Going green unintentionally

 

On 30 January 2015 Yanis Varoufakis, the finance minister of Greece's newly elected government, shocked European stakeholders: Even though Greece finds itself knee-deep in debt, he rejected cooperation with the so-called Troika. The Greek government faces the dilemma of maneuvering its way out of the dire straits while at the same time trying to achieve at least a minimum level of public spending, e.g. on hospitals, schools, roads, etc. This dilemma is quite severe, as austerity measures have put a strong constraint on Mr. Varoufakis' scope of action. 

 

While Greece's situation is an extreme example, finance ministers throughout the world are constrained by tight budgets. Next to the need to repay debt, another pressing issue is the necessity to lower corporate tax rates to prevent private capital – and with it also jobs – from leaving the country. Due to the growing integration of world markets, this has become an increasingly harmful race-to-the-bottom over the last decades. The problems on the income side of public finance are aggravated by problems on the expenditure side. Think of the requirement to finance pension systems in economies with an aging population, or the need to invest in crumbling infrastructure. 

However, a solution to the outlined challenges can be found off the beaten track. Our study, which I have presented at this year's conference of the Green Growth Knowledge Platform, makes a strong case for a green tax reform for the national budget's sake. 

 

We analyze how governments should reform their tax system when they find themselves competing for mobile capital and are constrained by tight budgets, but have to finance productive public investments. The results of the study show that it is best to lower corporate taxes and instead put a price on the carbon content of fossil resources. This way, the tax system distorts the economy less even though it raises higher revenues. If the additional revenues are then invested to increase productivity, e.g. in education and infrastructure, everyone is better off. In short: It's better to tax bads instead of goods. Protecting the environment and stimulating the economy can go hand in hand. 

 

But what is the underlying reason? At first glance, both taxes seem to harm the economy in a similar fashion. Both increase the costs for businesses and thus the private sector reacts by moving part of its activity abroad. However, a CO2 price has the decisive advantage of shifting part of the tax burden away from businesses which produce goods and services, and towards the owners of fossil resources. This way, the CO2 price captures the resource rent. The resource rent is the portion of the resource owner's total revenue, which is in excess of the costs needed to supply the resource. So, when the resource owner's rent is decreased due to a carbon tax, resource extraction decisions do not change and there is no adverse impact on the real economy. (The Economist explains rent income using the example of a soccer star's income.) 

 

Unless a corporate tax is payed by a monopolist, it cannot capture as much rent as a carbon tax would. This is because businesses in a competitive market have comparably little revenue in excess of their production costs, when we include payments on interest, insurance against risk, and managerial activities. Otherwise, high excess revenues would be competed away. 

 

Now let's suppose that finance ministers actually implement the above suggested tax reform and succeed in balancing their national budgets. Is there not the danger that resource owners anticipate even higher carbon taxes in the future and thus speed up extraction? Will carbon taxes then not actually harm the environment due to an increase in emissions? 

 

The answer is a clear no: When carbon taxes are used to finance productive public investments, then this will affect both the demand and the supply side of fossil resources. Concerning the latter, the rate of extraction will not increase, because rent taxation has no effect on extraction decisions, as mentioned above. Therefore, the demand side fully determines when and how much resources are extracted. For the buyers of resources, the price of carbon increases, which lowers demand, postpones extraction, and reduces emissions. 

 

This is not to say that we do not need a binding global agreement on climate change. A unilateral fiscal reform which includes a carbon tax will not solve the climate problem just by itself. However, when politicians understand that green fiscal reforms benefit the whole economy, the above explained fiscal considerations can be an entry point for more stringent climate policy.