competitiveness issues and presents options to cushion possible negative effects on industries.
Section 4 focuses in on the use of revenues as a particularly important design feature. In section 5, the environmental fiscal reform in Germany is highlighted as a case of green industrial policy success and a practical example of many of the environmental fiscal reform design options discussed. Overall conclusions are drawn in section 6.
2. ENVIRONMENTAL FISCAL REFORMS
2.1. DEFINING ENVIRONMENTAL FISCAL REFORMS
Environmental fiscal reform is a political process aimed at putting a price on environmentally harmful behaviour through the use of fiscal reform tools. These tools include a range of environmental taxes, fees and charges, as well as channelling the revenues toward particular targets. The Organisation for Economic Co-op-eration and Development (OECD) defines envi-ronmentally related taxes as “any compulsory, unrequited payment to general government levied on tax bases deemed to be of particular environ-mental relevance” (OECD 2006: 26). Environenviron-mental fiscal reform also covers the removal of supports or subsidies that are environmentally harmful, such as tax exemptions for kerosene or subsidies for coal.
Within environmental fiscal reform, the narrower concept of an environmental tax reform is, according to the European Environment Agency, a
“reform of the national tax system where there is a shift of the burden of taxation from conventional taxes, for example on labour, to environmentally damaging activities, such as resource extraction
or pollution. The burden of taxes should fall more on ‘bads’ than ‘goods’ so that appropriate signals are given to consumers and producers” (EEA 2005:
84). Environmental tax reform is a subset of envi-ronmental fiscal reform.
2.2. THE RATIONALE BEHIND
ENVIRONMENTAL FISCAL REFORM
Before discussing effects and design principles, it is important to understand what environ-mental fiscal reform instruments are meant to accomplish. They are useful to achieve a range of goals that can be broken down into three broad categories:
1. Benefiting the environment 2. Raising fiscal revenues
3. Increasing fiscal efficiency and competitiveness
BENEFITING THE ENVIRONMENT
The most common rationale for environmental fiscal reform is its positive environmental impact.
This environmental benefit is often referred to as the first dividend of environmental fiscal
104 reform (Goulder 1995). Increasing the price of environmentally harmful products or processes by taxing them discourages their use through a market mechanism. This type of government intervention corrects a market failure if the envi-ronmental damage of a given action constitutes an externality. Negative externalities arise when-ever the actions of one party harm another party and the first party does not bear the full cost of their harmful actions (Gruber 2011). Market actors receive a distorted price signal because the exter-nalized costs are not included in the price paid by the actor. Increasing the price of environmentally harmful products or processes, to the extent of fully internalizing the external costs, incentivises actors to limit their harmful behaviour. The envi-ronmental fiscal reform intervention thus gives market actors a correct, or at least a more accu-rate, price signal—one that better reflects the full and thus true costs of their actions.
Market actors have free choice whether to curb their actions or to pay a price, which is very much in line with the philosophy of a market economy.
They can individually adapt their behaviour and will choose or develop the least cost options to avoid environmental damage. Theoretically, this leads to a situation in which a given environmen-tal objective is achieved at minimal cost.
This internalization of external costs is thus a very attractive concept. In practice, estimating the external cost of certain actions can be a complex process–even for something as simple as produc-ing, using and disposing of a plastic bag. None-theless, a variety of methods are used to estimate various costs imposed by pollution including costs to health, to productivity, and to the envi-ronment. Much progress has been made, allowing us to fairly accurately assess the external costs in many areas, particularly in transport (Freeman 2003; Schwermer 2012a, 2012b; Schwermer et al.
2014; Parry 2014).
RAISING FISCAL REVENUES
Raising revenues for government spending is the second obvious benefit of environmental fiscal reform. Be it through taxes, fees and charges;
through the removal of environmentally harmful subsidies; or through auctioning pollution allow-ances: environmental fiscal reform enables govern-ments to collect funds, thus easing the pressure to collect funds from other areas. The funds can then be spent in various ways–to balance the budget, reduce overall public debts, reduce other taxes, reduce social security contributions or increase spending. The funds can be channelled towards
general consumptive or environmental purposes.
Spending can also finance research and develop-ment for technological innovations or fund infra-structure required for a green transition. Revenues can furthermore be used to compensate vulnera-ble groups, individuals or companies for increased prices that can result from the implementation of environmental fiscal reform instruments.
Practice has shown that the administrative costs involved in raising environmental taxes are often comparatively low. Environmental taxes, and energy taxation in particular, have the advantage of being relatively easy to administer and there-fore may prove particularly attractive in countries where tax collection mechanisms are not yet well developed. The underlying rationale is that energy taxes, such as on petroleum products, can usually be levied from a very limited number of actors–
importers, refineries and depots–and are therefore relatively simple to administer and enforce. Even when energy taxes are collected at the points of sale, metering infrastructure is often already in place, such as at petrol pumps or electricity meters (Fay et al. 2015). For example, in Germany the administrative costs of environmental tax reform are estimated at just 0.13 per cent of the revenues raised (OECD 2006).
INCREASING FISCAL EFFICIENCY AND COMPETITIVENESS
Environmental fiscal reform can improve the efficiency of fiscal systems by removing distort-ing effects. Regular taxes, such as payroll taxes, distort markets in a way that makes certain goods and services artificially unattractive and creates a loss of economic efficiency, in this case for labour.
Environmental fiscal reform can ease the pres-sure on governments to tax labour by providing an alternative source of revenues, thus opening fiscal space to reduce labour costs, to remove labour market distortions and ultimately to increase employment. This is another dividend of environ-mental fiscal reform (OECD 2000).
When environmentally harmful behaviour becomes more expensive, market actors search for, and tend to find, ways to achieve their goals by changing their production and consumption patterns. If revenues from energy taxes on fossil fuels are used to reduce taxes on labour, labour becomes more attractive relative to production factors that rely on the use of energy. Therefore, energy tends to be substituted by labour. Ideally, people’s knowledge and engineering capaci-ties find innovative ways to use energy more efficiently and to substitute fossil energy with
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renewable energy sources. Several studies find that when structural unemployment15 exists in an economy, environmental tax reform can boost employment and profits (Bovenberg and Van der Ploeg 1998; Holmlund and Kolm 1997; Schöb and Koskela 1996).
A high tax on the use of fossil fuels and on related emissions makes investments in alternative forms of energy production more attractive, leading to innovation in these fields. According to the Porter Hypothesis, environmental regulation can help businesses to overcome market failures in inno-vation, thereby allowing them to gain an advan-tage over their competitors from countries without taxes that incentivise innovations (Porter and Van der Linde 1995; Ambec 2017, this volume). Innova-tion, in turn, can lead to job creation in new and possibly politically favoured industries. If revenues are recycled to fund environmental innovation, lower tax rates may be needed to achieve envi-ronmental goals because switching to alternative technologies becomes cheaper.
2.3. HOW ARE THESE RATIONALES TRANSLATED INTO PRACTICE?
Countries in Europe are at the forefront of design-ing and applydesign-ing environmental fiscal reforms, having started in the late 1980s, intensifying their efforts in the 1990s, and further refining these reforms since then. In most cases, energy and carbon dioxide are at the core of environmen-tal taxation, but they are often complemented by taxes on transport, waste and land use (Vivid Economics 2012). Most countries used these revenues to reduce labour costs and increase employment, since unemployment was the major political concern at the time of their introduction.
As well, most countries apply a revenue-neutral approach, thus matching the new environmental tax with corresponding reductions in other areas.
In addition to environmental taxation, in 2005 European countries decided to introduce a carbon emissions trading system. In an emissions trad-ing system, governments set an overall limit on emissions and distribute permits or limited authorizations to emit up to the level of the over-all limit. The governments may sell the permits;
but in many existing schemes they grant permits to regulated polluters according to specific crite-ria—for example, a baseline derived from each polluter’s historical emissions. To demonstrate
15 Structural unemployment exists in an economy in which wages are slow to adjust and labour is relatively immobile between sectors. Changes in demand and in production technology can create structural imbalances in the labour market so that at a given wage, the supply of labour is higher than demand.
compliance, polluters must own permits at least equal to the quantity of pollution they emitted during a given time period. Polluters can emit less than allowed by their permits, and sell the excess;
or emit more than allowed, and buy permits from other participants. In effect, the buyer pays a charge for polluting and the seller gains a reward for operating with reduced emissions.
In theory, emissions trading and carbon taxes have very similar features; but in practice, carbon and particularly energy taxes are easier and quicker to implement. Most countries already have tax systems in place, while they would have to set up emissions trading schemes from scratch (Pegels 2016). Furthermore, trading schemes often turn out to be ineffective in practice. Since emis-sion permit prices are frequently far too low to influence investment decisions, the major objec-tive of the trading system is not achieved. Without going into detail on the various reasons under-lying this observation, one conclusion from the European experience is that energy and carbon taxes should fill in, at least for the interim time until trading systems are delivering as intended.
This could be achieved using a carbon floor price that ensures at least a minimum price has to be paid for all emissions.
The Eastern European countries that joined the EU in 2004 have various long-established systems of environmental fees and charges mainly addressing air and water pollution, but including several product taxes. Their approaches provide useful and inspiring examples for less developed countries as they design and implement their sustainable development (Schlegelmilch 1999).
When they joined the EU, many of these Eastern European economies were quite weak and had relatively low administrative capacities; however, they had established comprehensive systems of environmental fees and charges. These fees and charges enabled funding for at least some environmental infrastructure. While far from sufficient, they accomplished more than would have been possible otherwise, since official state budgets provided hardly any funding for envi-ronmental purposes. In effect, these fees and charges applied the polluter pays principle and provided incentives to avoid pollution, although the incentives were not strong enough to produce substantial effects (Schlegelmilch 1999). Coun-tries that are currently industrialising can explore the options of following this model or of directly
106 leapfrogging to the approach of comprehensive environmental fiscal reforms.
Experience from developing country peers also can provide valuable guidance. A useful compar-ative study of several African and Indian Ocean island states, for example, provides detailed insights into how developing countries can tran-sition from fossil fuels to renewable energies, including through the application of environmen-tal fiscal reform elements (Cottrell et al. 2015). The
lessons learned from these island states provide constructive insights. In many of these countries, energy taxation is the most important element they use. Several countries direct these reve-nues to promotion of energy savings, efficiency and renewables. These countries face significant challenges, including rising sea levels and storms worsened by climate change, while depending on fossil fuel imports. Moving to energy independ-ence through renewable sources and greater effi-ciencies is a very attractive goal.
3. MANAGING EFFECTS ON COMPETITIVENESS
From an environmental perspective, full inter-nalization of environmental costs would be the priority aim of reforms. In practice, however, competitiveness and social consequences need careful consideration, and both aspects are important factors in the design of an effective environmental fiscal reform, particularly in the revenue-raising component of environmental taxes. Ideally, environmental fiscal reforms can have neutral or even positive effects on competi-tiveness at firm, sectoral and national levels; and, in practice, many have been shown to produce positive outcomes (Pegels 2016). However, nega-tive effects on individual industries are possible.
In the following subsections, the potential for positive versus negative effects on competitive-ness are discussed first. Then, various options are presented that show the potential to reap positive and manage negative effects, particularly through the combination of tax exemptions with negoti-ated performance agreements, carbon border adjustments, and international coordination on environmental pricing. The subsequent section 4 discusses how effective design of revenue recy-cling components can help environmental fiscal reforms avoid negative social consequences.
3.1. POSITIVE OR NEGATIVE EFFECTS?
When considering how to prevent possible nega-tive effects on competinega-tiveness, it is important to recall the rationale for environmental fiscal reform: the implementation of the polluter pays principle and the internalization of external envi-ronmental damage costs. “By seeking to protect the environment, environmentally related taxa-tion is by definitaxa-tion intended to distort produc-tion decisions and have a disproporproduc-tionate impact on polluters” (OECD 2010: 144). Thus, the very objective of environmental fiscal and, more narrowly, tax reform is to create a competitive disadvantage for those companies that pollute
or are less energy-efficient, while also providing incentives to reduce pollution by the most effi-cient means at their disposal. At the same time, the taxes create a competitive advantage for firms with environmentally sound products and processes. As instruments of green industrial policy, environmental taxes can have positive effects on competitiveness–as demonstrated by numerous examples:
◼ Environmental taxes can spur innovation when price changes trigger improvements in products and production processes (Görlach et al. 2005).
◼ Environmental taxes can spur economic growth as demonstrated for six EU countries in a targeted research project report. All six countries achieved an increase in GDP of up to 0.5 per cent compared to a baseline with-out the environmental tax reform measures, while CO2 emissions decreased. The report states, “As a general rule, the effects of the [environmental tax reform] will be positive on economic activity, depending on how the revenues from the environmental taxes are recycled. However, it is likely that there will be transition costs, so the gains may not be immediate” (COMETR 2007: 41–42).
◼ Companies may benefit from reducing costs by increased efficiency, but also from growing markets for the environmentally sound prod-ucts they are either selling, applying, or both.
This has been shown for several companies in Germany (Knigge and Görlach 2005).
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These benefits demonstrate the potential posi-tive effects for the industry. These examples of energy tax outcomes show that competitiveness concerns usually relate only to a few energy-in-tensive sectors and are frequently exaggerated, for several reasons (Green Fiscal Commission 2010):
◼ Fluctuations in energy prices on global markets tend to be far more significant than the effect of a tax on energy.
◼ Not all energy-intensive goods are highly traded internationally; in these cases, increased costs can be passed on to the consumer.
◼ An increase in energy prices will incentivise both energy efficiency measures and innova-tion, which may result in stable or even falling energy costs for firms over time.
◼ Revenues can be used to counter negative effects and to support investment in reduced energy use or installation of appropriate technologies.
Fears about energy price increases expressed by companies can prompt governments to over-com-pensate industry. During discussions with indus-try regarding the impact of such measures, the regulator has less information than business—an information asymmetry that puts business at an advantage in negotiations. In some cases, the cheapest possible energy price is not a top priority for business (Box 7.1).