Journal Issue
Working Paper Summaries (WP/94/77 - WP/94/147)

Summary of WP/94/106: “Tax Policy and the Environment: Theory and Practice”

International Monetary Fund
Published Date:
February 1995
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This paper reviews the effectiveness of three types of environment taxes--Pigouvian taxes (per unit taxes on emissions); taxes on inputs or consumer goods whose use is related to environmental damage; and environment-related provisions in other taxes--and surveys the use of these taxes in 42 developing countries, economies in transition, and industrial countries.

The paper finds a wide gulf between the theory and practice of environment taxation. The three types of environment taxes are ranked in terms of conventional efficiency criteria: Pigouvian taxes, with appropriately set tax rates, are efficient; taxes imposed on goods whose use is linked to environmental damage are not usually efficient and are ranked second; and environment-related provisions in other taxes are ranked third. The survey suggests that environment taxes are not used extensively and that Pigouvian taxes, the efficient tax solution to environmental damage, are not generally employed. The conventional efficiency argument in favor of environment taxes is thus typically invalidated by the widespread use of taxes other than Pigouvian taxes.

A number of possible explanations for the wide gulf between the theory and practice of environment taxation are identified: (1) design and implementation factors vary significantly across countries, with the consequence that environment taxes may not be straightforward to use; (2) the effectiveness of environment taxes can be hampered by macroeconomic instability, soft state-owned enterprise budget constraints, and a failure in markets for substitutes for the taxed item; and (3) efficient environment taxes may conflict with other policy objectives such as economic output, employment, international competitiveness, and equity.

The preceding three impediments apply, in varying degrees, to all types of environment taxes, but the difficulty in designing and administering Pigouvian taxes, especially in developing countries, is the most significant obstacle to mitigating environmental damage through the tax system. In circumstances where Pigouvian taxes cannot be employed, environment taxes are not necessarily the best policy. Consequently, in practice, a combination of policies is likely to be required to address environmental damage. The extent to which use is made of environment taxes in these circumstances is defined by their relative cost effectiveness.

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