Inside Story

Carbon pricing and household compensation: is it enough?

Peter Whiteford assesses the government’s package of compensation measures

Peter Whiteford 12 July 2011 1350 words

Andrew Jeffrey

A MAJOR component of the government’s clean energy plan is a package of assistance measures to compensate households for higher prices. The government will provide assistance through increases in pensions, allowances and family payments, as well as through income tax cuts. From a political and social perspective, the adequacy of this compensation will be of crucial importance.

On average, household expenditure is expected to increase by $3.30 per week due to higher electricity prices and by $1.50 per week due to higher gas prices. Most items in consumer budgets will increase by less than 1 per cent; the average household is expected to spend only an additional $0.80 per week on food, for example.

In total, average household spending is expected to increase by a bit less than $10 per week under a $23 carbon price, which means an overall increase in consumer prices of 0.7 per cent in 2012–13. By 2015–16, carbon pricing will have raised consumer prices by an estimated additional 0.2 per cent, for a total effect of 0.9 per cent.

These effects are small compared with the effect when the GST was introduced in July 2000, increasing consumer prices by 2.5 per cent. They are also small compared to historical movements in consumer prices from year to year.

In assessing the compensation package it’s important to go beyond these averages and look at the distribution of impacts and the pattern of expenditure within different households. While lower-income households spend less in dollar terms than higher-income households on energy costs, for example, this is a higher proportion of their overall budget.

For a single pensioner household in the poorest 20 per cent of the population the average price impact is estimated to be 1.0 per cent in 2012–13, but for a one-income household with no children in the richest 20 per cent of the population, the average price impact is estimated to be 0.6 per cent. In relative terms, costs will also vary with the composition of households – higher for those with children, lower for those without. At any income level, some households will also have higher needs for energy, because of medical conditions, for example.

The government plans two rounds of income tax cuts as well as increases in pensions, allowances and benefits. The centrepiece is an increase in the income tax threshold from $6000 a year to $18,200 next financial year and $19,400 in 2015–16. Broadly, increasing the tax threshold potentially gives all taxpayers with incomes above $18,200 a tax cut of $1830 a year; instead of paying a tax rate of 15 per cent on income between $6000 and $18,200 they will pay zero over this income range in future.

The situation is a bit more complicated, however, because currently low-income taxpayers benefit from a targeted low-income tax offset, which raises their effective tax threshold to $16,000 a year. The offset is income-tested and currently reduces by 4 cents in the dollar starting at taxable incomes of $30,000 a year, so that it is completely extinguished at incomes of $67,500. Raising the basic tax threshold means that part of the offset will be unnecessary, so it will be reduced to $445 next financial year and $300 in 2015–16. The higher basic threshold plus the $445 offset means that, in effect, the tax threshold for lower-income earners will rise from $16,000 to $20,542. An increase in the tax threshold is very expensive, however, since the vast majority of taxpayers – including those with very high incomes – potentially get the same tax cut as low-income earners. The government considers that higher income earners can deal with the impact of higher energy prices without compensation, and plans to increase the first tax rate above the threshold from 15 per cent to 19 per cent and the second rate, on incomes over $37,000 a year from 30 per cent to 32.5 per cent and then to 33 per cent. Overall, single people with taxable incomes under $80,000 a year get an income tax cut, while those above this income level will have no real change in their tax bills.

Apart from compensating individuals below $80,000 a year, the increase in the tax threshold will mean that more than a million people will no longer need to file a tax return. Someone on the minimum wage can now work for about 25 hours per week before being liable for income tax. The government argues that this will simplify life for low-income earners and boost incentives to work.

To compensate people in the social security system, who generally don’t pay income tax, it is necessary to increase rates of pensions, allowances and family payments. These people will be paid a lump sum by June 2012, just before the introduction of the carbon price, to make sure they’re not out of pocket when prices start to rise. Compensation will then be provided as a separate regular indexed payment, and people with exceptional expenses will be entitled to an extra $140 assistance under the Essential Medical Equipment Payment.

This compensation will be more than sufficient to offset the projected increase in prices. For single pensioners with no other income, the price impact is expected to be $204 in 2012–13, and they will receive a pension increase of $338. Because there will be some variability around these average price impacts, this over-compensation is intended to guarantee that no pensioners will be disadvantaged.

Pensioners and self-funded retirees will get up to $338 extra per year if they are single, with a combined $510 per year for couples. Families receiving Family Tax Benefit Part A will get up to an extra $110 per child and single-income families with children will get up to $69 extra in Family Tax Benefit Part B. And allowance recipients (the unemployed and young people) will get up to $218 per year for singles, and $390 per year for couples.

ONE of the criticisms of the compensation package is that it will reduce the impact of the carbon price and undermine incentives to reduce energy consumption. But economic incentives can act in two ways – through the income effect and the substitution effect. Full compensation means that the income effect is not relevant – if households have enough additional money to offset the increase in prices then if they so choose they can spend this additional income on electricity, for example, and not reduce their carbon consumption. But the substitution effect will undoubtedly operate. Households will face changes in relative prices, with goods made with fewer emissions becoming relatively cheaper. By choosing less carbon-intensive goods and services, and taking simple actions to improve energy efficiency in their daily lives, households will be able to save money. Higher-income households who don’t receive compensation will have stronger incentives to economise, as both the income and substitution effects will operate.

It is also worth noting that Treasury’s analysis of impacts on households overstates the effect of carbon pricing on consumer prices because it assumes emissions costs to households are passed on fully, based on fixed consumption patterns. The true change in the average cost of living is likely to be lower than this, as households shift to lower-emissions goods and services. For example, Treasury also projects that around half of the increase in prices of emissions-intensive goods and services will be offset by lower consumption of those products. The effect on average consumer prices is also likely to be overstated because the model assumes production technology is not adjusted. The degree of overstatement is likely to be greatest for higher-income households, which are more able to shift consumption towards less emissions-intensive goods through product substitution. Because households that can change their consumption patterns will face lower price impacts than households that cannot, some households that appear to be “losers” under the package will not necessarily be as strongly affected as the calculations suggest.

Overall, the household compensation package seems well designed and is likely to achieve its aims. But its reception could still be rocky. If other factors increase prices – electricity prices, for example, have risen by over 40 per cent over the past five years without any kind of carbon tax – then households might blame what they perceive to be inadequate compensation, and the government will face the difficult job of persuading them to the contrary. •