XXII. Public Expenditure and the Environment

Ke-young Chu, and Richard Hemming
Published Date:
September 1991
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Does economic activity degrade the environment?

What are the least-cost methods of moving an economy toward a sustainable development path?

Who gains and who loses in the implementation of a program of environmental protection?

What issues arise when one country’s economic activities give rise to transnational or global environmental problems?

In recent years, increasing attention has been paid to the importance of proper management of environmental resources in both industrial and developing countries. For the most part, this concern has reflected the emerging view, championed by both ecologists and economists, that economic policies should be directed toward achieving sustainable development, that allows the present generation to meet its needs without compromising the ability of future generations to meet theirs. As such, environmental resources are viewed as national assets that should be utilized in a manner consistent with maximizing their value across generations.

Fiscal instruments are central to proper and prudent environmental management, and can influence directly or indirectly such things as the rate at which natural resources are depleted, the extent to which air and water are polluted and soil is eroded, and whether or not entire species of animal and plant life are threatened. This note describes the role of fiscal instruments in general, and public expenditure in particular, in the design of policies to promote growth and development consistent with appropriate conservation of environmental resources.

Objectives of Environmental Policy

Environmental degradation is a production or consumption externality—see the note on Public Expenditure and Resource Allocation. Thus, the standard approach to the design of economic policy toward the environment is to attempt an evaluation of the costs associated with this externality and then reflect them in resource allocation decisions. The problem is summarized in Chart 1. The intersection of the demand curve DD and the free market supply curve SS generates equilibrium price and output combination A. However, the market will not take into account the fact that the use of resources in this way imposes costs elsewhere—these external costs imply that the supply curve should be SS’, resulting in an equilibrium B, where price is higher and output lower compared to the case where external costs are ignored. The market therefore underprices and overuses resources, and the objective of environmental policy is to effect a move from an equilibrium like A to one like B.

Chart 1.The Impact of External Costs and User Costs

The fact that the development process may often involve the adoption of technologies involving negative environmental externalities does not necessarily imply that all such technologies should be avoided and environmental damage should be halted. Indeed, if the objective was to stop further damage, let alone return the environment to its initial state, few economic activities would take place and development would cease. Rather, the benefits and costs of such damage have to be compared and activities undertaken only to the point where (usually decreasing) marginal social benefits are equated with (usually increasing) marginal social costs. Thus, from an economic perspective, an optimal degree of environmental degradation can be established. This will be related to the carrying capacity of the ecosystem, that is its ability to repair ecological damage and to regenerate itself.

This optimal degree of environmental degradation is linked to the issue of sustainable development. In the absence of corrective measures, an activity may be undertaken that results in a reduction of the economic value of a country’s environmental resources greater than the income stream the activity itself generates. In such an instance, development cannot be said to be sustainable; in essence, the economy is cannibalizing itself. With corrective measures, the activity may still be undertaken, but at a smaller scale. The net income flow generated by the activity must be at least as great as the reduction in the economic value of the country’s natural resources and environmental assets—and hence net wealth at a minimum maintained—for development to be sustainable. The choice of the social discount rate is crucial in such comparisons, especially in cases of intertemporal externalities.

Much of the literature on environmental economics is concerned with estimating the direct costs associated with environmental degradation. Cost estimation in this area is tricky. The absence of property rights in respect of the environment means that external costs are often not recognized and that the benefits of reducing damage are generally non-appropriable. Ignoring these externalities may overstate the returns of damaging economic activities, and will understate the returns of undertakings with strong conservation components. Efforts to place a value on environmental damage rely either on indirect indicators—such as the extent to which housing prices are lower in the proximity of airports or factories—or are based on willingness-to-pay studies, where people are asked what they are willing to pay to prevent or repair environmental damage. At best, these estimates are only approximate, but it is generally better to have an appropriate qualitative guide to resource allocation decisions than to ignore the problem.

The failure to take account of user costs, that is the indirect costs of natural-resource depletion and of environmental degradation, is also a problem. The optimal degree of environmental degradation, taking into account external costs, could be consistent with the exhaustion of nonrenewable resources and the extinction of certain species. Advocates of sustainable development emphasize the irreversible character of much environmental damage, which makes it difficult or impossible to correct mistakes which, in retrospect, turn out to be inconsistent with long-run development policy. Recognition of user costs implies that the impact of current policies for the availability of environmental capital to future generations should be reflected in resource allocation decisions. User costs imply a supply curve such as S” in Chart 1, producing a new equilibrium C with a higher price and lower output than when external costs alone are considered. However, estimating user costs is especially difficult, since determining how much environmental capital any generation should consume is not a question with a clear answer in either principle or practice. For the moment, the importance of the user cost concept again lies in its qualitative implications—resource allocation decisions should at least reflect an awareness of the future ramifications of those decisions. In this connection, much recent attention has focused on the implications of economic and environmental policies in the M-7 megabiodiverse countries (Australia, Brazil, Colombia, Indonesia, Madagascar, Mexico, and Zaire), which contain more than half of the world’s species.

Instruments of Environmental Policy

The environment is a classic public good (see the note on Public Expenditure and Resource Allocation). It is therefore the proper role of government to encourage the preservation of the environment. The government has at its disposal a wide range of instruments. The choice of instrument or combination of instruments depends upon a number of factors. Insofar as it is possible to ensure a better quality environment by altering the behavior of consumers and producers, the range of instruments includes the regulatory and legal framework, moral suasion, environmental subsidies and taxes, and other expenditure measures. There is also a need to correct policy failures which have led to the implementation of measures that do unintended damage to the environment.

Regulation, legal framework, and moral suasion

When metering is difficult—that is, pollution cannot be measured—regulation in the form of pollution standards (including the prohibition of particularly hazardous activities), specification of acceptable techniques of production, the issuance of pollution permits, or the use of refundable deposits may be the only alternatives. Pollution permits convey the right to pollute up to some agreed maximum level, and may be initially allocated or auctioned to firms. Furthermore, so long as they are marketable after being initially allocated or auctioned, pollution permits can be dynamically efficient. Politically, however, the sale of “licenses to pollute” may be unpopular. Where metering is possible but for technical reasons is not viable, refundable deposits have the advantage that they shift the burden of proof about pollution control to the claimant. In cases where the problem of externality derives from the ill-definition or lack of property rights, the assignment or clarification of property rights by the government, most notably through the legal system, and the subsequent development of mechanisms to establish legal liability, may also be an efficient instrument to preserve the environment. The efficacy of such an approach depends on, among other things, the enforceability of the rights themselves and the transaction costs associated with civil litigation. Moral suasion—that is, efforts to educate and otherwise persuade the public about the benefits of environmental protection and conservation—is appropriate where effective monitoring of regulations is difficult, as in the case of forest-fire prevention.

Environmental subsidies and taxes

When metering is economical, fiscal measures in the form of environmental subsidies and environmental taxes may have the clear advantage on efficiency grounds, because they have the potential to affect resource allocation decisions at the margin. Conservation or environmental subsidies are aimed at compensating those who voluntarily reduce the amount of pollution they generate. Examples include subsidies for installation of solar-generation capacity, for planting trees as windbreaks against soil erosion, and for taking marginal, highly erodible soil out of production or converting such land into permanent grasslands. However, only if there are strong political objections to charging are subsidies a substitute for taxes (or fees), since the latter have advantages. While in principle there is an equivalence between subsidies and taxes in terms of cost per unit of pollution reduction, a tax penalizes a polluter; not only could a subsidy protect an otherwise unprofitable firm from bankruptcy, it also has adverse implications for the fiscal balance. There is a case for cutting back on environmental subsidies that are clearly less efficient than viable alternative policy measures, as well as subsidies that encourage environmental degradation (e.g., subsidies on pesticides, chemical fertilizers, gasoline, etc.). The principal shortcomings of taxes relate to the uncertainty of their impact and their inflexibility, both in terms of the possible need for change over time and differences between localities (see the note on Transfers to Local Government for a discussion of the advantages of centralized tax collection). Fiscal control of the revenues generated by environmental taxes is also an issue, with the main debate concerning whether such revenues should be used for general funding or earmarked to pollution abatement and conservation programs (see the discussion of earmarking in the note on Pricing and Cost Recovery).

Other expenditure measures

While all of the above measures have expenditure implications—they have to be administered—only subsidies are a direct expenditure measure. However, public expenditure policy is not limited to subsidies. The government can give grants to producers to install equipment to control pollution—the problem with grants of this sort is that they do not address the pollution problem directly. A grant provides little incentive to reduce emissions to an appropriate level or to use the most efficient method of achieving such a reduction; indeed, there is no guarantee that pollution will be reduced at all. Because grants share many of the same shortcomings as subsidies, only in exceptional cases are they likely to be an effective element of pollution-control strategy.

Government expenditure also has a clear role in investment activity. This is especially true where the public good characteristics of investments make private supply inefficient and/or there are scale economies—water purification is a case in point. Mounting evidence also indicates that many environmental projects have very high rates of return when economically correct forms of cost-benefit analysis are employed. This is especially true in energy and agricultural land conservation projects (see the discussion of shelterbelts in the note on Public Investment). However, a lack of institutional capability on the part of country authorities to evaluate environmental projects and/or to incorporate evaluation of environmental impact into project analyses prevents many governments from recognizing this potential benefit. Numerous countries, with the assistance of nongovernment organizations and multilateral lending agencies, are now addressing these deficiencies, with a view to improving investment allocation decisions and promoting sustainable development.

Government expenditures on operations and maintenance can also serve to promote environmental objectives. Thus, a well-maintained road network may improve vehicle fuel efficiency, thereby saving scarce resources and reducing the emission of harmful exhausts. Operations and maintenance expenditures to preserve water resources can play a critical role in the maintenance of natural ecosystem balances. Finally, operations and maintenance expenditures that ensure efficiency in electricity generation and transmission reduce energy losses, are thereby environmental degradation through harmful emissions.

The design of effective environmental policy involves the appropriate use of available instruments in pursuit of clearly specified objectives. In this sense, it is no different from economic policy making in general. It does, however, differ in one significant respect. If one looks at the way economic policy is made, there is at least a semblance of an effort to match targets and instruments in a way broadly consistent with well-established principles of policy formulation. In the case of environmental policy, the evidence suggests a strong reluctance to put principle into practice. In part, this reflects inadequate institutional capabilities referred to above. However, distributional considerations and problems involved in securing international agreement on environmental issues are the main constraints.

Constraints on Environmental Policy

Distributional impact

Environmental protection produces gainers and losers, and the distribution of these gains and losses has a significant bearing on the willingness to adopt effective environmental policies. This issue has a number of aspects. In industrial countries, there is a view that environmental protection is a luxury good, and its benefits are biased toward the rich. They have the time and education to lobby effectively; they make more intensive use of recreational facilities; and they have more resources and options to compensate for any adverse economic impact of environmental policy. In developing countries, the same argument can be interpreted as implying a pro-poor bias associated with environmental degradation. These countries are under severe pressure from rapidly growing populations and endemic poverty. The poor cannot afford to postpone consumption, and the rapid depletion of natural resources is necessary for subsistence. Politically, it is difficult for governments of industrial countries to resist the wishes of the large middle class and for the governments of developing countries to ignore the needs of the poor. The political difficulties in implementing environmental policy are compounded by the fact that those who must bear the costs of environmental protection—mainly industry—have been able to oppose policy measures effectively.

International dimension to environmental policy

The evidence of environmental damage across national boundaries is overwhelming. This takes two forms: transnational spillovers, as for example when acid rain affects the environmental quality in a bordering country, and international spillovers, as for example when oceans are overfished and polluted, or when there is global warming and depletion of the ozone layer. In the former case, property rights may be well-defined, but transactions costs associated with bilateral or multilateral negotiations hinder the effective resolution of the problem. In the latter case, property rights for international common property are not clearly allocated, and transactions costs are very high because all the countries of the world should theoretically be party to a negotiated settlement. Effective control, which is difficult at the national level, has proved almost impossible at the transnational and international level. The particular problems that arise are easily demonstrated. Any country that imposes a penalty on a polluting industry will raise its costs and affect its ability to export, with adverse balance of payments consequences; if other countries impose such penalties, a country that does not follow suit can benefit from the resulting terms of trade advantage. One solution may be for affected countries to impose trade restrictions on polluting nations. From other viewpoints, such measures have little to recommend them and, unless internationally coordinated, would not be effective.

Country Illustration

The national environment program in Madagascar

Recent estimates have placed the annual costs of environmental degradation in Madagascar at between US$100 million and US$290 million, roughly equivalent to between 5 and 15 percent of GNP. Deforestation accounts for about 75 percent of the cost, while decreased productivity in agricultural and pasture lands due to soil erosion accounts for another 15 percent. Increased operating costs and reduced life spans of infrastructural investments, especially irrigation and road networks, account for the balance. In an effort to address these environmental and economic problems, and in recognition of the unique biological diversity of the country, the government has recently strengthened its national environmental program in concert with foreign official donors as well as with nongovernmental organizations.

In August 1989, the Central Bank of Madagascar completed a debt-for-nature swap—the first of its kind in Africa—with the World Wildlife Fund (WWF) for an amount of US$3 million. In the first phase of the operation, the WWF used US$950,000 to purchase approximately US$2.1 million of eligible Malagasy debt at a price of US$0.45 on the dollar. The domestic currency counterpart provided by the central bank in exchange for the debt is currently being used to protect Madagascar’s biodiversity, large tracts of undisturbed rain forests, and several critical watersheds. The proceeds are also being used to protect and manage Madagascar’s highpriority protected areas and to train, equip, and support 400 park rangers. The budgetary programming of these expenditures was jointly agreed upon by the WWF and the government. In 1990 and 1991, the WWF will seek to convert the remainder of the debt for additional conservation efforts through the budget.

In collaboration with the World Bank, the government has also developed the first five-year segment of a 15-year Environmental Action Plan (EAP), again the first in Africa. The EAP consists of seven components: (i) protecting and managing the unique ecological system together with the development of peripheral zones; (ii) promotion of soil conservation, agroforestry, reforestation, and other rural development activities in priority zones, including several large watersheds; (iii) development of maps and geographic information for program-related areas; (iv) improvements in land security through titling; (v) the training of environmental specialists and the promotion of environmental awareness and education; (vi) the initiation of environmental research programs on land, coastal, and marine ecosystems; and (vii) the development of support activities, including institution building and the adoption of environmental-assessment procedures. In terms of fiscal impact, the program is expected to be neutral in the short term, but substantially positive over the long term. The positive fiscal impact over the long term stems from improvements in land-tax collections due to titling efforts, greater rural tax collections as a result of improvements in agricultural productivity, the development of eco-tourism and the collection of tourist fees, cost-recovery efforts in park areas, and larger royalty payments resulting from a more effective management of resources.


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