Distributional impacts of carbon taxation in Scotland
Modelling a compensation system to safeguard low income households
Project duration: September 2013 to September 2014
Setting a price on carbon, through taxes or trading schemes, is recognised as a key potential driver to bring about necessary reductions in carbon emissions: it enforces the ‘polluter pays’ principle and provides a financial incentive for reducing emissions. This study was commissioned by ClimateXChange* to explore how domestic climate justice might be achieved in practice using the example of a carbon tax on household energy use and private transport in Scotland.
The research looks specifically at what may constitute a ‘green and fair’ taxation system – one that promotes the desired environmental outcomes (carbon savings) whilst protecting those least able to pay, or able to change their behaviours to reduce their tax exposure. The study therefore enhances the evidence base on carbon taxation and distributional impacts, providing benefit to the wider research community.
CSE was part of a consortium delivering this research, working with the Institute for Fiscal Studies (IFS) and Policy Studies Institute (PSI). This team had previously collaborated on a project modelling carbon tax in the UK and had modelling expertise highly relevant to the study. Two applications used in and fundamental to the research were developed by the consortium’s members, namely:
- CSE’s Distributional Impacts Model for Policy Scenario Analysis (DIMPSA): which calculates the consumption and expenditure on household fuels and petrol and diesel of UK households, providing the necessary inputs to model the impact of a carbon tax on energy consumed in the home and private road travel.
- IFS’s TAXBEN model: which calculates the effect of changes in taxes and benefits, thereby providing the tools to explore the potential for compensation packages to mitigate any negative distributional impacts of a carbon tax.
DIMPSA is also used to take into account the effects of existing policies on household energy consumption and road transport emissions, providing modelled estimates of consumption in 2017/18. Changes to the benefit system are scheduled to come into force over the period to 2017/18 hence this year was selected for the purpose of the modelling.
Impact of domestic sector carbon tax on household bills
The results from modelling a carbon tax on household energy use and private transport in Scotland show a range of distributional impacts, including:
The richest 10% of households would pay on average more than twice the carbon tax on household fuels and road transport than that of the poorest 10% of households; however this represents a smaller proportion of their household income compared to lower income households.
Households in the more rural areas pay on average more tax on energy consumed in the home; this is likely to reflect the nature of dwellings (a higher proportion of older, less energy efficient properties and reliance on more carbon intensive heating fuels due to lack of mains gas network).
Mitigating negative impacts of carbon taxation
The modelling simulated a compensation package to redistribute the revenue raised from the carbon tax in a way that protects low income households from adverse impacts.
A key criterion in designing the compensation mechanism was ‘revenue neutrality’ – to ensure the revenue from the carbon tax and the increase in benefits are equal. Minimising the number of low-income households that lose out financially as a result of the tax was another key aim.
On average, the increases in benefits distributed to compensate lower-income households were sufficient to offset the adverse impacts of the carbon tax. The poorest 30% of households (the bottom three income deciles) gained on average from the combined carbon tax and compensation package, with average net gains of about 2% of income in the bottom group and about 0.8% of income in the third.
Potential ‘winners’ and ‘losers’
To identify the key groups of ‘winners’ and ‘losers’ after the implementation of the combined carbon tax and compensation package, a threshold of better or worse off by more than £1 per week was applied. A ‘broadly unaffected’ category was included for those households who gain or lose by less than £1 per week. Overall, a third of households are predicted to be better off as a result of the combined effects of the carbon tax and its compensation package, 59% worse off and 8% ‘broadly unaffected’.
Further statistical analysis (Chi-squared Automatic Interaction Detector, CHAID) showed that the revenue from a carbon tax could be used to compensate low-income households in Scotland for their carbon tax payments, with a large majority gaining from the combined tax and compensation.
The compensation package does not eliminate low-income ‘losers’ entirely. Some low-income households are not entitled to means-tested benefits (e.g. because they have significant amounts of capital or because they are students) or have particularly high carbon emissions (e.g. resulting from high energy needs). Nevertheless, about 90% of households in the first and second income deciles and almost 80% of households in the third income decile are compensated, or more-than-compensated, for the carbon tax that they would have to pay.
This research has therefore shown that a carbon tax on household energy and private road transport use in Scotland could be implemented in such a way that, through appropriate redistribution of the tax revenues through the benefits system, most lower-income households could be protected from regressive effects.
* ClimateXChange is Scotland’s Centre of Expertise on Climate Change, providing independent advice, research and analysis to support the Scottish Government in developing and implementing policy relating to climate change and the transition to a low carbon society.