Because we can have both increased energy use and decreasing pollution, the US has proven that for years.
Next, you say “Any tax levied by the government will increase product cost more than the tax itself.” This is not true. If you tax the output of production (say via a sales tax), this doesn’t increase the product cost by one penny more than the tax.
This is because where you tax is as important as how much you tax. Any tax is like a weight on the economy. But it’s like a person carrying a weight. It’s easier to walk with forty pounds (18 kg) strapped to your back than with forty pounds strapped to your ankle. Taxing the inputs to production, as opposed to the outputs of production, is like strapping the weight to your ankle. Taxing inputs (whether of materials, labor or energy) slows down the economic cycle more than taxing the outputs. It may be the same weight, but it’s around your ankle.
w.
My wife and I tried the import/wholesale business once. We thought it would be clever to reduce the markup rate to increase our sales. We found that much less than 50% margin and we were either getting less return on our investment than we could get from a bank deposit or we were working for less than minimum wage.
We moved on to other occupations not subject to fluctuating exchange rates and freight costs.
Another great post Willis.
George Tetley says:
March 18, 2011 at 2:18 am
Yeah, five bucks is lost in each transaction, but it doesn’t matter because the government makes up the loss by the sheer volume of transactions …
w.
The purveyors of these taxes would probably see this as a feature not a bug. The purpose of such a tax is supposedly to discourage the use of energy. Widgets are bad, goes the logic, because they use energy. The tax is to discourage widget use. And indeed you’ve just demonstrated that they work. The economy slows – everyone gets poorer, and less widgets are produced and consumed. From a green point of view what is not to like.
Willis said: “And that’s why a “revenue-neutral” energy tax isn’t neutral at all … and more to the point, it’s one reason why taxing energy in any form is a really dumb idea. Even when it’s revenue-neutral it slows the economic cycle, and when it’s not revenue-neutral, it slows it even more.
Why will the economy slow? If we have the same amount of goods at higher prices, demand will fall and the economy will slow. It’s basic economics.”
You have misunderstood what revenue neutral means. It does not mean it will be revenue neutral *for you*. It is not the overall cost you must consider but the revenue that the Government receives from the process. You would not be getting $10 from the Government. You and all the other players in the process would see a reduction in other taxes equivalent to the $10 energy tax.
As explained at Juduth Curry’s page it is supposed to be an policy that does not alter the total revenue of the Government – replacing one tax with another. eg, working out how much an emissions tax would bring in and shaving a bit off income tax to keep Government revenues static. A reduction in income tax would leave more money in your pocket offsetting the higher sales prices you would be paying.
The merits of such a change are likely shortlived though. If the tax worked the Government would see a reduction in revenue due to falling emissions, and either increase the emissions tax rate or put up other taxes. That is where the drag on the economy would come – the Government making a change that changes market behaviour but not being prepared to ride out the revenue consequences of it.
Has anybody calculated how much it cost to apply and control this tax monstrum? Whoz gonna pay that?
There’s no such animal as a true ‘revenue neutral’ tax, be it on energy or anything else, even if the government-du-jour introduces this tax as such.
Come the next budget, this tax will allow a government some nifty manipulations/social engineering.
They’d claim that those above a certain income level can’t/won’t get the whole amount back because they surely would like to support ‘the poor’. So have your income tax code handy for every time you buy a widget from Willis … and the government will then also have a very good idea who buys what with their own, hard-earned money.
Next, they rise this tax. Since it’s revenue neutral, this doesn’t really matter, right?
Well – those on ‘higher incomes’ will get even less back while the government retains more.
Next, the level at which the tax will be paid back in full will be extended downwards, so more people will get less back … and so forth.
Can’t happen? Hah! Show me one government which isn’t adept at getting more out of people’s pockets, year by year!
Here in the UK, this sort of thing is called ‘stealth tax’, and we Brits have been exposed to this sleight-of-hand since 1997.
And the premis for the tax would be ….what ? Don’t tell me that the prescribed taxation bureaucrats and authority, which draw salaries and absorb administrations costs, do this for the sole purpose of giving the collected taxation back to the taxpayer for no administrative gain. What, is the tax collector now trying to participate in playground/sandpit activities ?
Even without the profit multiplier it’s still a bad deal, because the buyers have less money for most of the year, thus less ability to spend their money on anything. Typical consumers won’t feel the annual refund as a compensation for the money they overspent. It will just feel like inflation of prices without inflation of wages.
Willis,
You never mentioned imports from other countries use their own fuels in manufacturing, have cheaper labour, etc.
So, unless the governments slaps on a tariff, the imports would have an unfair advantage.
The tariffs would be against free-trade agreements and the added revenue from tariffs are another tax imported into the governments pocket.
TFN Johnson says:
March 18, 2011 at 1:06 am
Your cost line in inaccurate.
The widget maker does NOT get the rebate.
His costs still must account for the $10 ‘neutral tax’ until he recovers it. But as I’ve noted above, he does not get the rebate. The government will not distribute the rebate back to the single, rich widget maker, but rather the thousands of widget buyers. Move votes with the widget buyers than widget makers.
There are a few errors here in various people’s calculations.
Willis – I’m afraid you have missed something.
The businessman makes an extra $10 profit, as money can’t just get lost.
(That’s $40 – $30 = $10 extra profit).
Somebody thought that the refund would go to the businessman so he stilled charged $60 dollars. That’s not how taxes and redistribution works.
It’s the buyer who pays the full $80 and gets $10 back, so he’s a net $10 out of pocket.
Now in the case of CO2 taxes, there is NO low cost local competion.
The widget manufacture is competing with the “fairy floss” widget maker, who has to charge $80 just to scrape a poor living, because his process is so inefficient.
AND the government charges the widget maker tax on his extra $10, so the manufacturer is not quite as much in the money as the above would suggest.
What’s more, all these extra costs and taxes go to add to inflation, so up goes the prices, which set off another merry-go-round.
Finally, many psychological studies have shown that people hate additional costs, much more than they like winfall gains.
AND the extra cost comes when you pay your electricity bill or fill your car with petrol.
The tax reimbursement comes when you pick up your pay packet or at the end of the year when you get your tax refund – “mmmmm – I seem to have a bit more in my packet this week, so I go off to the pub and have a quick one on the way home”.
Get home late, get a pasting from the better half, open your electrcity bill and see that it has gone up once again.
Swear to vote for the opposition the next time around.
What’s more, the cost of widgets is built into every single article produced and service rendered.
It’s a drag on the economy.
Taxes have to be raised to pay for essential government services.
Taxing energy at the base of the production pyramid is the dumbest way to raise government income.
And do you really imagine that the fiendish foreigners will play by the same rules as your good goverment.
Naw – they’ll find a smart undetectable way to cheat.
CO2 will keep going up in the atmosphere.
Plants will continue to grow faster with more CO2.
Oh and you will be out of work because widgets are now imoprted and your employer has gone broke.
I wonder why?
Oh well, that’s life, but at least we’re “doing good”.
Willis,
1. The tax is supposed to reduce or slow the growth of CO2 emissions, so unless there’s an equal or better substitute for emitting CO2, it *must* slow the economy.
2. A tax on “the output of production” is a consumption tax. It’s misleading to speak as if it were a tax on production, although obviously it will slow down production, unless there’s an equal or better substitute etc. as I said.
I understood that the “tax returned” to the consumer is usually quoted “net of costs” ie all the bureaucracy.
Another extra is the tax on tax situation. In Britain we pay 20% value added tax (VAT) this is calculated on the cost of the product. If the product cost already includes a hidden energy tax, this is taxed again. This VAT on the extra energy tax is not returned in any proposal I’ve seen. In USA I presume this is equivalent to state and federal taves.
Moreover, the widget may (1) be an item characterized by demand elasticity and (2) be a labor-saving device. If so, at least some folks won’t buy it and will instead divert some of their labor from activities (such as medical research) that only humans can do to activities (such as shoveling their walks) that machines could handle. Result: less productivity, less human welfare.
vindsavfuktare said: I disagree. Taxing energy has the side effect of decreasing pollution (not talking CO2 here). Taxing labour has the side effect of increasing unemployment.
What do you mean by “taxing labour”? It sounds like you’re talking about a tax on employers, but I don’t think you are. Unless you are, “taxing labour” is misleading.
Any tax levied by the government will increase product cost more than the tax itself.
That’s not true. For example, except in some cases, a sales tax increase raises the retail price, but not by as much as the tax. Exactly how much it raises it depends on the slopes of the supply and demand curves. It would take too much writing for me to explain this, but I assure you I’m not making it up. It’s in economics textbooks, and it is not controversial.
Barry Dwyer said: Excellent, simple description. The pollies only talk about the part that relates to the business. So they hide the inconvenient truth that the consumer pays the tax – ie., increased price.
No, the consumer pays part of the tax. The consumer may pay all of it, but this is far from guaranteed. I’m not speaking of the legal arrangement. I’m speaking of the economic loss. This is in economics textbooks, and it is not controversial.
The point is well made about the administrative costs of such a carbon scheme. In fact, looking at these issues from the point of view of suppressing CO2 production is precisely the wrong way to look at them. The reason they do not seem to make sense is that the main drivers for them are not the ones that are claimed.
The first aim of government is to keep existing. To do this it needs functions. Government does not care whether a tax scheme will do what it is intended to do or not – it cares about how many jobs it will get out of it. Government proposals already have suggested levels of carbon tax which would be completely ineffective in order to try to get agreement for the big prize, which is a huge increase in government jobs, paid for by admin costs.
Traders and businessmen want to make money. They want to go for complex trading schemes where they can turn a profit. So we have these as well. The do nothing for CO2, but a lot for the operators….
The Al Gores of this world make their money out of scare stories. The last thing they want is decreasing temperatures, or, even worse, decreasing CO2 levels…
I suspect that the only people who really want CO2 levels to go down are the rank and file Greenpeace activists. And they only have the haziest conception of what CO2 is, and have no power to do anything at all….
As a thing of note, the multiplier of 2 that Willis uses does not really mean that company that produces said widget is making 100% on it. Majority of that multiplier is going to pay for distribution and retail. The end product is going to wholesaler, then to local distributor, then to a local store shelf, and so on. Everyone in the chain has to make money. Depending on the product, multiplier can be as large as x3, while profit margins could be 15%-25%.
By charging tax on the “front end ” of production cycle, any multipliers that are applied to the cost of the product will be applied to the tax as well, and had to be applied to rebate to be revenue neutral on all of the levels of the distribution. That will require exact knowledge of multiplication factor at every level and will make cost of collection enormous.
Willis,
Most successful businesses don’t price based on cost. Not that it doesn’t happen, but it is almost never the best way. Successful business price based on value (charging the customer the maximum willingness to pay), and taxes add no value.
Also, if the tax is applied to all businesses, even if they do price based on cost, it is unlikely the tax will be included. To do so would be somewhat like trying to charge a premium for a commodity. If some businesses tried to add a mark-up to the tax, others will see an opportunity to capture market share by not adding a mark-up to the tax. Those marking up the tax will be forced to follow or lose market share.
There may be some measure of the effect you describe, but I think it will be much smaller than you expect.
In any case, please don’t confuse this with support for the tax. I agree no good comes from taxing energy.
Sorry, Willis, but, for the first time here at WUWT, I have to disagree with you.
As was pointed out earlier in this thread, competition will prevent manufacturers and distributors from passing on more than the actual tax amount to the consumer, and that exact amount will be returned in the form of a prebate. (Only citizens and legal residents will get the prebate so, indirectly, the carbon tax will penalize and thus discourage illegal aliens.) Thus, the economy will not suffer.
The revenue-neutral carbon tax that for example, Charles Krauthammer, the conservative opinion leader (and, James Hansen, pardon the expression, but even a stopped clockis correct twice a day) have in mind would be charged at the port of entry, mine, or well for all fossil fuels, based simply on their carbon content. This will cost very little to administer because the government already imposes taxes at that level and the carbon tax will be an add-on.
A big advantage of a revenue-neutral carbon tax over the cap and trade scam, is that there will be no need for the government to monitor actual carbon emissions. Just tax the carbon going in to the system and let industry and consumers figure out what is in their own best self interest. No government snoops looking for gas in our underwear or accountants calculating our wind power credits and other “green” stuff – just carbon in – tax money out – distribute the money to all citizens and legal residents!
As we saw when world events pushed gasoline to $4 and $5, people will adjust their behavior when the money is coming out of their own pockets. Some will car pool, or take public transit, or move closer to work, or bicycle, or vacation closer to home, etc. Some industries will make energy-saving capital investments, if that is in their own interests. Others will pay the tax – according to their own calculations of self-interest.
See Carbon Tax YES! – Cap&Trade NO!.
Economists have these things called Supply-Demand charts that (purport to) show that prices are not set by merchants, cost of production, markup, etc they are set by supply and demand. They draw a line that (purports to) show cost vs supply and another that (purports to) show cost vs demand. They assert that prices will fall around the “equilibrium” point where the two lines cross.
http://en.wikipedia.org/wiki/Supply_and_demand
I have some doubts about this stuff, but economists don’t. And in fairness to economists, although they don’t usually run experiments even when they could, in this case, there really is is experimental evidence that prices do converge to a point. Who knows, it might be the equilibrium point.
So, what we probably need to do is figure out how the tax shifts the supply and demand curves and see where the new equilibrium point is. I haven’t the slightest idea how to do that. I’m not sure that anyone does.
I don’t know how your sales tax system works in the US, but in the UK we have VAT currently at 20%. This is calculated after all other duties and taxes have been added. Thus if £10 energy tax was levied, £12 would be added to the cost even without the seller restoring his margin. If we ever saw the £10 returned in a rebate we would still be £2 out of pocket.
Let’s not forget sales tax. I would be paying $4.20 sales tax on the $60 price, $5.60 on the $80 price. So much for neutrality.