The Case for a Carbon Tax and Not Subsidising Solar, and Whether a Carbon Tax Beats Tradable Permits

Answer

Part (a) — The case for a carbon tax and against a solar subsidy [10]

Both decisions are grounded in allocative efficiency.

Why tax carbon. Fossil-fuel production by power stations and oil refineries generates a negative externality: greenhouse-gas emissions impose an external cost on third parties, so marginal social cost (MSC) exceeds marginal private cost (MPC). The free market, pricing only private costs, under-prices the good and over-produces at Qm (MPB = MPC) relative to the social optimum Qs (MSB = MSC), with a deadweight welfare loss. A carbon tax equal to the marginal external cost raises MPC to align with MSC, internalising the externality and cutting output and emissions to the socially efficient level.

Why not subsidise solar. Assuming no external benefit in consuming solar, the price mechanism already allocates resources efficiently where MPC = MPB. A subsidy would distort this, creating an artificially low price that causes over-consumption — and would breed complacency, since producers’ costs are lowered by transfer rather than by genuine productive efficiency. Leaving the solar market to market forces therefore preserves efficiency; intervening would create government failure.

Part (b) — Is a carbon tax more appropriate than tradable permits? [15]

A carbon tax is a market-based instrument: it prices in the external cost so producers and consumers face the full social cost. Tradable permits (“cap and trade”) are a command-and-control instrument: the government caps total emissions at the socially efficient level and issues that many permits, which firms may buy and sell.

Strengths of a carbon tax. It raises government revenue that can fund clean-energy R&D and other abatement, supporting sustainable growth. As a market-based measure it requires little monitoring, relying on the price mechanism. Differentiated rates could target the most damaging gases, though at higher administrative cost.

Strengths of tradable permits. The cap guarantees a quantity of emissions. Firms with low abatement costs cut pollution and sell unused permits, profiting from reductions, which attracts investment in green technology and contributes to growth. The incentive structure rewards the cheapest reductions first.

Weaknesses. A carbon tax can erode the export competitiveness of energy-intensive, export-oriented industries — raising business costs and risking cost-push inflation and harm to the maritime, aviation and tourism sectors if trading partners impose no equivalent tax; the right tax rate is also hard to set because the marginal external cost is hard to value, risking over- or under-taxation, and the burden can be passed to consumers (inequitable for low-income households — partly correctable by targeted rebates). Tradable permits face the symmetric problem of setting the cap — ascertaining how much pollution the environment can absorb — and require costly monitoring and enforcement; profitable high-abatement-cost firms may simply buy permits and keep polluting.

Judgement. A carbon tax is more appropriate for Singapore specifically, and the decisive reason is the size of the economy. Tradable permits need a sufficiently large number of firms to create a functioning market for trading — feasible in the US and EU, but not in Singapore’s small domestic sector, where too few firms exist to support viable trading. Monitoring atmospheric pollution is also harder in a small, wind-exposed territory. By contrast, a carbon tax is feasible regardless of firm numbers, needs little monitoring as a price-based signal, and yields revenue to fund the clean-energy transition. The short-run loss to energy-intensive sectors is outweighed by the long-run gains to the clean-energy sector and society, provided the tax is not set excessively. On balance, for a small economy like Singapore, the carbon tax is clearly the more appropriate instrument.