Brookings: Experts - Warwick J. McKibbin

Australia's Banana Republic Political Fiasco is Hurting It Internationally

Warwick J. McKibbin — Fri, 22 Mar 2013 00:00:00 -0400

Any Australian overseas on March 21 was glued to their internet connection, just as I was in Washington, awaiting the outcome of a key battle in the civil war within the Labor Party. After weeks of senior ministers telling the Australian people to their faces that there was no leadership issue, there had been a spill of the party leadership.

Either these more outspoken ministers were knowingly lying to the Australian people about instability in the Labor government or they were ignorant of what was going on around them. Either way, they should not still be representing the Australian people.

However, the issues run much deeper than honesty. They go to the extreme damage that political uncertainty is doing to Australia’s international reputation and ultimately the Australian economy.

For the week before the spill I had colleague after colleague filing through my office at the Brookings Institution asking questions about what was happening. After 20 years of commuting between Canberra and Washington, the interest in Australia was very different. The questions, however, were worrying.

Why was a country that had withstood the worst of the global financial crisis suddenly switching direction and following the Latin American model?

Why get on that slippery slope of backroom deals, attacking business, giving unions power over economic decision-making and abandoning the path of economic reform when the opposite had seemed to work well for so long? Australia had just become a role model for economic management. Most importantly, why was the government attacking freedom of speech? In Washington, where Congress was in a stalemate, even being unable to put together a budget, the question was why would a prosperous country like Australia squander a position that Americans dreamed of?

Political uncertainty accompanied by bad economic policies can quickly shift an economy from the path to prosperity to a populist but poor economy, such as was a far too common experience in Central and South America over the 20th century.

I found myself, as a proud Australian, on the one hand defending it but on the other hand, as an academic, having to offer an honest analysis of what was going wrong.

It came down to a number of factors. A major problem was minority government – where one party clung to power and sacrificed its very soul to make deals with minor parties and individuals. Declining popular support drove policies that distorted decisions across the economy in order to channel funds back to the base constituency, including the trade union movement. It would have been far cheaper for the economy if the government had paid direct bribes rather than distort economic activity but the latter is harder to trace, thus more popular.

When governing by spin (or propaganda) stops working because the results are not consistent with the never-ending announcement of major policy reform, a politician has no choice but to admit it was an illusion or to attack freedom of speech. This was particularly important where that freedom of speech pointed to glaring problems in the government.

If the independents, the Greens or anyone in the Labor Party have the national interest at heart they need to end the current government and let the people decide who should govern. Another six months of the fiasco will have enormous reputational costs internationally and cause enormous economic damage in Australia.

In the end the Gillard government has had at least two spectacular achievements.

It has made the Whitlam government look like good economic managers and it makes the US Congress look functional after all. Most importantly, it has made my American friends feel more comfortable with the failures of their own political system.

A happier America is good for the world economy.

Authors

Warwick J. McKibbin

Publication: Australian Financial Review

Image Source: © Regi Varghese / Reuters

China’s Carbon Tax Proposal Highlights the Need for a New Track of Climate Talks

Adele Morris, Warwick J. McKibbin and Peter J. Wilcoxen — Fri, 15 Mar 2013 00:00:00 -0400

China’s Ministry of Finance recently announced a carbon tax. Although the statement was vague about the timetable and the tax rate, the mere prospect of China pricing carbon should have prompted swift laudatory international responses, especially by countries that have long hectored China to take stronger action on climate. China’s announcement, and the underwhelming response of the international community, shows that it’s time to start an international conversation about pricing carbon and invite anyone who’s interested aboard. A Carbon Pricing Consultation (CPC) would allow China and other countries that want to price carbon (via a carbon tax, cap-and-trade system or a hybrid approach) to learn more about it, exchange views, find out what other countries are considering, and potentially coordinate their policies.

In a recent paper we proposed a CPC process that would lead to detailed, pragmatic, and ongoing international discussion of the implementation details of domestic carbon pricing approaches, policies that economists widely agree could address the climate problem cost effectively. A domestic carbon price creates broad, efficient incentives to reduce greenhouse gas emissions. Done well, it would gradually shift consumer demand, production methods, new investment, and technology development towards less emissions-intensive goods and services without unduly burdening poor households. Pricing carbon can also raise revenue to fund government programs or cut distortionary taxes. Finally, a carbon price can promote economic growth by replacing less efficient regulatory and spending policies.

Accordingly, we think parties should embrace carbon pricing as a key low-carbon growth strategy and establish a venue to discuss it. Disparate carbon prices across different countries can shift emissions, production, investment, and trade patterns, and mutual understanding of these cross-border effects is of interest to all. Several countries have adopted or are implementing carbon pricing policies, so there is increasing experience to discuss. And the vehement opposition to the EU’s efforts to price carbon in aviation fuels suggests that unilateral approaches to carbon pricing can undermine progress.

This moment to begin a CPC process is opportune. Climate talks in December 2012 in Doha, Qatar, resolved contentious questions about the future of the Kyoto Protocol and finally retired the constraints of the Bali agenda. Now negotiators will turn to developing a new agreement under the United Nations Framework Convention on Climate Change to cover the post-2020 period. At the same time, the Major Economies Forum (MEF) needs a new thrust of engagement, having developed the Clean Energy Ministerial into an enduring venue for technology discussions. A CPC would fit nicely within the MEF, or possibly the G20.

This new line of discussion would address a glaring gap in climate talks to date. Negotiations have tackled emissions targets, temperature targets, technology transfer, financial assistance to poor countries, forest preservation, and many other topics, but not the practical design of cost-effective domestic mitigation policy. Indeed, few countries include their finance and trade ministries in climate talks outside of discussions of finance. This vacuum of economic expertise and leadership leaves parties prone to commitments, such as a two degree maximum global mean temperature increase, that imply implausibly stringent global efforts and fail to identify concrete solutions.

The CPC, unlike existing clean energy and climate consultations, would be led by finance and trade ministries (not the environment and energy ministries). It would focus exclusively on the practical administrative and technical aspects of responsible mitigation policy. One advantage of this pragmatic approach is that parties could sidestep divisive issues such as who bears responsibility for collective mitigation goals, who should compensate whom for what, and whose approach is more ethical. However justifiable, these debates have done little to promote real emissions mitigation.

The CPC would focus on the technical and administrative aspects of the policies, such as options to identify taxable or regulated entities and sources and methods to track revenue, minimize administrative costs, and ensure compliance. Parties could also discuss the role of international offsets and the interplay between carbon pricing and other domestic climate and energy policies. Countries could discuss ways to predict the effects of alternative tax trajectories, and they could discuss how to distribute and manage markets of allowances and tax revenue. Other topics could include the design of border carbon adjustments and other trade-related issues. The CPC could also steer existing resources to assist developing countries in reducing fossil fuel subsidies and pricing carbon.

One impediment to climate policy in the United States is the concern that without meaningful action by developing countries, pricing carbon will harm the US economy with little overall environmental benefit. A move towards transparent price-based policies give all major emitters comfort they are moving forward in concert with others. The first step is to discuss how to do it.

Authors

Publication: East Asia Forum

Image Source: © Darley Shen / Reuters

Poor Economic Policy Must End No Matter Who Wins Australian Election

Warwick J. McKibbin — Tue, 12 Mar 2013 13:25:00 -0400

Over the past several decades there has been a fundamental reshaping of the global economy. The billions of new consumers and workers entering the world economy from throughout the emerging world have had two major implications for Australia.

The first has been that events outside Australia changed a range of prices including the price of commodities relative to manufacturing and the price of high-skilled versus low-skilled workers.

The second implication was that the high demand for Australia’s endowment of resources that emerging economies needed for their economic development substantially increased Australia’s income.

The comparative advantage that generated wealth for Australia also accelerated the need for structural change. All advanced economies faced structural problems, but Australians were lucky that they also had the revenue to pay for productivity enhancing reform.

When Labor came to power in 2007 there was a great opportunity to use an enormous bounty generated from the boom to fund the needed restructuring and reforming of the Australian economy. There was hope that the new Labor government would continue the work of economic reform that was the hallmark of the Hawke and Keating governments.

But before the government was able to act on the hard reforms, it was blindsided by the global financial crisis. Fiscal conservatism and sound economic management were replaced by populism. Australia had clearly changed direction when in February 2009 then prime minister Kevin Rudd declared capitalism dead. This was a great irony since the reason Australia did so well relative to other advanced economies was because of the two decades of earlier reforms that had enhanced the robustness of the economy.

Without a guiding principle that what Australia needed was economic reform based on a capitalist model with an Australian twist, the DNA of old Labor rose to the surface and the old themes of class warfare and wealth distribution rather than wealth generation dragged around a floundering ship of state. Spin without substance came from minister after minister as billions of Australian taxpayer funds were wasted. Union power was allowed to raise the cost of labor.

A poorly designed carbon tax raised the cost of energy. The cost of doing business accelerated due to a fixation with nanny state regulation. Any pretence of fiscal discipline was discarded. Large subsidies were given to the multinational car makers – the list of poor policy goes on. Australia’s competitiveness problems today are as much about high input costs caused by bad policy as they are about a strong currency.

Today Australia faces new challenges from the global economy. Europe continues to walk along a cliff without knowing exactly where the edge is. The United States has large fiscal issues to resolve but is much better placed than Europe.

An energy revolution is under way in the U.S. Our research suggests that the energy boom from unconventional oil and gas in the U.S. could raise the economic growth rate by 0.5 per cent per year for at least the next decade. Lower energy prices and a renaissance of energy intensive manufacturing such as petrochemicals are already stimulating the U.S. economy. The real factors from the energy boom – including a reawakening of investment in energy and energy related industries – are overlaying an economy where the housing market has turned upwards and where the Federal Reserve board’s monetary stimulus is already late in being withdrawn. The next phase of the global economy is likely to be a massive shift of capital out of Europe towards a growing U.S.

The energy transformation in the U.S. directly lowers Australia’s terms of trade because Australia is an energy exporter. This has important implications for exporters of coal, oil and gas. The Fed will need to move away from quantitative easing as soon as possible, which implies rising nominal interest rates. The flow of capital into a growing U.S. will probably raise long-term real interest rates globally.

Any countries with a debt problem (either public or private) will have to face a more urgent reality of painful adjustment. It is likely that good news in the U.S. will be good for exporting countries but bad for debtor countries. On balance, this is likely to be bad news for Europe.

Australia has a choice in how it adjusts to a rapidly changing and volatile global economy. Whichever government emerges in Australia in September will face tough challenges. A legacy of a decade of economic mismanagement combined with major new international risks will require unpopular decisions.

Key to improving Australia’s performance will be to move away from populist short-term policy along a path of structural reform that increases the flexibility of the Australian economy. Large investments in infrastructure and efficient pricing of congestion and other problems are needed to drive productivity growth.

These investments should be based on independent assessment of the economic returns and not the political returns to marginal seats or the lobbying of vested interests. The Productivity Commission is critical to this process.

Most urgently there is need for a comprehensive review of current government spending programs and measures to reform the tax system. Australia desperately needs the next prime minister to be a leader rather than one who is a fighter.

Authors

Warwick J. McKibbin

Publication: Australian Financial Review

A Climate Diplomacy Proposal: Carbon Pricing Consultations

Adele Morris, Warwick J. McKibbin and Peter J. Wilcoxen — Fri, 08 Feb 2013 10:19:00 -0500

I. Introduction

Climate talks in December 2012 in Doha, Qatar, wrapped up lines of negotiation that were begun years before in Bali. Negotiators resolved contentious questions about the future of the Kyoto Protocol and finally put the constraints of the Bali agenda behind them. Now they will turn to developing by 2015 a new agreement under the United Nations Framework Convention on Climate Change (UNFCCC) to cover the post-2020 period. At the same time, the Major Economics Forum (MEF) needs a new thrust of engagement, having developed the Clean Energy Ministerial into an enduring venue for technology discussions.[1] This momentary opening for new agenda items offers an excellent opportunity to expand the dialogue to include technical aspects of the one policy approach that would actually address the climate problem cost effectively: pricing carbon and other greenhouse gases (GHGs).

Negotiators should take this opportunity to establish a Carbon Pricing Consultation (CPC) process: a detailed, pragmatic, and ongoing discussion of the implementation details of domestic cap-and-trade and GHG taxes. A CPC process would address a glaring gap in climate talks to date. Negotiations have tackled national emissions targets, global temperature targets, technology transfer, assistance to poor countries for adaptation and mitigation (a.k.a. “finance”), clean energy, forest preservation, compensation for countries affected economically by mitigation measures, and many other topics. Carbon pricing, however, has received little multilateral attention. It has generally been considered to be a national-level policy—to be adopted at the discretion of individual governments—and therefore outside the purview of international talks. However, much could be gained by bringing countries together to discuss carbon pricing. A CPC process would provide an opportunity for negotiators, as well as the administrators of national pricing policies, to discuss how to induce, practically and efficiently, the broad economic shifts required to de-couple emissions and economic activity.

Why focus on carbon pricing? A carbon price, arising either via a cap-and-trade market or a carbon tax, creates broad, efficient incentives to reduce greenhouse gas emissions. Done well, it would gradually shift consumer demand, production methods, new investment, and technology development towards less emissions-intensive goods and services without unduly burdening poor households. A carbon tax or auctioned cap-and-trade allowances can also raise revenue to fund government outlays or reduce other, more distortionary, taxes. Finally, a carbon price can promote economic growth by replacing less efficient tax, regulatory, and spending policies. For these reasons, there is nearly universal agreement among economists that a price on carbon is a highly desirable step for reducing the risk of climatic disruption. Most would also agree that to be effective in the long run, any significant carbon policy will have to involve a price signal.

Why international consultations? First, outside of finance issues, few countries have sufficiently included their finance and trade ministries in climate negotiations. Thus the perspectives and expertise most familiar with the economics of market-based emissions approaches have been missing in the talks. Second, many countries have recently adopted carbon pricing policies, so there is increasing experience to analyze and discuss. Third, some countries that have not yet adopted carbon prices, such as the U.S., have considerable expertise in efficient administration of excise taxes and could provide valuable advice. Fourth, talks to date have focused on emissions targets, both collectively and by country, divorcing the dialogue from the economic realities of achieving those commitments. It is much easier to reach consensus on the goal of containing global mean temperature increases to 2 degrees centigrade than to grapple with the potentially high price signals on carbon that would may necessary globally to achieve the goal. Until negotiators directly address the levels of economic effort involved and how to minimize the cost, collective commitments to stabilization targets will remain both theoretical and infeasible, however compelling they may be scientifically. Fifth, disparate carbon prices across different countries can shift emissions, production, investment, and trade patterns, and mutual understanding of these cross-border effects is of interest to all parties. Finally, the vehement opposition to the EU’s efforts to price carbon in aviation fuels suggests that unilateral approaches to carbon pricing can undermine cooperation and climate policy progress. Not least, it shows the critical relationship between carbon pricing and international commerce and bolsters the case that this topic is a natural basis for a new climate diplomacy.

II. Towards Carbon Pricing Consultations

The international community should establish a CPC to provide a much needed place to discuss, laud, and understand efforts by countries to price greenhouse gases. It would differ from most talks under the United Nations Framework Convention on Climate Change (UNFCCC) in that the agenda would focus specifically on administrative, economic, and trade-related aspects of policies that price carbon and other GHGs. For example, discussions could include an exchange of countries’ views, experience, and methodologies related to:

how cap-and-trade and/or carbon tax systems work administratively;
administration of excise taxes on carbon content of fuels, including ways to identify taxable entities, establish a tax base (emissions and sources), set reporting requirements for firms, track revenue, minimize administrative costs, and ensure compliance;
ways to harmonize tax administration across countries to foster compliance by multi-national firms and prevent tax gaps and double-taxation;
the potential economic benefits to developing countries of carbon pricing as a low carbon growth strategy and efficient revenue instrument;
the environmental and economic effects of alternative carbon tax levels and tax trajectories;
mechanisms for managing allowance markets and registries, and distributing allowances or allowance auction proceeds;
the design and implementation of border carbon adjustments;
approaches to taxing carbon in bunker fuels;
the feasibility of including non-CO₂ gases, agriculture- and forest-related emissions, and process-related CO₂ emissions in a carbon pricing system;
the role of sub-national approaches;
the macroeconomic and trade impacts of carbon pricing;
the distributional effects of a price on carbon, such as effects on poor households or disproportional regional effects, and how to address them;
approaches to pricing carbon in imported and exported fossil fuels and closely-related products;
experience with the environmental performance of carbon pricing;
other fiscal reforms made in conjunction with carbon pricing (such as budget deficit reductions or reductions in other taxes), and their impacts;
approaches to fiscal cushioning (such as reducing other energy taxes while establishing a price on carbon);
how to report on carbon pricing policies so that measures can be compared across countries;
the relationship between carbon pricing and other policies, such as energy efficiency standards and renewable energy subsidies; and
efficient implementation of carbon pricing in large, complex, federalist systems.

The goal of these international discussions would be to build mutual comfort and confidence in carbon pricing, share views, prevent disputes and trade disruptions, identify and replicate successful approaches, learn from one another’s mistakes, build institutional capacity, and generally promote mutual cooperation on serious, economically efficient, measures to mitigate emissions.

The CPC could also consider how to guide resources and activities of existing bilateral consultations, multi-lateral development banks, the Green Climate Fund, other institutions, and private sector entities towards efficient carbon pricing. One particular option could be to find ways to assist developing countries in their efforts to reduce fossil fuel subsidies and adopt a carbon tax or cap-and-trade program for greenhouse gases. For example, the U.S. Environmental Protection Agency already works with China’s Ministry of Environmental Protection to build the institutions and infrastructure for sulphur dioxide cap-and-trade programs.[2] And the Asian Development Bank currently assists its member countries in establishing and enforcing value-added taxes. The CPC could discuss whether multilateral technical support, either directly through member agencies or through regional development banks, could assist developing countries with similar measures for greenhouse gas emissions trading and carbon excise taxes.

The CPC could also consider ways to enlist existing institutions for analytical support related to carbon pricing. For example, the International Monetary Fund recently issued a report on fiscal policy approaches to mitigate climate change that can help policymakers in its member countries think through the potential for a carbon tax.[3] Likewise, the OECD has prepared an illuminating cross-country comparison of energy and carbon pricing approaches.[4] The CPC could consider ways to expand or target efforts by these institutions to facilitate cooperation on climate change.

It may be possible—and it is desirable—to embed the CPC within the Major Economies Forum, the G-20, or other existing forums as much as feasible. The defining characteristic of the CPC, distinguishing it from existing clean energy and climate consultations, would be that the finance and trade ministries (not the environment and energy ministries) would take the lead. These are the ministries charged with international economic relationships, tax administration, and general macroeconomic stewardship. Of course, to the extent that environment or energy ministries oversee domestic carbon tax or cap-and-trade systems, they would play a role. However, the focus of the discussions would be on the technical, administrative, and economic cooperation aspects of carbon pricing policies, with minimal attention to whether any particular country’s approach would achieve any particular emissions target or other goal. To that end, the typical level of engagement within the CPC may best lie below that of the ministerial level, and it should include those with technical expertise.

One advantage of this approach is that it would separate the work of the CPC, i.e. the pragmatic details of carbon pricing, from divisive issues such as who bears what responsibility for collective mitigation goals, who should compensate whom for what, and whose approach is more ambitious or moral. These debates, however important, have contributed little to global emissions mitigation. Subsequent or parallel efforts can review the adequacy of the price signals and seek to increase and/or harmonize them; the CPC should center on relatively low-profile but critically important administrative and technical policy exchanges by interested countries. An underlying premise is that most major emitters have a mutual interest in effective policy machinery to price carbon.

One useful outcome of the CPC dialogue could be to shape negotiations under the UNFCCC so that countries can supplement their emissions targets with commitments in the form of carbon pricing, allowing compliance by either achieving their emissions targets or by demonstrating significant effort through imposing agreed price signals.[5] Price-based commitments would reduce the risk of inadvertent stringency or laxity, help achieve and document compliance, and allow Parties to compare their efforts transparently.

III. Why a CPC is in the interests of the United States

Consultations around mutual efforts to price carbon are clearly in the interests of countries that have already adopted or are seriously considering adopting such policies. However, even though the U.S. does not currently price carbon at the Federal level, it would also benefit from carbon pricing consultations.

First, an increasing number of US trading partners are adopting carbon pricing, and it is in the US interest to follow these developments closely. Carbon taxes have been adopted in Sweden, Australia, Finland, Ireland, Norway, and South Africa, and the EU has a major CO₂ emissions trading system. As mentioned above, India has a small tax on coal, and China is experimenting with cap-and-trade measures at the local and regional level for possible expansion nationwide. Canada also has several sub-national carbon pricing systems.

To be sure, the magnitude of the price signals and the scope of emissions to which they apply vary significantly across and within countries. But gradually more global fossil fuel consumption is falling under some sort of carbon pricing policy. The United States should welcome a venue in which it can learn from other countries’ efforts, discuss potential economic spillovers and effects on international commerce, and foster discussions that could prevent international incidents such as the dispute over the EU aviation tax.

Second, the United States has considerable tax administration and cap-and-trade expertise that could highlight potentially successful approaches. Although this experience is not climate-related, the United States deploys an efficient and highly compliant excise tax system, and it could assist developing country efforts to build their own capacity to tax carbon. For example, the United States missed an opportunity to applaud and support India’s recent adoption of a small tax on coal. The United States could offer to share its experience in administering its similar coal excise tax, which it collects under the Black Lung Benefits Act of 1977. The United States also has long experience with cap-and-trade systems for criteria air pollutants, much of which is transferable to greenhouse gas emissions trading.

Finally, one key impediment to carbon pricing in the United States is the concern that if the United States prices carbon and other major emitters don’t, then U.S. climate efforts will harm its economy to little environmental benefit. An international venue to discuss carbon pricing policies among major emitters could fruitfully evolve into a place to address such concerns and coordinate, if not fully harmonize, carbon price signals.

IV. Next Steps

As a way forward, we recommend that at their next meeting this spring in Washington, MEF members discuss their preliminary views around the potential for carbon pricing consultations and options for CPC agenda items for future MEF meetings. Australia, given its experience in carbon pricing design, could also propose a CPC agenda item for the G-20 meetings that it will host in Brisbane next year. Discussions within the MEF and G20 could explore whether members believe a CPC agenda item would be productive within the UNFCCC process.

[1] The 17 major economies participating in the MEF are: Australia, Brazil, Canada, China, the European Union, France, Germany, India, Indonesia, Italy, Japan, Korea, Mexico, Russia, South Africa, the United Kingdom, and the United States.

[2] For more, see EPA’s Clean Air Markets website: http://www.epa.gov/airmarkt/international/china/index.html

[3] Fiscal Policy to Mitigate Climate Change: A Guide for Policymakers, edited by Ian W.H. Parry, Ruud de Mooij, and Michael Keen, International Monetary Fund, 2012.

[4] Taxing Energy Use: A Graphical Analysis, OECD Publication, January 28, 2013.

[5] McKibbin, Morris, and Wilcoxen (2012) outline just such an approach. http://www.brookings.edu/research/papers/2012/07/carbon-tax-mckibbin-morris-wilcoxen.

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Image Source: © Stringer Shanghai / Reuters

How to Capitalize on Low Interest Rates

Warwick J. McKibbin — Thu, 27 Dec 2012 16:30:00 -0500

The decision by the Labor government to jettison a surplus for the 2012-13 fiscal year is a good one. To continue with such a promise in the face of years of government overspending based on uncertain revenue outcomes would have been very damaging economically once the revenue shortfalls hit home.

However, the eventual losses from the economic management of the past decade will not be avoided by this decision. The damage will now be spread over many years rather than causing a sharp economic contraction in 2013.

The key debate in fiscal policy should be about the quality of spending and taxes and less about the size of the budget surplus or deficit. Both the spending and tax sides of the fiscal accounts need to be urgently reviewed for the economic benefits they bring rather than the votes they buy. Also, a transparent distinction in the government accounts should be made between current expenditure, including transfer payments, and capital expenditure.

Government spending can be productivity-enhancing or it can be wasted. Spending that does not generate an economic return but which is financed by debt can be very difficult to service. Taxes can destroy incentives, raise input costs and damage economic activity but they can also be used to change behavior in a way that society values. Well-designed infrastructure spending based on credible evaluation of expected rates of return can reduce input costs in a growing economy and acts like an increase in private sector productivity.

Good government is about risk management. Australia is facing a number of risks such as a declining terms of trade while undergoing enormous structural change. The problem is due not only to a strong exchange rate but also to a large rise in input costs relative to productivity. The cost of labor, energy and other costs such as inefficient environmental regulation are making Australia more uncompetitive. Working on addressing reducing input costs should be a key focus of policy.

Understanding the reason for the strong exchange rate today is also a potential source of advantage. The strong exchange rate today is partly due to the mining boom but it is increasingly due to a shift in global preferences towards Australian assets. Foreigners want to have assets that reflect Australia’s still relative high rate of return, which is due to our factor endowments and our comparative advantage relative to Asia. Economic management that is better than other countries which are in crisis also makes Australia an attractive place to invest.

This major shift in global investor preferences is potentially an enormous opportunity but it is also volatile. How should Australia respond during 2013?

The first response should be to produce more assets that foreign investors want to hold. If the capital flowing into Australia pours into existing assets there will undoubtedly be a surge in the value of these assets and perhaps an eventual crash if that funding is not used to create more physically productive assets to back the financial assets.

A more direct option that reduces the risk of this volatility is for the government to create an explicit capital account in the government accounts and issue 50-year government debt on this account. If sold to foreigners at current world interest rates, the cost of servicing this debt is locked in at very low levels for a very long time. This would take pressure off other domestic asset values to minimize asset bubbles. It would also provide a large cheap source of funds that should then be used to undertake infrastructure projects with high rates of return. The assessment of these projects would need to be undertaken independently and with full transparency. The result would be a once in a generation opportunity to avoid another asset price boom and bust and a substantial expansion of the supply capacity of the economy to support private sector productivity.

The problem is how to constrain the political process from making the mistake of driving decisions by ideology rather than economic returns. The answer surely is to place more reliance on independent institutions such as the Productivity Commission.

Fortunately, unlike many other countries, Australia is not a basket case facing a fiscal crisis. It is a lucky country that has unfortunately wasted a significant amount of national wealth on ideological exercises that did not (and possibly will not) give the rates of return that were imagined by decision makers who rolled the dice and believed in the wrong forecast. It would be a mistake to rule out what is good policy for the problems that Australia faces today because these policies were badly implemented in the past.

It is better to react now to the opportunity of cheap global finance and the benefits to avoiding excessive asset price rises over 2013, rather than waiting and regretfully looking backwards over the decade that might have been.

Authors

Warwick J. McKibbin

Publication: Australian Financial Review

Bridging The Gap: Integrating Price Mechanisms Into International Climate Negotiations

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Mon, 03 Dec 2012 15:34:00 -0500

EXECUTIVE SUMMARY

The Parties to the United Nations Framework Convention on Climate Change (UNFCCC) continue their efforts to forge a new binding international agreement by 2015. The negotiations face daunting odds, but the 2009 Copenhagen Accord’s shift towards heterogeneous national commitments was a positive step forward for climate policy. The prior presumption that binding commitments could only take the form of a percentage reduction relative to historical levels alienated rapidly industrializing countries and led to unproductive disputes over base years and other issues of target formulation. However, the disparate approaches now under discussion complicate comparing the likely emissions reductions and economic efforts required to achieve the commitments.

This paper makes two points. First, we offer good reasons and ways to adapt international negotiations to allow for price-based commitments. The economic uncertainty surrounding target-only commitments is enormous. Combining a clear cumulative emissions target with limits on the cost associated with achieving the target would balance the environmental objective with the need to ensure that commitments remain feasible. This economic insurance could foster greater participation in the agreement and more ambitious commitments. Specifically, we suggest that in addition to their cumulative emissions targets for the 2013 to 2020 period, major economies could agree to a "price collar" on greenhouse gas emissions in their domestic economies. This would include starting floor and ceiling prices on a ton of CO2 and a schedule for real increases in those prices. All major parties would need to show at least a minimum level of effort regardless of whether they achieve their emissions target, and they would be allowed to exceed their target if they are unable to achieve it in spite of undertaking a high level of effort. The paper provides an example of how a price collar would work in the U.S. context under a cap-and-trade system.

Second, analyzing proposed climate commitments in terms of their implied economic stringency, as measured by the implied price on carbon necessary to achieve the targets, offers transparent and verifiable assurance of the comparability of effort across countries. It possible to calculate "carbon price equivalents" of climate commitments in a conceptually similar way to the tariff equivalents used in international trade negotiations.

In sum, the lack of transparency in the level of effort involved in achieving particular emissions targets highlights the potential value of allowing for price-based commitments and argues for greater economic transparency in the international negotiation process.

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Bridging The Gap: Integrating Price Mechanisms Into International Climate Negotiations

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Pricing Carbon in the U.S.: A Model-Based Analysis of Power Sector Only Approaches

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Wed, 10 Oct 2012 12:25:00 -0400

EXECUTIVE SUMMARY

In June 2010, as the prospects in the U.S. Senate for an economy-wide cap-and-trade bill dimmed, some proponents of climate policy began to push for an approach more limited in scope. One proposed way to limit the scope of the bill was to apply the cap-and-trade program only to the carbon dioxide (CO2) emissions from electricity generation. This paper uses an intertemporal computable general equilibrium (CGE) model of the world economy called G-Cubed to compare a power-sector-only climate policy with economy-wide measures that either place the same price on carbon or achieve the same cumulative emissions reduction as the program limited to the power sector.

We first model a power-sector-only scenario (the Core Scenario) that broadly represents the emissions reduction ambition of a proposal offered by Senator Bingaman in July 2010. We calculate a linearly declining series of emissions caps for U.S. electricity generation from 2012 to 2030 that fall to 17 percent below 2005 levels in 2020 and 42 percent below 2005 levels in 2030. We calculate the CO2 price path that rises at the real interest rate that achieves cumulative emissions equal to the sum of the caps. The price rises at the real interest rate to 2030 and is constant thereafter. We assume that all tax revenues are distributed lump sum back to U.S. households. We then model a second scenario (the Same Price Scenario) in which the carbon price from the first scenario is applied to all fossil CO2 emissions in the US economy, not just CO2 from the power sector. Comparing this with the Core Scenario shows the incremental emissions reductions and other effects of expanding the policy from the power sector to the entire economy. The third scenario (the Same Emissions Scenario) calculates the increasing CO2 price path that if applied to all fossil energy CO2 achieves the same cumulative reductions as the Core Scenario through 2030. Comparing it with the Core Scenario shows the consequences, for both carbon prices and other effects, of using a narrow rather than a broad-based policy. To isolate the effects of U.S. policy, we assume the U.S. alone adopts these climate policies, with no comparable efforts abroad.

As might be expected, the Core Scenario results in a carbon price in the power sector that is almost twice the economy-wide price that achieves the same cumulative emissions. In particular, the power-sector-only approach requires a price on CO2 that begins at $23 in 2012 and rises to $46 in 2030, whereas the economy-wide price begins at $13 in 2012 and rises to $25 in 2030. We find that a price on carbon only in the power-sector does not produce offsetting increases in emissions in other sectors. Rather, we find that carbon emissions outside the power sector fall slightly relative to baseline. This is because of the economic linkages between sectors and the consequences of higher electricity prices on overall economic activity. Global emissions leakage is negligible as the price of oil in other currencies changes little.

All three policies have modest (less than one percent) negative effects on employment in the first decade and little effect thereafter. The policies that price carbon in oil, the Same Price and Same Emissions scenarios, produce much more revenue than the Core scenario.

We find that GDP grows in all of the scenarios at a rate slightly below the reference average in the first decade, but then remains close to reference thereafter. The most environmentally effective policy, the Same Price scenario, also produces the largest short run negative effect on GDP growth and long run negative effect on investment and consumption levels.

We find that all three policy scenarios reduce investment in the capital-intensive energy sector, which lowers imports of durable goods and strengthens the U.S. terms of trade. Thus we find trade consequences of climate policy even in the power-sector-only scenario, which one might think would have relatively low effects on terms of trade given that the U.S. electricity sector uses mostly non-traded fuels. All of the policy scenarios produce an overall decrease in consumption and investment in the U.S. relative to baseline. For consumption, the positive effect from relatively lower price of imported goods is offset by the declines due to higher embodied energy prices.

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Pricing Carbon in the U.S.: A Model-Based Analysis of Power Sector Only Approaches

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Image Source: © CHRIS KEANE / Reuters

Combet’s Carbon Incompetence

Warwick J. McKibbin — Thu, 30 Aug 2012 00:00:00 -0400

The federal government’s announcement that the proposed floor price on carbon would be replaced by a deal to be part of the European emissions trading system in 2015 is astounding.

It shows a complete lack of understanding of what good climate policy should be and what is in Australia’s national interest.

Worse, it raises the economic costs of the existing carbon pricing policy because it creates even greater uncertainty about the price of carbon in future years. It also creates real concern about whether the government knows what it is doing, which adds to sovereign risk.

A minority government, seeking longevity by making whatever concessions are required to whatever sectional interest presses hardest, is clearly the basis for present policy design in Australia.

Vested interests have been allowed to chip away at the carbon price scheme just as they have at most other good ideas, and in the end most Australians are worse off.

It is one thing to make large-scale economic errors when the world economy is giving Australia several per cent of gross domestic product in extra revenue each year. It is another to plan errors for future years when the global economy is looking decidedly uncertain.

In the case of carbon pricing, the idea the Australian scheme should be linked to the European carbon trading scheme is equivalent to the idea the Australian dollar should join the euro zone.

This might be appealing to the government. After all, Australia ratified the Kyoto Protocol just as it was to become redundant and many countries were planning to announce their inability to achieve Kyoto targets at the Copenhagen climate conference. Australia is joining the European carbon scheme just as it has been demonstrated to being one of many policy failures in Europe.

Surely now is not the time to subject Australia to economic shocks out of Europe through an additional channel of the price of carbon. By joining the euro zone, we would complete the trifecta of fundamental policy errors and we could then blame someone else for our economic failures. This may be politically appealing, but it is also appalling public policy.

Carbon rights are like currencies.

The value of a carbon permit depends on the credibility of the government verifying that the carbon right is backed by an emission reduction. Just like money, the only value in an emission permit is the value given to it by a government’s credibility.

The single currency in Europe is under pressure because some governments within the euro zone have not followed policies that support the value of the currency they have created. This lack of credibility not only brings down the economy causing the problem, but it can bring down the entire currency unit because a euro is a euro and its value depends on the credibility of all governments in the system.

The same idea applies to the widespread trading in emissions rights across countries.

The global system is vulnerable to the bad behaviour of a single big player in the carbon permit market. At a time when Europe’s economic judgment is widely questioned, the federal government gives up the right to determine its own carbon price and give that right to Europe. The only case for this is that Europe has greater credibility in policy design and pricing than Australia. This may be true – for now.

The enormous uncertainty over the future of the single currency project in Europe shows why policy design under uncertainty is so important. To expose Australia to the European carbon trading system is a pure cost to the Australian economy. To have a carbon price at $23 a tonne, rising to $29 per tonne in 2015 then falling into a potential abyss, is bad for investment in energy technologies. Yet the solution to climate change will largely be driven by investment in such technologies.

If joining the European trading mechanism is such a good idea in 2015, why not join now? One reason is that the government made an error in providing compensation based on estimated revenue so that whatever happens to the carbon pricing system, the compensation will still need to be paid. Another error is in understanding that the world is highly uncertain and policy should not be made based on a punt about the future. Policy should be robust to different futures.

Australia’s climate policy design has been a farce – and it keeps getting worse.

Authors

Warwick J. McKibbin

Publication: Australian Financial Review

Australia's Economy Must Adapt or Suffer the Consequences

Warwick J. McKibbin — Mon, 30 Jul 2012 00:00:00 -0400

Daily news of job losses and closure of high-profile production facilities again raises the question of what should governments do to deal with the apparent rapid transformation of the Australian economy and particularly the problems in the manufacturing sector.

The causes are many in number and vary significantly by sector. It is misleading to lay the blame for everything on a strong dollar or the carbon tax or changing government policy or the unions or poor management practices. In fact, what is needed in framing appropriate policy is a detailed understanding of the structural adjustment that Australia is facing.

In the political debate there is a tendency to oversimplify the causes. There is an overwhelming desire to find a simple common cause for everything so blame can be allocated. There is also a tendency to reject outright a driver of change that might be important because it can’t explain everything.

There are many causes of structural adjustment and many shocks occurring at the same time. Policy should be designed to respond in detail to these where possible, but within an overarching framework of what is happening and a focus on how individual policy responses fit together in a consistent fashion.

Put simply, there are many problems facing the manufacturing sector as a whole in many countries. Australia is not alone in dealing with structural adjustment.

The issues are best thought through by understanding what drives businesses to close. The problems occur when the costs of producing goods exceed the price that can be achieved from selling goods in a competitive market. Input costs include the price of labour (driven higher by labour market rigidities); the cost of capital (driven higher through financing costs); the cost of energy (driven higher, particularly in electricity, by years of neglect in infrastructure spending on generation and distribution and further increased by the carbon tax); and costs of government regulation.

After accounting for all the input costs, the strong currency is making it even more difficult to compete in foreign markets or with foreign imported products. Each sector is affected differently by each of these forces.

It is worth drilling down on the role of the carbon tax: $23 is a substantial price and it is higher than in other countries. It is not a coincidence that some industries are adjusting more quickly than others to the tax.

In the 2008 Treasury report on Australia’s low-pollution future, it is clear where the negative effects of a carbon price are focused. That report assumed global action but without the rest of the world taking action the effect on Australia will be larger than estimated due to additional competitiveness impact. The report summarises results under the carbon pollution reduction scheme (CPRS) where the government targets a 5 per cent reduction in emissions below 2000 levels by 2020.

In this scenario, the most affected sectors and the output decline by 2050 are coal mining (minus 30 per cent); oil refining (minus 37.7 per cent); aluminium (minus 45.2 per cent); and coal-fired electricity (minus 71.5 per cent).

This is the long-run outlook for these sectors. In the Treasury modelling, this takes time to unfold as the constraint of ever rising carbon prices kicks in. In reality, an industry facing such a future would begin to divest as soon as it could mobilise its funds out of these declining sectors.

It should be no surprise that we’re already seeing job losses in these sectors. It is what the carbon tax is designed to achieve. Politicians who say the carbon tax has no impact on jobs are as wrong as those who argue it is the entire story.

The carbon tax is only part of a complicated structural adjustment. The world economy is fundamentally changing and always has. What is different now is the scale of the effect of the emergence of the big emerging economies into the global economy.

As many parts of the emerging world (particularly China and India) enter the global economy, there is a fundamental transformation of production and consumption patterns around the globe.

Manufacturing has been declining as a share of gross domestic product in Australia for decades. Some things we produce are no longer competitive with foreign goods that are very similar, primarily due to the input cost structure outlined above.

On top of this decline, Australia is experiencing a mining boom which further appreciates the currency and so makes non-mining goods more expensive. Sectors that have some degree of flexibility on input costs can offset the rising currency by lowering input costs. Sectors that have rigid labour costs such as the automotive industry find it difficult to adapt. Energy-intensive industries that need high-cost energy inputs find it hard to adapt. Capital-intensive companies that need access to capital but face a high cost of funds because of global economic risk and domestic political risk cannot borrow and therefore cannot easily adapt.

Australia is being swept along by this global tide. Should we resist this change or should we adapt to the change? History gives a clear indication of the answer. Successful economies are those that adapt both their economic structures and their social structures to ride global waves of change.

A good place to start is where the rigidities are sharpest and the sources of this inflexibility. In some cases it is government that is to blame, in others, as pointed out by Treasury, it is the managerial practices in companies. One would expect the market to sort out the managerial problems eventually, but governments have a capacity and an obligation to the public to change what they do and how they do it.

As key economic managers in the Reserve Bank of Australia and Treasury have made clear, Australia has an big challenge ahead, but clearly great opportunities.

It will require a bipartisan acceptance of the national interest. It will require an understanding that governing for the few vested interests in unions or companies or regions should come second to the interest of the majority of Australians.

It will require a major role for the Productivity Commission in focusing on the costs and benefits of major structural policies. It will require an understanding of unintended consequences of legislation that locks in higher costs in labour markets, capital markets and energy markets.

It is hard to see how this change in culture can occur in a Parliament governed by minority interests.

Authors

Warwick J. McKibbin

Publication: Australian Financial Review

The Potential Role of a Carbon Tax in U.S. Fiscal Reform

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Tue, 24 Jul 2012 16:15:00 -0400

Executive Summary

This paper examines fiscal reform options in the United States with an intertemporal computable general equilibrium model of the world economy called G-Cubed. Six policy scenarios explore two overarching issues: (1) the effects of a carbon tax under alternative assumptions about the use of the resulting revenue, and (2) the effects of alternative measures that could be used to reduce the budget deficit. We examine a simple excise tax on the carbon content of fossil fuels in the U.S. energy sector starting immediately at $15 per metric ton of carbon dioxide (CO2) and rising at 4 percent above inflation each year through 2050. We investigate policies that allow the revenue from the illustrative carbon tax to reduce the long run federal budget deficit or the marginal tax rates on labor and capital income. We also compare the carbon tax to other means of reducing the deficit by the same amount.

We find that the carbon tax will raise considerable revenue: $80 billion at the outset, rising to $170 billion in 2030 and $310 billion by 2050. It also significantly reduces U.S. CO2 emissions by an amount that is largely independent of the use of the revenue. By 2050, annual CO2 emissions fall by 2.5 billion metric tons (BMT), or 34 percent, relative to baseline, and cumulative emissions fall by 40 BMT through 2050.

The use of the revenue affects both broad economic impacts and the composition of GDP across consumption, investment and net exports. In most scenarios, the carbon tax lowers GDP slightly, reduces investment and exports, and increases imports. The effect on consumption varies across policies and can be positive if households receive the revenue as a lump sum transfer. Using the revenue for a capital tax cut, however, is significantly different than the other policies. In that case, investment booms, employment rises, consumption declines slightly, imports increase, and overall GDP rises significantly relative to baseline through about 2040. Thus, a tax reform that uses a carbon tax to reduce capital taxes would achieve two goals: reducing CO2 emissions significantly and expanding short-run employment and the economy.

We examine three ways to reduce the deficit by an equal amount. We find that raising marginal tax rates on labor income has advantages over raising tax rates on capital income or establishing a carbon tax. A labor tax increase leaves GDP close to its baseline, reduces consumption very slightly and expands net exports slightly. Investment remains essentially unchanged. In contrast, a capital tax increase causes a significant and persistent drop in investment and much larger reductions in GDP. A carbon tax falls between the two: it lowers GDP more than a labor tax increase because it reduces investment. However, its effects on investment and GDP are more moderate than the capital tax increase, and it also significantly reduces CO2 emissions. A carbon tax thus offers a way to help reduce the deficit and improve the environment, and do so with minimal disturbance to overall economic activity.

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The Potential Role of a Carbon Tax in U.S. Fiscal Reform

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Image Source: Sam Mircovich / Reuters

Australia's Labor Sowing Seeds of Its Own Destruction

Warwick J. McKibbin — Mon, 07 May 2012 00:00:00 -0400

One way to judge the 2012 federal budget is to line it up against the economics of sound fiscal policy. Some widely agreed guidelines include: fiscal sustainability is related to the stock of government debt relative to the size of the economy and not just the surplus or deficit; the fiscal deficit or surplus does influence the business cycle and should be either neutral or counter-cyclical but never pro-cyclical; the quality of government spending (measured as a social or economic rate of return on the investment) relative to the cost of taxation is just as important as the scale of that spending.

The fiscal deficit or surplus in a single year is not the main indicator of a country’s success or failure in fiscal policy. A more relevant measure is the stock of government debt relative to gross domestic product. There is ample evidence that when the stock of government debt rises above 60 per cent of GDP increasing amounts of production need to be put aside to service the interest payments on that debt. This problem is reduced to the extent that debt is used to finance activities that pay a higher return than the interest on the debt. But there is a major crisis brewing when the stock of government debt rises above 100 per cent of GDP, which it has in a number of major economies. It becomes increasingly unlikely that a country can economically, socially and politically put aside large parts of production to service that debt, especially if most of the government debt is held by foreigners.

Holders of debt require higher yields to entice them to continue to hold onto debt as it becomes riskier due to apparently unsustainable government debt levels. Interest costs then rise quickly. The critical elements are the size of the debt and the interest costs relative to the growth rate of the economy. The problems in Europe are both excessive borrowing, poor investments using that debt, falling economic growth and punishingly higher risk premiums.

While the stock of gross debt to GDP in many advanced economies is more than 100 per cent of GDP (226 per cent in Japan, 184 per cent in Greece, and 109 per cent in the United States in 2013, according to the Organisation for Economic Co-Operation and Development), it is estimated in Australia the gross stock of government debt to GDP will be 28 per cent in 2013.

Rational economic analysis does not suggest that there is a fiscal sustainability problem in Australia.

However, if the budget is designed to improve fiscal sustainability then it should be judged by the stock of debt relative to GDP in a future year, such as 2016. If the budget shifts spending and taxes across years to generate a surplus in 2012-13 but does not change the stock of debt relative to GDP at some future year, then it should be judged a failure.

The second aspect of fiscal policy that matters is the shift in spending and taxes that influence the business cycle. A rise in a budget deficit during a slowdown is to be expected, just as a rise in a budget surplus is expected during a boom because spending and tax revenue generally move in line with the business cycle. When the fiscal deficit rises during a slowdown this automatically injects demand into the economy and is called an “automatic stabiliser”.

Some economists argue that governments should move even more than the automatic stabilisers to raise spending and cut taxes during a slowdown. That is, they argue that governments should run fiscal deficits when growth is below trend and run surpluses when growth is above trend. This philosophy partly drove Australia’s fiscal policy during the 2009 global financial crisis. Other economists argue that the government should not use fiscal policy proactively this way and they should only allow the fiscal stabilisers to work but do no more.

But no serious economist argues that fiscal policy should be used to accentuate the business cycle and to make economic slowdowns even more severe. Thus from a counter-cyclical fiscal policy position, the budget will be a success if it is at least neutral or to some extent anti-cyclical. It will be a failure if it is pro-cyclical; that is, removes demand from the economy when the economy is forecast to slow relative to trend. This policy would accentuate the business cycle and cause excessive economic losses in future years.

The third aspect of good fiscal policy is whether government spending yields a higher rate of return than the cost of funding this spending and whether the taxes that generate revenue lead to the lowest cost in terms of deadweight loss for the economy. Thus the economic criteria behind the choice of spending cuts and tax revenue increases will be critical. One hopes that there is a rigorous economic analysis of where changes in taxes and spending give the greatest benefit to the Australian people.

From the announcements to date the Australian government appears to show a lack of understanding of what good fiscal policy should look like. If fiscal policy is seen clearly to be pro-cyclical because the government has a large fiscal contraction when it is forecasting a slowing in the economy below trend growth, then it fails on the second criteria. And if the tax increases have large deadweight loss and the spending cuts have large economic costs because high return activities, such as infrastructure and education, are cut, then the budget will also be a failure of economic leadership.

The main question is, why do financial markets need to be persuaded that the government can manage a debt to GDP ratio of 28 per cent even though this is the second-lowest in the advanced world? It is not whether there is a surplus in 2012-13 that drives Australia’s fiscal credibility, but whether the government shows an understanding of the broad principles of sound fiscal policy.

The problem with the entire fiscal debate in Australia today is that many economic concepts have been spun so far they have lost meaning. There is serious economic damage being caused by attempting to reach political goals with no economic rationale. This is as true about the budget deficit debate as it is about the carbon tax pledge, where the world carbon price is now much lower than was forecast. Bad policy based on political motives increases uncertainty in the economy and damages investment and growth. Australians deserve policies that achieve national interest goals at least economic cost, not political goals no matter what they cost.

The unfortunate irony for the government this time around is that any macro-economic mistakes made in this budget will probably come home to roost in the run-up to the next election in 2013. The seeds of the next economic disaster are usually sown in the short term response to a current political problem. Examples abound in recent years, but none more clearly than the promise to run a surplus in 2012-13 no matter what this means to Australia.

Authors

Warwick J. McKibbin

Publication: The Australian Financial Review

Image Source: Andrew Taylor / Reuters

The Danger of Tinkering with Our Future

Warwick J. McKibbin — Tue, 03 Apr 2012 00:00:00 -0400

Superannuation should not be about targeting certain groups, it should be about encouraging people to save for their retirement.

Even talking about taxes on super without saying what you're going to do is very damaging to confidence. It's a very bad strategy to be so imprecise, as Craig Emerson has been.

This is a dangerous policy from a dangerous government. And so I would say don't decide on super policy because of that particular issue. What is its purpose—that has got to be the focus.

It also raises all sorts of other questions: Should you treat different assets in different ways? What about the value of the investment in your house?

As much as possible the government ought to treat these things in the same way. Any time the government taxes something differently it creates a distortion. It changes behaviour and outcomes.

There is a compact between the government and individuals and society. In this case it was changing the nature of the retirement lifestyle.

In the old days the government would pay a pension and everyone would get a pension.

Then in the Bob Hawke/Paul Keating era, long-term decisions were made to improve that system.

If you come along and change it you've not only broken a promise but you've created uncertainty which both damages the economy and destroys long-term planning for a successful economy.

The government has continued to follow the very strange set of policies coming out of Latin America. If you target higher-income earners directly they will simply leave the country, taking many jobs with them. The UK under Margaret Thatcher also discovered that overtaxing leads to a brain drain.

Whatever the definition of "fabulously wealthy", these people have made money because they have taken risks, they've been entrepreneurial and they've enhanced Australia's prosperity.

They are also the most mobile: they could just leave and erode the entire tax base.

I'm not saying there is not a case for changing how superannuation is taxed but you've got to do it in a way that doesn't undermine the incentive to save for retirement.

This is a government that has lost the plot. They are just floundering around trying to come up with a policy that will give them a bounce in the opinion polls and it's damaging.

What is the philosophy of superannuation? That should be the focus.

Authors

Warwick J. McKibbin

Publication: The Sydney Daily Telegraph

In Australia, A Carbon Price Over $10 Makes No Sense

Warwick J. McKibbin — Wed, 07 Mar 2012 00:00:00 -0500

The introduction of a carbon price into the Australian economy from July 1 this year is a landmark policy. It will begin the process of changing the incentive to emit carbon in Australia over a very long time scale.

Unfortunately the current policy, unless improved, is likely to cause unnecessary costs to the Australian economy in the short term. What is worse, these costs are likely to be far greater than any expected benefits.

There are many ways that a carbon pricing system can be designed but many fewer ways in which it should be designed, given the nature of the Australian economy and the uncertainty around global climate-change negotiations.

Political compromise and a lack of understanding about the role of uncertainty in designing carbon pricing mechanisms means the Australian approach is likely to be a problem once the time for implementation arrives.

What are the key problems that need urgent attention? First, the idea that the global price of carbon in 2012 or 2015 would be known with any precision when forecast in early 2011 was clearly an exercise in hope over rigour.

The starting price of $23?per tonne of CO2 was partly based on the idea that this would be close to the world price on July 1, 2012. Who knows what that price will actually be on the starting date, less than four months from now, but now the price varies around $6 to $9 per tonne.

Thus Australia is in danger of introducing a carbon price between three and four times the world price.

Second, the policy in 2015 will switch from a fixed carbon price at about $25 per tonne (in 2012 prices) or $28 in 2015 prices to a carbon trading system with a floor price of $15 per tonne in 2015 prices and no effective ceiling price. Most of the economics literature in this area focuses on imposing an effective ceiling price to bind the economic costs close to the expected benefits.

The combination of a floor and ceiling price reduces the volatility and hence the uncertainty in the expected price. Now, consider what happens if the world price in 2015 is below the floor price. Australia will have a carbon price of about $28 on June 30, 2015, which would fall to $15 per tonne on July 1, 2015.

Under this very plausible scenario, the much higher carbon prices paid by Australians between 2012 and 2015 would be unnecessary waste.

More importantly, the value of permits could drop by close to 50?per cent on July 1, 2015. This would cause enormous disruption to carbon abatement policy in Australia – much akin, but on a much larger scale, to the known consequences of stopping various renewable energy subsidies halfway through a scheme.

It is not sound policy to have such wild swings in a carbon price, yet it is a very likely scenario. This type of inconsistency destroys the incentive to invest in carbon abatement activities.

Another argument for a high carbon price in 2012 is the belief that no one will change behaviour at a price below $23 per tonne. This shows a complete lack of understanding of the investment decision process. Companies and individuals making energy production and consumption decisions take into account the expected future price of carbon and the expected volatility in that price over the horizon of the investment project.

A high price today that is expected to collapse because of a faulty design (not to mention the lack of bipartisan support) will merely cause input costs of energy to rise but generate little investment in reducing emissions. A price that is low but expected to rise in future years in a robust system, with the interests of key players aligned through clever allocation of permits, will likely generate a far greater investment response. Uncertainty stifles investment. The current carbon pricing system has too much uncertainty.

Instead of attempting to lead the debate on reducing global emissions in a world losing interest in this debate, the case for a bipartisan carbon price in Australia should be based on our national interest within a realistic assessment of how we can contribute to the global policy debate. The national interest argument is that having no carbon policy generates uncertainty, which inhibits investment in all types of energy systems, which has significant economic costs.

It is in Australia’s national interest to have the price of carbon on July 1 this year starting at closer to $10 per tonne. This price balances the benefits of reducing investment uncertainty against the costs of climate abatement policy.

It appears, as well, that this may be closer to the world price, which helps offset the potential competitiveness problems the current policy creates.

Until the world takes more concrete actions, this is where Australian policy should be focused. When the world takes greater action, the carbon price can be moved up.

The urgent question today is what will the government do between now and July 1 to fix the potential problems created by badly designing the carbon pricing system?

If the government does not realise the potential problems it faces and does nothing to address them, there is a silver lining. A significant carbon price shock will give economists a good set of data to properly evaluate the gross domestic product and employment consequences of this type of policy so we can go back and more accurately recalibrate our models for next time.

Authors

Warwick J. McKibbin

Publication: Australian Financial Review

Subsidizing Household Capital: How Does Energy Efficiency Policy Compare to a Carbon Tax?

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Wed, 26 Oct 2011 17:28:00 -0400

The full article, included in the Quarterly Journal of the IAEE's Energy Economics Education Foundation Volume 32, Special Issue, can be accessed through the journal website or is available as a direct download (pdf).

ABSTRACT

This study uses a general equilibrium model to compare environmental and economic outcomes of two policies: (1) a tax credit of 10 percent of the price of household capital that is 20 percent more energy efficient than its unsubsidized counterpart, assuming half of new household investment qualifies for the credit; and (2) a tax starting at $30 ($2007) per metric ton of CO2 rising five percent annually. By 2040, the carbon tax and tax credit reduce emissions by about 60 1.5 percent, respectively. Assuming other countries impose no carbon price, we find that although the carbon tax reduces U.S. GDP, it improves U.S. household welfare because it reduces world fuel prices, strengthens U.S. terms of trade, and makes imports cheaper. The revenue neutral tax credit reduces welfare but boosts U.S. GDP growth slightly at first. Both policies have similar impacts on the federal budget, but of opposite signs.

Authors

Publication: International Association for Energy Economics

An Australian Carbon Price Is Not Much Help if the World Can Call the Tune

Warwick J. McKibbin — Mon, 11 Jul 2011 11:34:00 -0400

Pricing carbon is essential to an Australian economy that is to become less carbon intensive over time. There are however some important aspects of the detailed policy approach that make the risks and the economic costs larger than they need to be. It follows many of the broad principles of the hybrid approach set out in Climate Policy After Kyoto: A Blueprint for a Realistic Approach published by Brookings in 2002. In this there is market trading of emission rights over many years, but in the short term there is a floor price and a ceiling price of carbon where the ceiling is set by a central bank of carbon. In the announced policy there is a fixed price from July 2012, and then from July 2015 there will be a market with a floor price and a ceiling price. The ceiling price is not explicit, but because foreign permit trading is allowed, the ceiling price will be the price in the global carbon market. The difference between the hybrid and the announced policy is the source and stability of the ceiling price. The government relies on a global market and the hybrid achieves this through an Australian central bank of carbon transparently setting that price. This matters in a risky world. A long-term carbon price is essential to encourage innovation.

Companies that will be making long-term investments in carbon-reducing technologies today do not have a better understanding of what the carbon price is expected to be in 2040 relative to what they expected yesterday. This can easily be rectified if emissions permits for the 2050 target of an 80 per cent reduction are distributed now and traded.

The result of the Treasury modelling is that more than half of Australia's emission reduction will be generated by allowing foreign permits into the Australian carbon trading market.

Abatement within Australia is estimated to generate less than one-half of the emissions reductions by 2020. Relying so much on foreign permit purchases has both an environmental risk (the permits may not actually reduce emissions in countries we buy from) and an economic risk in that the large volume of permits flowing in could destabilise the local price if any major international climate market becomes unstable. This is not hypothetical, given the collapse and volatility of foreign carbon markets. It is not necessary to rely on foreign markets to cap the costs. The hybrid approach allows a less risky way of achieving this outcome.

A further issue is the amount of revenue churning in the policy. Free permits could have been given directly to Australian citizens that they could then sell to industry. The more revenue that is churned through the budget, the greater the political benefit to the government but also the greater the cost to the Australian economy. The fact that only 60 per cent of emissions are covered increases the administrative costs of the policy and raises the costs incurred in reducing emission from other activities.

Some clever use of revenue such as changing the tax-free threshold is a very positive aspect of a policy that clearly had more than just climate change in its sights.

Authors

Warwick J. McKibbin

Publication: The Age

Global Fiscal Consolidation

Warwick J. McKibbin and Andrew B. Stoeckel — Sun, 01 May 2011 00:00:00 -0400

ABSTRACT
The build up in government debt in response to the ‘great recession’ has raised a number of policy dilemmas for individual countries as well as the world as a whole. Where the government fiscal stimulus was seen as necessary to restore confidence to markets and stimulate deteriorating economies in the aftermath of the ‘great recession’ by 2010 the massive fiscal stimulus programs and associated run-up in debt had, for many economies, become a confidence sapping exercise. This need for a change of fiscal policy stance has fuelled another debate that has two related aspects. One is the impact of fiscal consolidation on economies that are tightening and the flow-on effects to the world economy. The other debate is how much tightening there should be and how quickly.

This paper explores these issues in a global framework focussing on the national and global consequences of coordinated fiscal consolidation. It explores the implications this fiscal adjustment might have on country risk premia and what happens if all countries coordinate their fiscal adjustment except the United States. A coordinated fiscal consolidation in the industrial world that is not accompanied by U.S. actions is likely to lead to a substantial worsening of trade imbalances globally as the release of capital in fiscally contracting economies flows into the U.S. economy, appreciates the U.S. dollar and worsens the current position of the U.S. The scale of this change is likely to be sufficient to substantially increase the probability of a trade war between the United States and other economies. In order to avoid this outcome, a coordinated fiscal adjustment is clearly in the interest of the global economy.

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Warwick J. McKibbin
Andrew B. Stoeckel

Publication: The Lowy Institute for International Policy

Subsidizing Energy Efficient Household Capital: How Does It Compare to a Carbon Tax?

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Mon, 25 Oct 2010 16:48:00 -0400

Abstract
Current U.S. law offers a variety of tax credits for different kinds of energy efficient household capital. This study uses an intertemporal general equilibrium model to compare the environmental and economic performance of two policies: (1) a tax credit of 10 percent of the price of household capital that is 20 percent more energy efficient than its unsubsidized counterpart, assuming half of new household investment qualifies for the credit; and (2) a tax starting at $30 ($2007) per metric ton of carbon dioxide (CO2) and rising 5 percent (inflation adjusted) each year. By 2040, the carbon tax reduces emissions by 60 percent while the investment tax credit for energy-efficient capital reduces emissions by about 1.5 percent. Under the assumption that other countries do not adopt a price on carbon, we find that although the carbon tax reduces U.S. GDP, it improves the welfare of U.S. households because it reduces the world price of fuels, strengthens U.S. terms of trade, and makes imported goods cheaper. The revenue neutral tax credit reduces welfare but boosts U.S. GDP growth slightly in the first few years. Both policies have similar impacts on the federal budget, but of opposite signs.

1. Introduction
Proponents of ambitious climate policy often support imposing both a price on carbon and “complementary policies” to provide incentives for the deployment of energy-efficient and low carbon technologies. Current U.S. law offers an extensive variety of tax benefits for certain kinds of energy production and conservation, including incentives for renewable electricity production, energy efficient household investments, and bio-fuel production. The U.S. Congress expressed its continued enthusiasm for these measures in the American Recovery and Reinvestment Act of 2009 (Recovery Act), which extended many consumer energy-related tax incentives as part of the fiscal stimulus package.

In particular, the Recovery Act expanded two energy-related tax credits for households: the non-business energy property credit and the residential energy efficient property credit. The non-business energy property credit equals 30 percent of homeowner expenditure on eligible investments, up to a maximum tax credit of $1,500 over 2009 and 2010. The capital and labor costs of certain high-efficiency heating and air conditioning systems, water heaters and stoves that burn biomass qualify, as does the capital (but not labor) cost of certain energy-efficient windows, doors, insulation and roofs. The residential energy efficient property credit equals 30 percent of the installed costs of solar electric systems, solar hot water heaters, geothermal heat pumps, wind turbines, and fuel cell systems.

Another potential expansion of subsidies for energy efficiency appears in HOME STAR, a bill designed to strengthen short-term incentives for energy efficiency improvements in residential buildings. This proposal would establish a $6 billion rebate program for energyefficient appliances, building mechanical systems and insulation, and whole-home energy efficiency retrofits. The program targets energy efficiency measures that would achieve an energy efficiency gain of 20 percent.

One key goal of subsidies for energy efficiency investments is to reduce electricity generation and thereby reduce carbon dioxide emissions and other air pollutants. Some analyses suggest that increasing energy efficiency is a relatively low, possibly negative, cost way to abate greenhouse gas emissions and other air pollutants as well. However, adoption rates for energy efficient technologies fall short of levels that many believe are justified by the potential return on such investments. For example, the rates of return households apparently require for investments in energy efficiency are considerably higher than the rates of return used by electric utilities when investing in new generation. That difference in rates of return has spurred the development of utility-based demand side management (DSM) programs which often include subsidies for household energy efficiency. A growing economic literature explores this “energy-efficiency gap.”

Regardless of the net benefits from investments in energy efficient capital, recent expansions in policies to promote those investments raises the question of how much they reduce carbon emissions and how they compare to policies that target carbon more directly. This paper uses an intertemporal general equilibrium model called G-Cubed to compare and contrast the environmental and economic performance in the United States of a tax credit for energy efficient household capital and an economy-wide price signal on carbon from fossil fuels used in the energy sector. We choose the tax credit and carbon tax rates of those policies so that they have roughly comparable fiscal impact on the US government; that is, if the policies were implemented together, the revenue from the carbon tax would offset most of the reduction in revenue associated with the tax credit. When examining the policies individually, we use a lump sum tax or rebate in order to hold federal spending and the budget deficit constant. A tax credit for energy-efficient household capital reduces its relative price to homeowners and induces them to invest more. As household capital turns over, the energy saving properties of the policy accrue along with the aggregate tax expenditure up to the point where households have adopted all the energy efficient capital that is cost-effective at the subsidized rate. Unless market conditions evolve to the contrary, the government must sustain the subsidy to prevent households from reverting to purchasing relatively lower efficiency capital. As a result, it will have permanent effects throughout the economy. By raising the rate of return on household capital relative to capital in other sectors, the subsidy permanently shifts the economy’s overall portfolio of physical capital.

The empirical evidence on the effects of investment tax credits is limited and pertains primarily to the effect of tax credits on investment levels and energy savings. Gillingham et al. (2006) summarize the literature on tax credits to promote energy efficiency. Hassett and Metcalf (1995) show that a 10 percentage point change in the tax price for energy investment would lead to a 24 percent increase in the probability of energy conservation investment. The degree to which households and firms anticipate policies can significantly affect the results, particularly in the early years of the policy. For example, if households anticipate a subsidy to capital then they will delay acquiring capital they would otherwise purchase in order to take advantage of the subsidy later. Similarly, Hassett and Metcalf (1995) and others point out that tax credits are unlikely to be efficient tools for reducing carbon emissions. Consumers who would have purchased energy efficient capital in the absence of the subsidy receive a windfall, and unless the subsidy is perceived to be permanent, the effect could be to induce an intertemporal substitution in investments more than a net increase. This intertemporal substitution can be an important real-world policy effect, and it is captured in the G-Cubed model via forward-looking behavior on the part of households and other investors.

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Confronting the Crisis of International Climate Policy: Rethinking the Framework for Cutting Emissions

Fergus Green, Warwick J. McKibbin and Dr. Greg Picker — Wed, 07 Jul 2010 11:04:00 -0400

The summary below is from the paper Confronting the Crisis of International Climate Policy, available for download above and at the Lowy Institute for International Policy site.

What is the problem?

Copenhagen failed to produce an agreement on climate change commensurate with the scale of the problem, highlighting the fundamental weaknesses in the existing UN framework. Progress on a new agreement is agonizingly slow, with fundamental disagreements remaining on nearly ever aspect of the negotiation agenda. Weightier commitments by the major emitters are necessary, but calls for 'greater ambition' ignore the structural problems embedded in the institutions, processes and policy models of the UN climate regime.

What should be done?

Under a price-based international framework, countries would undertake to implement specified actions and policies. Those policies should then be converted into an internationally standardized form of economy wide ‘carbon price equivalent,’ with each country pledging/negotiating to implement a starting carbon price equivalent policy along with a schedule of real annual price increases.

This framework would be more likely to achieve rapid emissions reductions and countries’ commitments should more readily conform to the widely accepted principles of ‘common but differentiated responsibilities’ and ‘comparable effort.’ The framework could be negotiated relatively promptly among the 17 highest emitters, which meet regularly within the US-led Major Economies Forum, while negotiations over a comprehensive treaty continue within the UN.

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Fergus Green
Warwick J. McKibbin
Dr. Greg Picker

Publication: Lowy Institute for International Policy

How Important is Infrastructure? A Look at its Economic Impact in a Globalized World

Thu, 10 Jun 2010 10:00:00 -0400

Event Information

June 10, 2010
10:00 AM - 12:30 PM EDT

Saul/Zilkha Rooms
The Brookings Institution
1775 Massachusetts Avenue, NW
Washington, DC 20036

Although the conventional wisdom on infrastructure is that it is a key ingredient in a country’s economic success, the relationship between infrastructure and growth is unclear and often misunderstood. Exactly how important is infrastructure to a country’s economy and how is it measured? Should a larger role for financing these investments be given to the private sector, particularly in developing nations?

On Thursday, June 10, the Economic Studies and Global Economy and Development programs at Brookings hosted an event to discuss the nature and role of infrastructure, including rigorous economic analysis to discern to what extent infrastructure can boost overall productivity and raise living standards. Speakers reviewed the most efficient ways to finance infrastructure spending as well as the strengths and weaknesses of the public and private sectors in infrastructure provision and management. Karen Dynan, Brookings vice president and co-director of Economic Studies, welcomed participants. Presentations by national and international experts were followed by a panel discussion led by Nonresident Senior Fellow Warwick McKibbin.

After the program, panelists took audience questions.