Chapter 2. The efficiency case for environmental taxation
Figure 2.1: Evolution of green bonds prices under different carbon pricing regimes
2.4.3.3 Empirics
The interaction effects described above are new additions to the literature, and so there are no empirical tests of these theoretical findings yet. However, a first analysis of the raw data from financial markets does confirm these results. As shown in Figure 2.1, green bonds are performing better in countries that employ carbon taxation than in countries with ETS.16
2.5. Interaction with value-added taxation
2.5.1 Ad-valorem and specific-rate taxes
Countries are broadly using two types of consumption rates. “Ad-valorem taxes”
increase the price of a good by a set percentage amount, whereas “specific-rate taxes” increase the price of a unit of fuel by a set monetary amount. The ad-valorem consumption tax used in most countries is the “value-added tax” (VAT) which is typically the second-most important source of revenue for a government after the personal income tax. A core reason for the VAT’s popularity is that it raises revenue in a more growth-friendly manner than other taxes. By raising the price of all products by the same proportion, the VAT seeks to minimise the distortions which taxes have on consumption choices. This objective is called
“fiscal neutrality” and aims to allow the market to achieve allocative efficiency while financing the state.
Environmental taxes have the opposite objective. Whereas the VAT strives for being neutral to consumer choices, environmental taxes seek to change behaviour.
To change this behaviour efficiently, environmental taxes must always be specific-rate taxes. Because the environmental cost of any product is given by the physical effects per unit of that product, the tax rate must equally be defined per physical unit of the product, not per price of the product. If the price of a barrel of oil in international markets doubles tomorrow, the social cost per amount of CO2
contained in a barrel is still the same. Hence, the efficient environmental tax does not fluctuate with the price of a polluting good but is fixed per unit of the physical good. An environmental tax should therefore always be applied as a specific-rate tax. Moreover, whereas the fiscal-neutrality principle underlying the VAT is to apply the same percentage tax rate for all products,17the Pigouvian principle underlying the environmental tax is to apply different unit tax rates for different products, to adjust each product price according to its product-specific marginal social damage. For example, a litre of gasoline and a litre of alcohol will both be taxed for their social costs with specific-rate taxes; these taxes will vary per unit while facing the same VAT rate.
A last important feature before we can consider the interaction effects is that tax
17Countries should thus not use the VAT to deal with environmental problems. The VAT on polluting products should be neither higher nor lower than the standard rate for products that pose envir-onmental damages or benefits. The law in some countries does diverge from these principles by granting reduced VAT rates for fuels or renewable energies. In these cases, the VAT system can destroy the Pigou efficiency of an environmental excise tax system. But those interaction effects are known.
Chapter 2. The efficiency case for environmental taxation
law in most countries applies the VAT to the sum of the product price and the specific-rate tax.18 The above is just standard tax principles, but the following implication is new.
2.5.2 Effect of environmental taxation on the fiscal neutrality of the VAT
If a polluting product is sold at lower prices because it can externalise part of its production cost, the absolute amount of VAT collected per unit of this product is artificially low, distorts competition and thereby removes the VAT neutrality. To see this effect, consider two competing products, one of which is polluting and the other one is not. Assume the production and sales price of the polluting product is lower than for the clean product for the sole reason that it can externalise costs.
Then the absolute amount of VAT paid per unit of the polluting product will be lower than for the clean product, further increasing the cost difference between the two products. The VAT will then aggravate the distorted competition between the two products. Environmental taxation is needed to rectify this problem. For the VAT system to achieve its neutrality objectives, the environmental tax needs to be applied on a specific-rate basis, at the Pigouvian rate, and be subject to value-added taxation itself.
Over the last thirty years, governments have relied ever more on the VAT as a source of revenue. The higher a VAT rate is, the greater is its scalar effect at amp-lifying the price difference of competing products. If those price differences are due to cheap products externalising social costs, increasing the VAT rate raises this allocative inefficiency. Therefore, the increasing use of VAT systems around the world increases the need for Finance Ministries to apply environmental taxa-tion as well. Otherwise, Finance Ministries would fail their objective of using the VAT to raise revenue in a fiscally neutral manner.
18The post-tax price after the levying of the VAT and environmental taxation is equal to (1+VAT rate)*(pretax price of one unit of the good + environmental tax per unit of the good), where the VAT rate is a percentage, and the environmental tax is a set amount of currency per physical unit of the good.
2.5. Interaction with value-added taxation
2.5.3 Coase’s second-best argument
Coase expressed concerns that environmental taxation would have adverse system-level effects on the efficiency of economies.“The Pigovian analysis shows us that it is possible to conceive of better worlds than the one in which we live. But the prob-lem is to devise practical arrangements which will correct defects in one part of the system without causing more serious harm in other parts” (Coase, 1960, p. 34). He rejected“a comparison between a state of laissez faire and some kind of ideal world”
(id., p. 43).“A better approach would seem to be to start our analysis with a situation approximating that which actually exists, to examine the effects of a proposed policy change and to attempt to decide whether the new situation would be, in total, better or worse than the original one. In this way, conclusions for policy would have some relevance to the actual situation”(ibid.).
The actual situation of fiscal policy in most countries today is that the VAT is the core of public financial systems. This VAT is presently distorting allocative efficiency through the mechanism that we described. A Pigouvian tax would, instead, decrease that system-level distortion. In this way, the Pigouvian solution is supporting rather than contradicting what Coase argues for.
Coase was concerned that “there is a real danger that extensive government inter-vention in the economic system may lead to the protection of those responsible for harmful effects being carried too far” (id., p. 28). But the starting point is that there is already extensive government intervention in the economic system, through systems like the VAT. And given that starting point, environmental taxation helps to reduce inefficiency.
Environmental taxation has many other system-level effects beyond this one ex-ample. Here we move on, but Heine & Black (2019) provide an extensive re-view of the literature showing that environmental taxation also has many other efficiency-enhancing system-level effects. Environmental tax reforms can reduce unemployment in labour markets with involuntary unemployment, in particu-lar of unskilled workers. They also reduce distortions of pre-existing income tax systems, generally broaden the tax base which allows reducing tax rates, and bet-ter align the tax system with “Ramsey efficiency”.19 Environmental taxes also
19Ramsey (1927, p. 56) showed that the optimal rate of a consumption tax is “proportional to the sum of the reciprocals of its supply and demand elasticities”. If a good that inelastically demanded is taxed more than a good which is elastically demanded, that variation minimizes the overall deadweight
Chapter 2. The efficiency case for environmental taxation
move fiscal burdens from the taxation of profits to the taxation of Ricardian rents and from the taxation of labour to the taxation of leisure. Environmental tax re-forms can equally reduce the overall compliance and administrative costs of tax systems, induce green technological change, and raise growth through energy efficiency. There is similar causal evidence that environmental taxes reduce pub-lic health costs, traffic congestion and traffic fatalities. The reader is referred to Heine & Black (2019) for the details on each of these effects, but the general point here is that environmental taxation creates system-level efficiency gains. So the efficiency-enhancing effect of environmental taxation on the VAT system is only one example. Coase can feel comforted that Pigouvian taxation does enhance system-level efficiency.
loss caused by the tax system. Therefore, the fact that the price elasticity of fuels is generally low price makes them a good tax base. When the revenue of fuel taxes is used to reduce general con-sumption taxes on goods that are demanded more elastically, the “Ramsey efficiency” of the overall tax system improves.
Chapter 3
Challenges to environmental taxation analysed in the
remainder of this dissertation
Chapter 1 has shown that some types of environmental damage1are now of a size that impacts the stability of the macroeconomy as a whole. As a result, it should be in the core interest of Finance Ministries to contribute to environmental protec-tion. In particular, Finance Ministries should no longer stand in the way of using tax policy for climate change mitigation. Chapter 2 has underscored this point by showing that taxation can reduce environmental damages in a cost-efficient manner. However, Finance Ministries have been slow to change their approach to environmental taxation. In this chapter, we consider what the barriers to action might be before the subsequent chapters investigate potential solutions.
1From climate change.
Chapter 3. Challenges to environmental taxation
3.1 The tax gap
To what extent are Finance Ministries already implementing fuel taxes in line with environmental damage? In Parry, Heine, Lis & Li (2014), the IMF provided the first calculation of Pigouvian tax rates for fossil fuels in 150 countries. The IMF subsequently compared these optimal tax rates to the rates of fuel taxes and fuel subsidies that countries have in reality. In 2015 that gap amounted to 5.3 trillion USD per year, which is equivalent to 6.5 % of global GDP (Coady et al., 2017).
To put this figure into perspective, consider that the international community’s aspirational (and unmet) target for mobilising finance to assist climate action in developing countries is 100 billion.
Coady et al.(2017) suggest that Finance Ministries are effectively encouraging actions that cause environmental and other climate damage, and they find that these figures are worsening over time, despite the increased environmental com-mitments that countries have made over the last decade. This lack of progress has been confirmed by subsequent quantifications of the tax gap by other au-thors. The OECD evaluates fuel taxes in 42 developed and emerging economies that jointly account for 80 % of global energy use, and finds that “apart from some modest steps forward in a couple of countries, there is little evidence of better use of taxes on energy use to address the mounting global environmental and climate challenges. Instead, real tax rates are gradually eroded by inflation in most coun-tries, suggesting indifference to the environmental efficacy of taxes” (OECD, 2018, p. 51). Rosset al.(2017) confirm this finding in the area transport policy, which is shocking given that transport had been the policy area where environmental tax policy had the biggest uptake. Nevertheless, they find that the global mean gasoline tax has fallen by approximately 10 % over the last decade.
This overview has shown that countries around the world are not taxing fuels in line with their carbon and environmental costs. Given our findings of chapters 1 and 2, we hence ask: what barriers are preventing policy action?