Economic Wows or Woes: The Canadian Carbon Tax

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Putting a price on carbon has never been more difficult. After months of intense pressure by opposition parties in the House of Commons, as well as a majority of Canadians wanting a temporary relaxation of the tax, the Canadian government has been forced to make a carve-out to their signature climate change policy.

On October 26, 2023, after months of pressure, Prime Minister Justin Trudeau announced a partial exemption of the carbon tax on home heating oil for 3 years, as well as a doubling of the rural supplement in the carbon tax rebate program, from 10 cents to 20 cents. Though aimed to relieve the burden on Atlantic Canada, where 30% of households still use traditional heating pumps, this partial exemption caused an outrage with other provinces, who also wanted exemptions.

The tax, introduced in 2019 as a part of Prime Minister Trudeau’s climate change policy, is now one of the Canadian government’s most embattled policy positions. Outrage and fury seem to follow any announcements regarding the tax, yet questions still remain over the economic impact of implementing carbon pricing. Namely, how does the carbon tax actually work? What are the economics of it? And should Canada even have one?

How the Carbon Tax Actually Works

The carbon tax has frequently been relabeled as carbon pricing, or in other words, placing a fee on emitting greenhouse gas emissions. This comes with a stated goal of shifting the responsibility of damages due to carbon emissions from the public to the emitters themselves. Moreover, a carbon tax, in theory, financially incentivizes emitters to switch from high carbon emissions technology to cleaner, more environmentally friendly operations. In other words, a carbon tax induces the economy to pollute less.

In the Canadian case, the federal carbon tax has two approaches. Either provinces can create their own carbon pricing models to suit their regional needs, or they may select a default federal pricing system. Additionally, the federal carbon pricing system consists of two parts: a regulatory fuel charge on fossil fuels, and a performance based industry charge, known as the Output-Based Pricing System. The current carbon tax is at $65 per tonne of carbon emitted, roughly resulting in a near 14 cent increase in gasoline prices. Yet, the price is expected to increase to $170 by 2030.

Furthermore, the entire Canadian pricing system is revenue-neutral, meaning most of the proceeds are given back to lower and middle class households in the jurisdiction of origin through Climate Action Incentive Payments. These are given back in quarterly household payments, ranging from $184 to $386.

Widely considered as the centerpiece of the Canadian government’s climate policy, the carbon tax works by, quite literally, “putting a price on carbon”. In theory, the carbon tax seems a robust environmental and financial incentive for corporations and carbon emitters. Clearly, it can not only induce market players to switch to cleaner energy, but also allows for greater environmental innovation. However, concerns and questions still remain over the economic effect of the tax

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What is its Effect on the Economy?

For decades, studies have been undertaken to accurately estimate the effect of a carbon tax on the wider economy. As a general basis, implementation of a carbon tax hurts businesses in the short run by raising the cost of burning fossil fuels. Consequently, the prices of goods relying on such inputs also surge. These changes of prices are generally believed to induce changes in consumers’ consumption patterns, leading to greater search for cleaner, greener alternatives.

The Peter G. Peterson Foundation has indicated that a carbon tax implemented on its own is a regressive tax, hurting lower-income individuals and households disproportionately since they spend a greater share of their incomes on carbon intensive goods. High income households may also see a reduction of income due to their greater amounts of capital caught up in carbon emitting practices. From a commercial perspective, the tax would most likely affect carbon intensive sectors, such as transportation, electricity generation, and related industries. Specifically, the power sector is relatively responsive to a tax, as emissions cuts remain more feasible and cheaper, while the transportation sector remains relatively unresponsive.

However, the validity and effectiveness of the tax has been reinforced by the Ecofiscal Commission in 2019, an independent group of Canadian economists, indicating the tax would be the greatest method to simultaneously cut emissions while maintaining economic growth. A carbon tax is also a strong method to raise government revenues: reports from the United States Congressional Budget Office found that a mere $25 per ton tax can raise up to $1 trillion in 10 years.

There are conflicted studies by economists and think tanks on the effect on the carbon tax on economic growth. For one, JW Diamond and George Zodrow have found that a carbon tax benchmark at $50 per ton can have an optimal effect on the macroeconomy as a whole. In fact, this tax resulted in a moderately positive long term increase in GDP and aggregate consumption, accompanied with rises in investment and labour supply. In contrast, the libertarian Fraser Institute found that a tax of $170 per ton - the tax value proposed for 2030 - may result in a 1.8% decrease in nominal GDP, as well as a loss of 184,000 jobs in the Canadian economy. A 1% decline in household incomes would also accompany this.

The implementation of carbon pricing also has little effect on inflation: according to the Bank of Canada, the tax only results in a 0.15 percentage point increase to inflation. While this is not insignificant, it is simply not a major driver in the recent inflationary trend.

Should Canada Even Have a Carbon Tax?

Concerns still remain over the possible increase of the carbon tax in upcoming years, especially in factors such as gasoline prices; due to the unresponsive nature of the transportation sector, it is possible consumers may have to endure increased prices. Businesses using inputs of fossil fuels will possibly lose out in the short run as the carbon tax places monetary pressure with an end goal of encouraging the switch to greener alternatives.

While long-run declines in GDP are associated with a larger carbon tax, a lower tax rate may be beneficial for GDP growth, as seen from Diamond and Zodrow’s study. It also remains a major tool of raising government revenue. Yet, studies have found that an efficient re-appropriation of revenues from the carbon tax might actually minimize or reverse any long term declines in economic growth. And, in Canada’s case, due to the revenue neutrality of its carbon pricing program, this seems possible.

In general, more studies are definitely needed to ascertain the effect of a carbon tax on individuals and the market as a whole. A thorough understanding of the other impacts of the carbon tax, such as its effectiveness at cutting long term emissions and its role in encouraging green innovation is also necessary to accurately answer the above question. But for now, most Canadians can agree that any policy with soaring economic potential and a positive effect on the environment is beneficial for all.