Why carbon dividends are having a moment

As Louis XIV’S finance minister Jean-Baptiste Colbert famously declared, “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing”. In other words when it comes to taxing companies or individuals, politicians may ask themselves how they can raise the largest amount of revenue possible while limiting social and political repercussions. Just how sensitive consumers are to tax changes that increase the cost of vital provisions such as transport and food has been brought to the fore recently in the Chilean protests and the gilets jaunes movement in France. Politicians will no doubt be keen to avoid further disruption of this kind – so they need a palatable taxation solution.

A currently in-vogue solution that has surprising backing across the political spectrum in the UK is the idea of carbon dividends. Carbon dividends work by recycling the proceeds of a carbon tax back to households. This ensures that low-income households in particular are no worse off than before – and in some instances they may become net beneficiaries if they receive more money back than is taken by the tax.

Why give away the feathers?

Reports in The Times have suggested that the government is considering pay-outs for families to offset green energy bills. This would require the Treasury to change conventional fiscal thinking that sees all revenue treated as general tax: no small undertaking given that institutional inertia within the Treasury often manifests in opposition to ‘non-conventional’ ideas. 

So if the Treasury has ‘endured the hissing’, why should it be persuaded to ‘give away the feathers’? There are strong political economy arguments to support this action.

First, public perception matters.

As extensive polling by Public First has confirmed, people are most likely to support climate policies that they consider to be fair. Using carbon tax revenues is one way to achieve this. Our own research shows that using 33 per cent of revenues for energy efficiency can ensure fuel-poor households are not adversely affected by carbon taxation.

Second, voter aversion to carbon taxation partly stems from the perception that carbon pricing is mostly fiscally motivated (a way to raise government revenue) rather than environmentally motivated (a way to reduce emissions).

Governments can use commitment devices, such as explicit plans for how revenues are to be redistributed (as are made each year by the Ministry of Finance in British Columbia, which are then approved by the Legislative Assembly, for example) to overcome suspicions about a government’s long-term commitment to revenue recycling.

Third, as policies to reduce emissions evolve, so do the arguments of incumbents and climate deniers.

Although the days when people publicly deny that the planet is warming are largely over, the most recent phase of climate denial has become demonising the ‘cost’ of net-zero and in particular, the impending rise in household bills. One only has to look at Nick Timothy’s recent polemic against net-zero in The Telegraph, alarmist headlines in The Times and Steve Baker MP’s ‘Project Fear’ on net-zero, to see this being played out in real time.

Of course, the cost of inaction will far outweigh the cost of reducing emissions to net-zero. But it is more important than ever to dispel these notions and it will take more than a well-justified counterargument. Polices that can demonstrably ameliorate any regressive impacts from carbon taxation and from the transition to net-zero more generally are therefore needed. This further strengthens the case for carbon dividends.

Choosing the right redistribution strategy

There is extensive literature on the pros and cons of the various ways in which tax revenues can be recycled. Redistribution can be made visible by showing how other taxes have been reduced, in pay slips or on tax statements, or by issuing explicit rebate cheques (dividends’) to households and firms. The dividends or lump-sum transfers can be distributed across households in equal shares (per person) or distributed across eligible households, with eligibility depending on, for example, household income.

Empirical studies show that cutting existing taxes when introducing a new tax is the least popular redistribution strategy. Although some countries do use tax cuts in this way, research from 2018 by Klenert et al. suggests that lump-sum dividends are more stable over time, particularly in countries that are encumbered by issues of economic inequality, political distrust and polarisation. Klenert et al. conclude that uniform lump-sum recycling is also preferable to income tax cuts from the point of view of enhancing socioeconomic equity – this is important for ensuring the cost of net-zero is distributed fairly across society.

A possible design for making carbon dividends work in practice

Although the case for carbon dividends has been made strongly, there has been far less discussion of the practicalities/methods of implementation. If the choice of redistribution is a dividend, it could be designed in the following way:

1. Tax revenues from carbon taxes would be deposited in a new UK Carbon Dividends Wealth Fund (see discussion on commitment devices above for rationale). The Wealth Fund would transparently use those resources to pay out dividends and to cover the operating costs of the dividend programme. 
2. People would be eligible for carbon dividends if they have a National Insurance number and bear a disproportionate burden from the carbon tax. The NI system could help determine those who are likely to bear a material burden from a carbon tax – assuming the transfer is differentiated. However, the question of eligibility is politically contentious and complex and more thinking on this needs to be done. As 100% of fuel poverty cases in the UK occur in income deciles 1–4 (the four poorest), this could be one set of parameters. But as our work for Zero C examined, we must assess both ‘vertical’ and ‘horizontal’ effects: that is, the differing effect of the tax on high- and low-income households, and the differing effects on households with similar incomes but different consumption patterns. Our research can inform which household types and which geographical areas, in addition to which income groups, may need particularly consideration. 
3. If the carbon dividend is unform, dividend amounts would be the same for all qualifying adults (which would be less administratively complex). All qualifying children would receive half the adult amount. 
4. Households would receive dividends quarterly, possibly through a separate direct deposit or the benefits system.
5. Dividend payments should at least in part pre-empt and cover any increases in energy bills arising from the carbon tax. This is necessary to avoid any transitionary periods where high carbon taxes increase energy bills before energy efficiency improvements are implemented.
6. Dividend payments would be exempt from any taxes, and they would not be counted as income for any means-tested benefits. This is particularly important as it would prevent households from losing eligibility for other benefits.
7. The dividend programme would be managed by the Department for Work and Pensions. 
8. Policymakers would withhold some carbon tax revenues to cover all operating costs and the Government’s own carbon tax burden. The dividend size would then be gross carbon tax receipts less these costs.

Even if such a policy were enacted, it would unlikely be enough. As I wrote recently, UK carbon pricing needs to be part of broader, more comprehensive programme of tax reform and accompanied by increasingly stringent standards and regulations. There also remains the issue that once the policy has bedded in, and the tax base is eroded over time, the Chancellor might reduce the dividend that is handed out. But such a scenario is predicated on significantly reducing emissions, in which case the policy would have succeeded.

While ‘giving away the feathers’ may not adhere to traditional economic lessons on efficiency, the question of whether to pay out or not is increasingly subsidiary to the primary challenge of garnering greater political acceptability and durability of policies over time. Unless the latter is embedded within policymaking, the transition to net-zero and the strong political and public consensus that surrounds it will be delayed and fractured.

This commentary was first published by Business Green.