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A little less than a year ago John Palmer at EclecEcon had a post on the three most important concepts in economics. While some fools were arguing utility theory and the theory of perfect competition, he argued for opportunity cost. Opportunity cost isn't just basic, econ 101 stuff, it is econ 101, day 1, page 1. It works this way: every time you engage in economic activity (i.e. buy something), you make a choice. I buy this litre of gas or that litre of milk, for instance. It's so simple, and so often misunderstood.

Why misunderstood? An example: when Stéphane Dion says we want to make polluting pay, that's opportunity cost. When he says he will return the money to you through the tax system, that's misunderstanding opportunity cost. Here's why: if it costs more to heat your house you have two choices: run the furnace less (i.e. turn down the heat) or sacrifice other economic activity to accommodate the extra cost (before the clever among you cite the obvious problem with this case, savings and leisure time both count as "economic activity"). If you're public policy objective is reducing carbon producing activity, this will effectively work. It is that choice between competing economic activities that will give you incentive to reduce. However, if you give back the extra you took at the thermostat, you have eliminated the incentive. Revenue neutral means, or is intended to mean, opportunity cost = zero. But with zero opportunity cost, there is zero incentive to reduce.

I have cited before others problems with both a carbon tax as it is being sold, and with the concept of revenue neutral: the real level of taxation required to be effective; revenue neutral means neutral for the government; what happens to the tax when it effectively works amd government revenues decline?

But the truth is the main reason revenue neutral is bad policy is opportunity cost. Revenue neutral means zero opportunity cost, and without opportunity cost Dion's tax shift is simply for the sake of shifting taxes. Or as Stephen Harper would put it, it's crazy economics.