Tax Policy and the Environment
Theory and Practice
Author:
Mr. David C Nellor
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Mr. Ronald T. McMorran https://isni.org/isni/0000000404811396 International Monetary Fund

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Publication Date:
01 Sep 1994
eISBN:
9781451947083
Language:
English
Keywords:
WP; environment tax; tax; firm; environmental damage; cost; carbon dioxide; consumer goods; pollution abatement; catalytic converter; waste emission
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This paper provides a framework for examining environment taxes. It reviews the theoretical efficiency of three types of environment taxes: taxes on emissions or Pigouvian taxes; taxes on productive inputs or consumer goods whose use is related to environmental damage; and environment-related provisions in other taxes. A survey of environment taxes in 42 countries--drawn from developing countries, economies in transition, and industrial countries--illustrates that the use of environment taxes differs dramatically from the recommendations of environment tax theory. This divergence between the theory and practice of environment taxes can be attributed to several factors; environment taxes are difficult to implement, there are many factors that impede their effectiveness, and their introduction may be discouraged by their implications for other policy objectives.

Abstract

This paper provides a framework for examining environment taxes. It reviews the theoretical efficiency of three types of environment taxes: taxes on emissions or Pigouvian taxes; taxes on productive inputs or consumer goods whose use is related to environmental damage; and environment-related provisions in other taxes. A survey of environment taxes in 42 countries--drawn from developing countries, economies in transition, and industrial countries--illustrates that the use of environment taxes differs dramatically from the recommendations of environment tax theory. This divergence between the theory and practice of environment taxes can be attributed to several factors; environment taxes are difficult to implement, there are many factors that impede their effectiveness, and their introduction may be discouraged by their implications for other policy objectives.

Introduction

A number of different types of taxes have been used to pursue environmental objectives. Two features of environment-related taxes are often overlooked. First, the efficiency argument in favor of environment taxes is invalidated by the widespread use of taxes that differ from Pigouvian taxes which economic theory suggests are the efficient solution to environmental damage. Second, design and implementation factors that determine the effectiveness of environment taxes vary significantly across countries. Consequently, environment taxes may not be straightforward to implement, and may not be the most efficient instruments for mitigating environmental damage, in all circumstances.

The paper has three main parts. First, a theoretical examination of three types of environment taxes provides a ranking of these taxes in terms of conventional efficiency criteria: Pigouvian taxes, that are imposed on emissions, are most efficient, taxes imposed on goods whose use is linked to environmental damage are ranked second, and environment-related provisions in other taxes are ranked third (Section I). Second, the use of environment taxes in 42 countries--economies in transition, developing, and industrial countries--is surveyed. Environment taxes are not used extensively. Of those environment taxes that are implemented, Pigouvian taxes are used infrequently; more common is the use of environment-related provisions in other taxes (Section II). Third, a number of factors are identified that contribute to an explanation of the wide gulf between the theory and practice of environment taxation. These include the difficulty of designing environment taxes, factors that impede the effectiveness of environment taxes, and the trade-offs between environmental and other policy objectives that can discourage their use (Section III). Policy implications and conclusions are presented in a final section (Section IV).

I. Theoretical Aspects of Environment Taxes

Taxes influence environmental damage by changing relative prices. 1/ There are three categories of these environment taxes: (1) taxes on emissions or Pigouvian taxes; (2) taxes on productive inputs or consumption goods whose use is related to environmental damage or indirect environment taxes; and (3) environment-related provisions in other taxes. This section examines the effectiveness of these three categories of taxes. Pigouvian taxes are the most efficient tax measure for pollution abatement according to the theory of externalities. However, the fundamental efficiency case for Pigouvian taxes does not apply to the variety of environment tax measures that countries may employ and this is often overlooked in considering environment tax policy. Other types of environment taxes are efficient in only a limited set of circumstances. Indirect environment taxes and environment-related provisions in other taxes can be equally cost effective for pollution abatement. However, unintended, incentive effects of environment-related tax provisions may make them less cost effective than specifically targeted indirect environment taxes. This suggests a general efficiency ranking of environment taxes; most efficient are Pigouvian taxes followed by indirect environment taxes, and, least efficient are environment-related provisions in other taxes.

1. Pigouvian taxes

Pigouvian taxes are specific rate taxes on units of emissions or damage. 2/ The rate of tax is equal to marginal social cost at the socially efficient level of emissions. The socially efficient level of emissions occurs where the marginal benefit to firms from waste emissions equals the marginal social cost of those emissions. By raising the price of polluting to reflect social cost, Pigouvian taxes ensure that polluters face the private and social costs of their actions.

A Pigouvian tax is illustrated in Chart 1 which shows the costs and benefits that arise from firms emitting waste. The marginal internal benefit (MIB) schedule shows the marginal benefit to firms from emitting waste at various levels of emissions. This marginal benefit is defined in an opportunity cost sense as the savings earned by the firm from being able to emit waste. Firms will emit waste as long as the benefit to them exceeds the private cost. Consequently, in the absence of environmental policy, firms will emit waste to the point, shown by B, where any further emission fails to yield benefits. This waste emission exceeds the socially optimal level which is shown as A in Chart 1. This emission level is defined by the equality of the MIB schedule and the marginal external cost (MEC) schedule; the latter schedule shows the marginal social cost of environmental damage from emissions. The Pigouvian solution is to introduce a tax at a rate per unit of pollution equal to the marginal social cost at the socially optimal level, or, in Chart 1, a tax equal to AC per unit of waste emitted. This tax reduces the marginal benefit to firms from emitting waste by the tax rate. Thus, the marginal internal benefit schedule shifts to MIB’ and firms optimize by emitting waste to point A which coincides with the socially efficient emission level.

Chart 1.
Chart 1.

Pigouvian Taxes

Citation: IMF Working Papers 1994, 106; 10.5089/9781451947083.001.A001

Two distinctive features of Pigouvian taxes make them attractive from the perspective of social efficiency. First, the costs of environmental policy may be reduced by taxes because they rely on the price system in contrast to the administrative costs of command and control policies. Second, Pigouvian taxes reduce pollution in the least cost manner by encouraging (a) the greatest pollution abatement by firms able to adjust at lowest cost, and (b) least cost abatement by each firm. Thus, as firms reduce waste emissions from point B to point A in Chart 1, they determine the combination of lower output, changes in inputs, and investment in new technology that reduces emissions at least cost. For example, a Pigouvian tax on vehicle emissions may induce a reduction in automobile miles traveled, improved maintenance of vehicles, and investment in catalytic converters.

2. Indirect environment taxes

An indirect environment tax is intended to encourage pollution abatement by taxing productive inputs or consumption goods whose use is linked to environmental damage, rather than taxing emissions directly as is the case under a Pigouvian tax. Indirect environment taxes provide price incentives that induce producers and consumers to change their emissions behavior so that the socially efficient level of emissions may be achieved. However, the fundamental efficiency case for environment taxes is, in general, invalidated by the use of these taxes.

The key to assessing the efficiency of an indirect environment tax is the nature of the linkage between the indirect environment tax base and the environmental damage. The importance of this linkage is illustrated by comparing two indirect environment taxes; a carbon (fossil fuels) tax--which is an efficient indirect tax--and a gasoline tax which is not efficient. A carbon tax is intended to minimize global warming which arises, inter alia, from carbon dioxide emissions. Carbon dioxide emissions will be reduced efficiently whether the input--fossil fuels--or the emission--carbon dioxide--are taxed because there is no “end-of-pipe” technology that permits a change in the fixed proportional relationship between the combustion of fossil fuels and emissions of carbon dioxide. 3/ Thus, reduction of carbon dioxide emissions is effectively met by either an indirect tax--a carbon tax--or a Pigouvian tax levied directly on carbon dioxide emissions. However, the carbon tax is an exception. In most cases an indirect tax, such as a gasoline tax intended to address local air quality concerns, is not as efficient as a Pigouvian tax because there is not a fixed proportional relationship between the use of gasoline and local air quality. An efficient tax on vehicle emissions would result in lower emissions from a combination of measures determined by their relative costs. Indirect environment taxes such as petroleum taxes do not encourage abatement on all margins. In fact, they may discourage the use of some efficient methods of emissions abatement, such as use of catalytic converters, that are made more expensive by the tax. Consequently, an indirect environment tax will generate a socially efficient level of emissions in the least cost manner only if there is a fixed proportional linkage between the taxed item and the other adjustment variables.

Chart 2, which is similar to Chart 1, illustrates the efficiency characteristics of an indirect tax by examining the implications of various methods of emissions abatement. The marginal external cost schedule (MEC) shows the marginal social cost of the environmental damage. The marginal internal benefit to the firm from polluting is conceptually the same as in Chart 1 but in Chart 2 the component parts of the schedule are illustrated. Assume that it is technically possible for the firm to reduce emissions on three dimensions; output, maintenance, and technology. The cost of abatement in each of these dimensions determines the firm’s marginal internal benefit schedule; the “output” schedule is the marginal cost of abatement secured by lower output; the “maintenance” schedule is the marginal cost of abatement attributable to improved maintenance; and the “technology” schedule is the marginal cost of abatement from investments in technology. As constructed, abatement of emissions from the pretax level is achieved at lowest cost via lowering output. However, once emissions decline to point A″ it becomes efficient to reduce emissions further via improved maintenance and, beyond point A’, lower emissions are best secured via investment in technology. The marginal internal benefit schedule is thus composed of the least cost segments of each abatement cost schedule and denoted VWXYZ. The intersection of the marginal external cost and marginal internal benefit schedules indicates that social efficiency requires pollution abatement of AC.

Chart 2.
Chart 2.

Indirect Environment Taxes

Citation: IMF Working Papers 1994, 106; 10.5089/9781451947083.001.A001

Two results are drawn from comparing the effectiveness of a Pigouvian tax and an indirect environment tax in securing social efficiency.

a. The indirect environment tax will impose greater costs than a Pigouvian tax. In response to a Pigouvian tax, firms reduce emissions by the least cost combination of adjustment on all possible dimensions; in Chart 2 from C to A″ by lowering output, from A″ to A’ by improving maintenance, and from A’ to A by investing in new technology. The total cost of abatement is the area under the marginal internal benefit schedule over the relevant range which is the area AWXYZ. In contrast, an indirect environment tax, that only encourages lower output to achieve the targeted reduction in emissions, imposes higher costs. The firm adjusts to the tax by moving along the “output” abatement schedule and not the marginal internal benefit schedule. The abatement cost of the indirect environment tax thus amounts to ABC which is more costly than the Pigouvian tax by the amount shown by the shaded area.

b. It may be preferable to permit continuation of the environmental damage rather than employ an indirect tax to achieve the socially efficient emissions reduction. This results because the private costs of reducing emissions may exceed the social benefits of the lower environmental damage over some ranges of emissions reduction (e.g., this occurs over the range DB in Chart 2). Indeed, excessive abatement costs may lead to greater social costs than the costs of the environmental damage that the tax is intended to mitigate. Therefore, it may be appropriate to either scale back the targeted emission reduction or to not employ any environment tax when a Pigouvian tax is not feasible.

In sum, indirect environment taxes are similar to Pigouvian taxes because they use the price system rather than a command and control policy and, thereby, indirect environment taxes may reduce the cost of environmental policy. However, unlike Pigouvian taxes, they will not encourage abatement of environmental damage at least social cost unless there is a fixed proportional linkage on all abatement margins. To avoid the risk that the indirect tax imposes excessive abatement costs, it is still important that the policymaker knows the marginal internal benefit and marginal external costs schedules. Indirect environment taxes do, however, have the advantage that it is often easier to tax goods that are linked to the damage than the damage itself as is required by the Pigouvian tax solution.

3. Environment-related provisions in other taxes

Environmental goals may be pursued through provisions in other taxes. These provisions can have similar effects to indirect environment taxes. For example, measures that provide incentives to invest in pollution abatement equipment are analogous to indirect environment taxes because they may only target one dimension of abatement. As a result, abatement may not occur in the least cost manner. Indeed, these measures may distort technology choices, leading to environmental and economic inefficiencies. 4/

The effect of a tax incentive for pollution abatement can also be illustrated by using Chart 2. For example, consider the case where an investment incentive is offered to firms to use equipment, such as a coal scrubber, to reduce emissions. Assume that the use of the technology effects only the emissions and is unrelated to other factors of production. In these circumstances, the firm will only use the environmentally favorable technology if it is compensated for the cost that is reflected in the “technology” abatement schedule. If the policy objective is to reduce emissions from point C to point A the minimum possible subsidy will be the area under the technology schedule or AWEZ. In this case, firms will be indifferent between using the technology or polluting. The social cost of abatement under the investment incentive exceeds the abatement costs of a Pigouvian tax by the area XYZE. The government budget will incur the financial cost of abatement.

Environment-related provisions that take the form of tax expenditures can introduce an additional source of inefficiency that does not characterize indirect environment taxes. Tax expenditures may encourage individual firms to reduce their emissions, however, the subsidy element of the tax expenditure means that exit of polluting firms is discouraged and, in fact, aggregate emissions may increase. 5/ In addition, there is a danger that environment-related provisions in other taxes, by intentionally using the tax system to modify incentives, will encourage numerous other demands to use the tax system for special treatment of specific activities.

Tax incentives that provide special treatment of specific activities may have unintended harmful environmental implications. These implications are discussed in Appendix II.

II. A Survey of Environment Taxes in Selected Countries

Appendix I surveys tax provisions of 42 countries--economies in transition, developing, and industrial countries--that may have an impact on the environment. The survey shows that environment taxes are not used extensively. In this section, the nature of environment taxes that are used is examined. Table 1, drawn from the survey, identifies environment taxes by country. The table suggests that the use of environment taxes, in practice, is the exact opposite to the ranking that environment tax theory would suggest is desirable. Indeed, environment-related provisions in other taxes are the most common environment tax measures. There are some special, or indirect, environment taxes that are targeted at environmental objectives; however, Pigouvian taxes--the theoretically preferred form of environment tax--are not used widely.

Table 1.

Selected Countries: Environment Taxes

article image
Sources: Tables 4 and 5.

1. Pigouvian taxes

Pigouvian taxes are used only on a limited scale and largely within Europe. 6/ Several countries--Australia, Austria, Belgium, Denmark, Finland, France, and Norway--impose waste disposal charges that resemble Pigouvian taxes because they are specific rate taxes related to emissions. Another example is provided by a number of countries--Belgium, France, Germany, the Netherlands, and Switzerland--that impose aircraft landing charges that relate the level of the charge to noise levels. The economies in transition are perhaps most advanced in using Pigouvian taxes. For example, Estonia, Hungary, Poland, and Russia all impose taxes on air and water emissions that take into account factors that affect the level of environmental damage such as quantity and toxicity of emissions.

It is easy, however, to exaggerate the role of Pigouvian taxes in pollution abatement--suggested in Table 1--for two reasons. First, there is no evidence to suggest that the rates of these taxes reflect marginal external costs. For example, the “two-stage” emissions tax in Russia probably diverges from a true Pigouvian tax because the tax rate increases after a threshold level of emissions is exceeded. Such a rate structure is not optimal unless there is a discontinuity in the marginal social cost curve. More generally, social cost estimates are not readily available making an assessment of rates difficult. There are indications, however, that tax rates are low. For example, Poland’s tax on sulfur dioxide (SOx) and nitrous oxide (NOx) emissions was approximately US$80 per ton while abatement costs have been estimated by Bates, Gupta, and Fiedor (1993) to be in excess of US$500 per ton. Calculations suggest that a tax rate of US$80 per ton of SOx and NOx emissions (Zylicz (1993)) implies an average effective tax rate of approximately 0.1 percent of the price of coal--the major source of SOx and NOx emissions. Second, the actual use of these Pigouvian taxes may diverge sharply from the legislated provisions. For example, in the economies in transition the enforcement of the taxes has not been strict--authorities delegated with administration of these measures have used their powers to waive tax payments from companies.

2. Indirect environment taxes

Indirect environment taxes--taxes on productive inputs or consumer goods whose use is related to environmental damage--have been implemented more widely but, in general, only by industrial countries; developing countries and economies in transition have not implemented this type of measure. Examples of indirect environment taxes include the special energy taxes introduced by some European countries (Denmark, Finland, the Netherlands, Norway, and Sweden), fertilizer levies (Austria, Finland, the Netherlands, and Sweden), and taxes on beverage containers (Canada, Denmark, Finland, Norway, and Sweden). Five European countries--Denmark, Finland, the Netherlands, Norway, and Sweden--have introduced carbon or carbonrelated taxes. These carbon taxes vary somewhat across countries. For example, the Dutch energy tax is based 50 percent on the energy component of the fuel and 50 percent on its carbon content. The Norwegian taxation of fossil fuels consists of an amalgam of taxes including taxation of electricity, mineral oils, petrol, coal, and coke as well as gas consumption in offshore petroleum activities. The introduction of many of these taxes was achieved by restructuring existing energy taxes.

3. Environment-related provisions in other taxes

Environment-related provisions in other taxes are the most commonly used instrument: they have been implemented in industrial countries, economies in transition, and developing countries. Environment-related provisions have been introduced in personal income taxes, corporate income taxes, general sales taxes, fuel taxes, and motor vehicle taxes.

Environment-related provisions in personal income taxes have been limited to industrial countries and include measures such as Portugal’s incentives for expenditure on forms of renewable energy and Switzerland’s incentives for expenditure on energy efficiency.

Many countries have provisions in their corporate tax systems that are intended to reduce environmental damage. Examples in industrialized countries include Japan’s capital allowance for solar energy saving equipment and Germany’s accelerated depreciation for energy saving and pollution reducing equipment. Developing countries have also used incentives to encourage investments that are environmentally benign. Kenya and Tanzania provide accelerated depreciation for investments that are intended to prevent soil erosion and for planting permanent or semipermanent crops. In Eastern Europe, Hungary provides incentives for the manufacture of environmental products and Poland encourages the use of recycled products and investments in environmental protection in the agriculture sector. In Latin America, incentives for reforestation are provided by Brazil, Chile, and Colombia. Chile also provides incentives for earning income from artificial forests.

There are some examples of environment-related provisions in general sales taxes or value-added taxes (VATs) across all countries. 7/ Examples of such provisions include: Australia’s exemption of recycled paper, solar power equipment, and conversion of engines to natural gas or liquid propane from wholesale tax; Hungary’s lower VAT rate that is applied to vehicles with catalytic converters; Austria’s higher VAT rate that is applied to large vehicles; Portugal’s lower VAT rate that is applied to equipment used for solar power generation; and Argentina’s higher VAT rate that is applied to some supplies of electricity.

Many industrial countries, economies in transition, and a few developing countries use motor fuel tax differentiation to reduce environmental damage. For example, many countries have a higher excise tax rate on leaded fuels and a lower rate on unleaded fuels. Such rate differentiation is intended to discourage consumption of fuels that are significant sources of heavy metal particulate matter.

Motor vehicle taxes have been used with varying degrees of sophistication to discourage motor vehicle use and fuel consumption. Countries, including Côte d’Ivoire, Australia, Japan, Russia, Italy, Portugal, and Argentina, apply annual taxes on automobiles but vary the tax rates according to a measure of fuel consumption such as engine horsepower, fuel consumption rate, vehicle weight or engine size. In other cases, vehicle taxes are designed to encourage the use of vehicles with lower emissions. Austria’s annual vehicle tax, for example, is lower if the vehicle has a catalytic converter. Other countries encourage consumption of less environmentally degrading motor fuels by varying their annual vehicle taxes according to the type of fuel consumed by the vehicle. Kenya’s tax on vehicles with diesel engines is twice that of the tax on nondiesel engines and Finland applies an annual levy to diesel vehicles.

In sum, Pigouvian taxes are used rarely and mainly in European countries. Indirect environment taxes and environment-related provisions in other taxes are more common--the former have been introduced by industrial countries and the latter by a wide range of countries.

III. The Scope for Environment Taxes

Environment tax theory suggests that Pigouvian taxes rather than other forms of environment taxes should be used for pollution abatement if policy decisions are based solely on efficiency grounds. A comparison of the non-Pigouvian taxes concluded that indirect environment taxes are likely to be superior to incorporating environment-related provisions in other taxes. However, in practice, environment-related tax provisions in a variety of taxes are relied on more than either indirect environment taxes or Pigouvian taxes to pursue environmental objectives. 8/

The divergence between efficient environment tax theory and the practice of environment taxes can be explained by examining three types of factors that influence the introduction of efficient environment taxes. First, efficient environment taxes are difficult to design and administer. Second, country specific economic and structural conditions can hinder the effectiveness of environment taxes. Third, the introduction of efficient environment taxes may conflict with other policy objectives such as economic output, employment, international competitiveness, and equity. Aspects of these factors apply to varying degrees to all three types of environment taxes examined in the paper but it is the difficulty in designing and administering Pigouvian taxes that is the most significant obstacle, especially in developing countries, to efficiently mitigating environmental damage via the tax system.

1. Design and administration of environment taxes

a. Design

In theory, the calculation of an efficient environment tax is relatively straightforward: determine the marginal internal benefit schedule and marginal social cost schedule for a source of pollution. The intersection of these schedules defines the efficient tax rate. In practice, however, the determination of the schedules will be difficult and remains the key challenge in designing an efficient environment tax. 9/

The determination of the marginal social cost schedule is a difficult valuation problem because there often are many dimensions to social cost. For example, estimating the social cost of a particular polluting activity may require an understanding of the impact of pollution on human health, the appearance of human habitats, natural parks and recreation facilities, and biological diversity. An additional layer of complexity is added to the valuation problem if the impact of pollution on these factors varies intertemporally or spatially. Similarly, the marginal internal benefit schedule will be difficult to measure. This schedule will depend on the many dimensions of pollution abatement such as adjustment in inputs, output reductions, and technological change. All of which may be difficult to assess empirically.

These aspects of defining the efficient Pigouvian tax rate also apply to indirect environment taxes. The design of indirect environment taxes suffer from another difficulty: they can involve uncertainty in estimating the responsiveness of the pollution to indirect environment taxes. Indeed, setting an indirect environment tax rate based on a quantity target requires an understanding of the elasticity of the damaging activity to the tax and the elasticity of the pollution to the damaging activity. This is especially important because of the potential for excessive abatement costs associated with indirect environment taxes. In fact, uncertainty in defining the tax rate to achieve a target emissions level may justify the use of quantity-based policies. The policy issue here is whether setting the quantity incorrectly or, via a tax, setting the price incorrectly will cause the greatest cost. 10/

b. Administration

Pigouvian taxes are analogous to specific rate excise taxes. Specific rate excise taxes on goods, such as alcohol and tobacco products, are viewed as easy to administer because they apply to goods that are easily identifiable. They are also subject to control if excisable goods cannot be released from bonded warehouses prior to payment of tax. This feature of excises does not, however, apply to Pigouvian taxes because it may be technically or practically difficult to measure and monitor physical quantities of pollution. For example, it may be relatively simple to measure pollution from a single emitting source such as a factory effluent pipe or smokestack but it is obviously quite difficult to measure each pollution source when there are many sources such as, for example, in the case of automobile exhaust pipes.

For Pigouvian taxes on some types of pollution, there may be significant numbers of taxpayers providing negligible amounts of revenue to the treasury. Indeed, the incentive to effectively administer efficient environment taxes will be reduced if revenue per unit of administrative outlays is low. In addition, the multiplicity of environmental problems implies that many taxes are required and this multiplies the difficulty of administering efficient taxes. Further administrative difficulties arise if spatial or temporal aspects of an environmental problem are addressed by taxes because measurement of emissions across geographic regions may be difficult. For example, the tax authorities would be required to determine the levels of emissions in urban and rural areas and impose taxes accordingly if an efficient environment tax on automobile emissions was to be adopted.

Many of these administrative difficulties would not have to be dealt with, in general, if an indirect environment tax were introduced because the tax would be calculated on the price of productive inputs or consumer goods. Thus, indirect environment taxes may be easier to administer even though more difficult to design than Pigouvian taxes.

2. Economic and structural conditions

Economic and structural conditions in a country may limit the effectiveness of efficient environment taxes. This could be a significant impediment to the introduction of such taxes. Three aspects of these conditions may be important: macroeconomic stability, the role of state-owned enterprises, and the prevalence of market failure.

a. Macroeconomic stability

Pigouvian taxes are difficult to maintain in the presence of macroeconomic instability. For example, high and/or variable inflation rates will limit the effectiveness of Pigouvian taxes because they are specific rate taxes. Inflation quickly erodes the real value of tax rates that are intended to reflect marginal social costs. Effectiveness can be maintained, in part, by providing mechanisms to adjust nominal tax rates frequently in order to maintain real tax rates. In practice, however, nominal tax rate adjustments may be difficult to implement. This has been confirmed by the experience of the economies in transition. 11/

Macroeconomic instability also limits the effectiveness of indirect environment taxes and environment-related provisions in other taxes. High or variable inflation mitigates the effectiveness of price signals thereby reducing the effects of indirect environment taxes. Inflationary conditions will also erode the incentive effects of some forms of tax expenditures.

b. State-owned enterprises

Environment taxes may well be ineffective in circumstances where state-owned enterprises play an important role because these enterprises may not be responsive to the price signals created by environment taxes.

Industrial pollution problems are often dominated by a few industries, particularly in the materials processing sectors, which in many economies are dominated by state-owned enterprises. Table 2 shows the most important polluting industries based on three measures of pollutants. Subject to the industrial structure of the country under consideration, it would not be unusual for a few industries to account for the major part of industrial pollution. Thus, in Indonesia, for example, Wheeler and Martin (1993) are able to identify five industries that account for well in excess of 50 percent and in some cases almost all of the industrial pollutants.

Table 2.

Major Industrial Sources of Pollution

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Source: Wheeler and Martin (1993). X refers to upper quartile in distribution of 38 ISIC intensities by pollutant.

BOD is biological oxygen demand resulting from the emission of organisms into waterways.

TSP is total suspended particulates.

TOX is toxic emissions including waterborne toxic metals and carcinogenic compounds.

Although direct evidence is unavailable, it is hypothesized that in many countries not only are state-owned enterprises important they are dominant in some of the most pollution-intensive sectors. 12/ In Poland, for example, the power industry, chemical industry, metallurgy, and building material industry account for 60 to 70 percent of total air pollution. 13/ In these instances, it is important to evaluate whether or not taxes will provide the appropriate incentives for reducing environmental damage. The results of a study evaluating the likely responsiveness of enterprises to higher energy prices in Poland showed that “in the short to medium term, these changes would have little impact on either the pattern of industrial fuel use or the general level of fuel efficiency.” 14/

c. Market failure

When there is failure in the markets for substitutes to an item subject to an environment tax, environmental damage may be exacerbated by the imposition of the tax. Table 3 suggests that some developing countries are characterized by substantial environmental damage. As a result, the imposition of an otherwise efficient Pigouvian tax may, while resolving one environmental problem, change relative prices in such a way that other forms of environmental damage are exacerbated. Indirect environment taxes could also induce such substitution effects. An example of this problem is the use of an indirect environment tax on petroleum fuels that worsens the problem of market failure in forests. By raising the relative price of fuels there is resort to fuelwoods whose price is unaffected by the change in policy. Another case arose in Thailand where a tax on chemical fertilizers, which in most circumstances is environmentally beneficial, resulted in environmental damage because it encouraged a technological substitution from intensive farming to extensive farming which was accomplished by clearing and cultivating marginal forest lands. 15/

Table 3.

Selected Countries: Environmental Damage Estimates 1/

article image
Source: Pearce and Warford (1993).

Various years in the latter half of the 1980s.

Pre-unification.

Benefits of environmental policy, that is, avoided damages rather than actual damages.

3. Other policy objectives

The use of inefficient environment taxes may be attributed to the balancing of environment policy objectives against other policy objectives such as economic output and development, employment, international competitiveness, and equity of the tax system. The balancing of these competing policy objectives could be a significant impediment to the introduction of efficient environment taxes.

a. Economic output

Environment taxes are likely to harm economic output although this conclusion can only be made usefully on the basis of a comparison of the output costs of alternative taxes. Although environment taxes provide social benefits in the form of reduced environmental damage, they are like other taxes in the sense that they lead to modifications in production decisions or consumption patterns. Such modifications may lead to reduced economic output. 16/ As a result, policymakers may consider balancing reduced economic output against the gains from an efficient environment tax. This may lead to modification of efficient environment tax proposals so that indirect environment taxes or environment-related provisions in other taxes are introduced. However, such measures may still involve a trade-off between environmental and output goals because relative to broad-based tax measures, indirect environment taxes can have significant output costs. Goulder (1992), for example, shows in a general equilibrium model of the United States that output costs of employing energy taxes significantly exceed the costs of increasing personal or income taxes and, by a bigger margin, the use of a broad-based consumption tax.

b. Employment

The possibility that labor bears the environment tax burden could influence the use of or design of environment taxes. Environment taxes may well harm employment of labor for two reasons. First, to the extent that these taxes result in lower output, as suggested above, they are likely to harm employment prospects. Second, employment prospects could be harmed further if the cost of labor is increased by the use of environment taxes. Although there is no general conclusion on the implications of environment taxes for relative labor costs there are a number of circumstances in which employment of labor could be made less attractive because labor bears a significant part of the tax burden. Labor, as the immobile factor of production, is likely to bear the major part of the tax burden where goods are tradable and environment taxes increase the costs of productive inputs. Domestic consumers are likely to bear the tax in the case of nontradable goods. However, just because the tax is borne by consumers does not ensure that employment prospects are protected. Labor income earners along with capital income earners as well as recipients of transfers all bear the tax when it falls on consumers. Taxes that raise consumer prices may interact with taxes on labor income adding to the distortion that shifts the supply of labor and discourages employment. 17/

c. International competitiveness

Environment tax measures can, subject to the incidence of the taxes, harm international competitiveness. This concern may be reduced somewhat if an environment tax is on tradable goods and it is levied at the consumption stage. However, the tax may interact with labor income tax distortions to worsen competitiveness. In other cases, the environment tax burden may be exportable. For example, a European proposal for a carbon/energy tax called upon other OECD countries, particularly the United States and Japan, to introduce similar measures. These countries combined are major importers of oil and if they imposed energy taxes it is plausible that the tax burden could to some degree be shifted to energy producers. In the absence of such agreements, international competitiveness concerns may impede the introduction of environmentally desirable taxes. 18/

The European Commission’s carbon/energy tax proposal is an example where the environment tax design is modified, reducing environmental effectiveness, to reflect concerns regarding international competitiveness. The carbon/energy tax proposal provided for (1) graduated tax reductions for energy-intensive firms that may be disadvantaged relative to competitors in countries not having comparable tax measures; 19/ (2) tax incentives and temporary exemptions from the carbon tax for firms embarking on energy saving investment; and (3) introduction of the tax in Europe was conditional on other OECD countries introducing taxes or measures with similar effect to the European carbon/energy tax. Many of these special provisions reduce the environmental effectiveness of the tax because they do not encourage substitution away from fossil fuels but, from a macroeconomic perspective, they limit the magnitude of the tax on tradable goods and perhaps shift the major tax burden from producers toward final consumption.

d. Equity

Equity concerns may impede the introduction of environment taxes. Many environment taxes are regressive because they raise the price of commodities which comprise a larger share of income of lower income consumers. For example, the empirical literature qualifies, although it does not refute, the common perception that a tax on the carbon content of fossil fuels will be regressive. The raw data for the United States support the conclusion that such a carbon tax is regressive; the percent of income going to fossil fuel consumption in the lowest decile of income is 10.1 percent compared to 1.5 percent of the highest decile of income. 20/ Other factors suggest that the tax may not be as regressive. For example, using permanent income to assess the progressivity of carbon taxes shows that the tax is considerably less regressive and, in a number of European countries, it is no longer regressive at all. Nevertheless, equity concerns are often raised as an impediment to the introduction of environment taxes.

IV. Policy Implications and Conclusions

This paper examined the efficiency of three types of environment taxes: Pigouvian taxes that are levied on emissions, indirect environment taxes that are levied on productive inputs or consumer goods whose use is linked to environmental damage, and environment-related provisions in various other taxes. Of these taxes, Pigouvian taxes are most efficient and, of the non-Pigouvian taxes, specifically targeted indirect environment taxes are likely to be more effective than use of incentives in other types of taxes.

A survey of environment taxes used in 42 countries--developing countries, economies in transition, and industrial countries--suggests that the practice of environment taxes diverges from the theory of environment taxes. Although environment taxes are not used extensively, the most prevalent environment taxes are environment-related provisions in other taxes. Pigouvian taxes and indirect environment taxes are not used widely.

The divergence between the theory and practice of environment taxes may relate to three types of factors that influence the introduction of environment taxes. First and foremost, environment taxes are difficult to design and administer due to problems with measurement, monitoring, and compliance. Second, the effectiveness of environment taxes can be hampered by macroeconomic instability, soft state-owned enterprise budget constraints, and failure in markets for substitutes to the taxed item. Third, trade-offs between environmental and other policy aims such as output, employment, international competitiveness, and equity may discourage the use of efficient environment taxes.

Ultimately, the role of environment taxes must be assessed in the context of the range of environmental policy instruments that could be employed. These other policy instruments include structural measures, such as land (property rights) reform, pricing reform for products that are linked to environmental damage, regulatory policies, tradable permits, as well as other fiscal measures such as nontax subsidies. A spectrum of policy combinations can be envisaged: at one extreme lies the Pigouvian tax, which environment tax theory suggests is the most efficient policy instrument, and perhaps at the other end of the spectrum is a regulatory system which could be preferred in circumstances where, for example, tax administration is weak. In practice, a combination of policy instruments is likely to be required to address environmental damage with the relative importance of tax and other environmental policy instruments determined by their relative cost effectiveness. The particular combination--and thus the importance placed on taxes--is defined by equating the marginal efficiency costs of each instrument. 21/ The greater the efficiency or other costs of using taxes the smaller the role they should play in environmental policy.

Appendix I: A Survey of Environment Taxes

Tables 4 and 5 survey tax provisions of 42 countries--economies in transition, developing, and industrial countries--that may have an environmental impact. These tables briefly describe environment tax measures that have been implemented--Pigouvian taxes, indirect environment taxes, and environment-related provisions in other taxes--and provisions in other taxes that may unintentionally have adverse environmental consequences. The former information has been summarized in Table 1. There are two appendix tables: Table 4 lists Pigouvian taxes and domestic taxes on goods and services, and Table 5 lists income, profits, and property tax provisions.

Table 4.

Selected Countries: Environment-Related Aspects of Taxes Pigouvian Taxes and Taxes on Goods and Services 1/

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Sources: Coopers and Lybrand International Tax Network (1993); Foreign Tax Law Publishers (1993); Gaines and Westin (1991); Gofman and Gusev (1993); IBFD (1993a, 1993b, 1993c, 1993d, 1993e); various IMF REDs; Jenkins and Lamech (1993); Kallaste (1993); OECD (1993a); Pomazi and Zsikla (1993); and Zylicz (1993).

The table identifies tax provisions which may have direct environmental implications. The table is not comprehensive because of the numerous possible interactions between the tax system and the environment as well as data limitations relating to various tax provisions. Subject to these qualifications, the absence of a text entry in the table indicates that the tax does not have direct environmental implications.

Table 5.

Selected Countries: Environment-Related Aspects of Taxes on Income and Profits, Property, and Motor Vehicles 1/

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Sources: Clark (1992); Coopers and Lybrand International Tax Network (1993); Foreign Tax Law Publishers (1993); Gaines and Westin (1991); Gofman and Gusev (1993); IBFD (1993a, 1993b, 1993c, 1993d, 1993e); various IMF REDs; Jenkins and Lamech (1993); Kallaste (1993); OECD (1993a); Pomazi and Zsikla (1993); and Zylicz (1993).

The table identifies tax provisions which may have direct environmental implications. The table is not comprehensive because of the numerous possible interactions between the tax system and the environment as well as data limitations relating to various tax provisions. Subject to these qualifications, the absence of a text entry in the table indicates that the tax does not have direct environmental implications.

The survey cannot be comprehensive due to the multiplicity of possible interactions between taxes and the environment. In addition, environment tax provisions in the countries surveyed may have changed considerably since the publication date of the various sources for the survey. Thus, the survey provides an illustrative picture of the state of tax policy and the environment at the end of 1993.

Appendix II: Tax Incentives with Unintended Harmful Environmental Implications

The survey in Appendix I showed that many countries provide tax incentives, such as tax holidays or accelerated depreciation intended to encourage industrial development that may lead to investment in environmentally sensitive areas or activities. Such tax provisions increase the return to producers from the polluting activity. In the framework of the environmental problem shown in Chart 3 (which is similar to the earlier charts), the tax incentive leads to an increase in the marginal internal benefit schedule of the firm to MIB″. The firm now chooses to pollute to the point C compared to B in the absence of the tax incentive. However, the socially efficient level of emissions remains unchanged at point A because it depends on the opportunity cost of adjustment and marginal external cost and not on policy-induced distortions.

Chart 3.
Chart 3.

Environmentally Damaging Tax Incentives

Citation: IMF Working Papers 1994, 106; 10.5089/9781451947083.001.A001

Many countries provide rate reductions or tax holidays to the agriculture, forestry, fishing, and mining sectors. Rate reductions and tax holidays are also provided for new investments in regions that may have been undeveloped because of low carrying capacity. There are also examples of provisions in sales taxes or VATs that may encourage consumption or use of environmentally damaging goods. For example, in many European VATs, a lower or zero tax rate has applied to coal. In some developing countries, including Malaysia and Egypt, petroleum products are exempt from the VAT or general sales tax. In some countries, automobile taxes may discourage ownership of new vehicles which are likely to be more environmentally friendly than older vehicles. For example, the rate of the annual automobile levy in Madagascar decreases with the age of automobiles. Other countries, such as Colombia, apply luxury VAT rates to new automobiles. There are also examples of fuel excise taxes that may encourage greater environmental damage. The Philippines, Côte d’Ivoire, and Chile, for example, apply lower tax rates to diesel fuel than to gasoline even though diesel engines have been identified as a significant source of airborne particulate matter.

The sheer number of these potentially environmentally harmful provisions suggests that a critical step in any environment tax reform should be the modification or elimination of such provisions so that they do not contribute to environmental damage. This course of action is consistent with traditional tax reform principles of base broadening and elimination of special incentives and exemptions. These reforms would contribute to both fiscal and environmental objectives, but are in contrast with the use of several environment taxes to address a number of environment problems in a given country. This reflects two sets of circumstances. First, circumstances where the tax provision is the cause of the environmental damage--a case of tax-induced policy failure--and second, circumstances where an environment tax is employed to address market failure. In the first circumstance, tax-induced environmental damage could be eliminated by reforming broad-based taxes. Resolution of market failure requires use of special environment taxes such as Pigouvian taxes.

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*

Opinions expressed are those of the authors and do not necessarily represent those of the International Monetary Fund. We would like to thank Ved P. Gandhi and Parthasarathi Shome for their comments on an earlier draft.

1/

For the purposes of this paper, environmental damage is defined to arise when the marginal social cost of using environmental resources exceeds the marginal social benefit. The divergence between marginal social cost and benefit can arise due to: market failure--the failure of markets to equate marginal social cost and benefit or policy failure--a microeconomic policy that encourages excessive use of an environmental resource.

2/

Discussion of the extensive literature on Pigouvian taxes, not considered here, is found in a variety of sources such as Baumol and Oates (1988).

3/

Taxing inputs may, however, remove the incentive for innovation of end-of-pipe technology that could reduce emissions.

5/

For example, Bramhall and Mills (1966) illustrate this outcome with a subsidy and Baumol and Oates (1988) contrast the cases of using a subsidy with a Pigouvian tax.

6/

Assessment of these Pigouvian taxes is complicated by the observational equivalence between what some countries term taxes and others charges, penalties, or fees. A tax is an unrequited payment whereas a charge is a requited payment. For example, the government might define property rights over an environmental asset and charge for the right to use that asset for waste disposal or other uses. A possible institutional rationale for use of the term fees or charges is that, in some countries, revenues from these go directly to the ministry responsible for administering the fee whereas tax receipts go to the consolidated revenue fund.

7/

The environmental implications of varying VAT rates is limited to final consumption goods. VAT paid on productive inputs is creditable against subsequent VAT liabilities thus levying a high rate on an environmentally damaging input only calls for a higher credit. The differential rates of VAT can thus only have an environmental effect on those items which are finally consumed or are used as business inputs in sectors ineligible for credits on input tax.

8/

One conclusion that might be drawn from the survey--based on the limited use of environment taxes--is that many countries simply do not choose to pursue environmental aims by using taxes. Indeed, there may be little political motivation to actively use taxes to pursue environmental objectives. In many circumstances of industrial pollution, for example, limited sources account for the bulk of environmental damage. In these cases, there may be effective political opposition to the use of environment taxes because the polluters are small in number (and perhaps well organized) whereas the beneficiaries of pollution abatement are large in number or diffuse. As a result, regulations or marketable permits may be preferable to environment taxes for pollution abatement because they can be designed to protect the interests of established enterprises.

9/

Cropper and Oates (1992) discuss the various means of valuation that might permit the setting of an efficient Pigouvian tax rate.

12/

State-owned enterprises play a significant role in many countries although their importance varies significantly across countries (see Milanovic (1989)). In the case of Poland, for example, while over 80 percent of the retail trade had been privatized by the end of 1992, only some 12-15 percent of industrial production was accounted for by privatized industry (see Bates, Gupta, and Fiedor (1993)).

15/

See Reed (1992), p. 105.

16/

This argument is simplified by assuming that the environmental externality has no effect on productivity and output. If productivity is harmed by environmental damage, the environment tax, to the extent that it alleviates that damage, may raise productivity. Should this occur, the excess burden for taxpayers should reflect both abatement costs and improved productivity (see Nellor (1994)).

18/

There have been a number of empirical studies evaluating the implications of environment regulations on competitiveness and location of investment. These studies suggest that the concern that environment taxes harm international competitiveness is perhaps misplaced. This is because the cost-reward equation for avoiding environment taxes is not profitable in any but the most energy intensive industry. See, for example, Richardson and Mutti (1976) and (1977), Duerksen and Leonard (1980), Leonard (1988), and Knodgen (1979).

19/

The graduated tax reductions are available to firms for whom energy costs exceed 8 percent of value added.

20/

See Poterba (1989). However, European data do not unambiguously support this conclusion. See Smith (1992).

21/

The cost effectiveness of tax and other environment policy measures, evaluated on a case-by-case basis, permits the choice between alternative policy instruments to be made. Such an approach is illustrated by Eskeland (1993) who demonstrates, in a study of Mexico City air pollution, that the use of a gasoline tax--which is inefficient in addressing local air pollution problems--combined with regulatory measures requiring automobile monitoring is superior to using either instrument alone. More generally, the conclusion that can be drawn from Eskeland’s analysis is that a combination of policy instruments should be used such that the efficiency costs of each instrument are equated at the margin.

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Cover IMF Working Papers
Tax Policy and the Environment: Theory and Practice
Author:
Mr. David C Nellor
and
Mr. Ronald T. McMorran
Volume/Issue:
Volume 1994: Issue 106
Publisher:
International Monetary Fund
ISBN:
9781451947083
ISSN:
1018-5941
Pages:
50
DOI:
https://doi.org/10.5089/9781451947083.001
Chart 1.

Pigouvian Taxes
Chart 2.

Indirect Environment Taxes
Chart 3.

Environmentally Damaging Tax Incentives