The GGKP's Fiscal Instruments Research Committee commissioned Kai Schlegelmilch (Green Budet Germany) to produce the paper 'Fiscal considerations in the design of green tax reforms', which he co-authored with Amani Joas (Green Budget Germany). In this blog they discuss some of the conclusions from their paper.
The best way to advance green fiscal reform in practice is to demonstrate to Ministries of Finance around the world, that ecological fiscal reform (EFR) is an excellent source of government revenues. Taxing ‘bads’, such as the environmentally damaging use of resources and energy instead of ‘goods’, such as labour and capital should be the goal of any revenue-raiser, who has a rudimentary understanding of economics. A shift from taxing goods to taxing bads not only corrects distorted prices and gives market actors an incentive to improve the environment (e.g. by reducing emissions and protecting limited natural resources) but also takes the burden of taxation off labour, which should help to create jobs and reduce unemployement.
Before venturing into EFR, any Finance Minister will want to know, how much revenue can be created by a specific green fiscal instrument. If she or he was a character in Cameron Crowe’s cult movie Jerry Maguire she or he would ask: “Show me the money”. Green Budget Germany/Europe developed a six step framework to do just that in Fiscal considerations in the design of green tax reforms, presentation: Fiscal Considerations in the Design of Green Tax Reforms – Evaluating their Revenue Potentials. Figure 1 shows the basic steps a Finance Ministry has to consider, when estimating the revenue potential of an EFR instrument.
Figure 1: Revenue potential of EFR
Step1: Estimate the potential revenue of your EFR instrument
The first step is to estimate the size of the revenue pie, which will later be reduced by various factors. Tax revenues are easily calculated by multiplying the tax base with the tax rate. However, these variables influence one another: As tax rates for a certain bad e.g. CO2-emissions increase, the tax base shrinks since actors reduce emissions in order to avoid being taxed. This effect is great from an environmental point of view, however, less pleasant for a revenue maximizer. Economists speak of high elasticity, when the tax base strongly reacts to price changes (here: caused by taxation). Generally broad tax bases, such as energy or CO2 are rather inelastic, while narrow tax bases such as the use of plastic bags are more elastic and react stronger to taxes. For instance, introducing a 0.15 EUR charge on plastic bags in Ireland, decreased plastic bag usage by more than 90 percent from 328 bags per capita to 21 bags per capita within a single year. In order to estimate potential revenues it is therefore crucial to estimate the elasticity of the tax base with respect to the tax rate. Generally tax rates should reflect the (marginal) costs of environmental damages. For a finance ministry it is crucial to estimate the potential revenue from such a tax. A gradual phase-in of the tax with an annual increase of rates towards the final target rate can help to clarify revenue potential in the first phase of its implementation.
Step 2: Subtract exemptions and reductions (or avoid them altogether)
Having estimated potential revenues this way, one must consider secondary economic effects and the realm of ” Realpolitk”, which may reduce revenues in predictable ways. First of all, Finance Ministries should estimate the value of exemptions and reductions, which are often necessary to muster sufficient political support for an EFR. Special treatment of certain groups is generally neither sensible from an environmental nor from a fiscal perspective: Offering lower rates to certain groups e.g. energy intensive industry reduces their motivation to produce their output in environmentally friendly ways and also distorts factor and product prices across markets, since prices no longer reflect the true marginal social costs of production. Furthermore, governments may lose substantial revenues as is the case with Germany’s electricity tax, where 35 % of potential revenue is lost due to various privileges and exemptions. However, exemptions and reductions may be considered a necessary evil and are justified in the rare cases, in which EFR actually harms the international competitiveness of national firms. The value of these lost revenues should be determined and subtracted from overall potential revenues.
Step 3: Consider external revenue effects
In the next step ministries should consider so-called “external revenue effects” of the EFR policy in question. The idea behind this is rather straightforward: introducing a new tax for one base may reduce the tax bases in other areas. For instance, introducing a CO2 tax on the kerosene used in air travel would directly impact and increase the costs of the airline industry. If the new tax is deductible as a cost, it would dampen profits and therefore lower the revenues from profit taxes of this industry. However, as we have ventured into second order effects, we cannot simply conclude that our new kerosene tax decreases tax receipts through external revenue effects. The world is more complex: Assuming that higher prices of air travel motivate passengers to switch to other modes of transportation, such as trains, we would expect more demand for rail transport and possibly also more domestic travels, higher profits from these companies and therefore larger tax revenues ceteris paribus. It is impossible to quantify from the outset, which effect any EFR will have on external revenues, but directions of potential impacts can and should be considered. Therefore, it is crucial to estimate the wider economic and therefore revenue effects of an EFR in order to find out, which way this effect goes. Generally, it is fair to assume that “external revenue effects” are neutral on average.
Step 4: Plan for inflation - and time effects - adjustment is key!
Depending on the kind of EFR, one also needs to consider the effects of time and inflation. Inflation matters for the real value of revenues if taxes are designed as quantity taxes. Quantity taxes raise a certain nominal amount of tax per physical unit, e.g. EUR/litre of gasoline. If the nominal amount of the tax is not adjusted, the tax looses its real value due to the overall increase in price levels throughout the economy. A striking example is the U.S. federal fuel tax, which has been frozen at a nominal rate of 18.4 US cents/gallon or 4,86 EUR cents/litre since 1993. Given official inflation figures, the real value of this tax has eroded to 11,1 cents/gallon (in 1993 USD) until 2013. This means that over 20 years it has lost roughly 40 % of its value. In order to avoid such an impact from the outset, Finance Ministries should opt to automatically raise nominal tax rates each year to adjust at least for inflation. However, it is not only inflation which can lower revenues over time. One can also expect actors to become better at avoiding taxes over time, which once again, is great from an environmental point of view. For instance, it may be difficult to avoid a CO2 tax in the energy sector in the short run, however, as new technologies evolve it may be cheaper to switch to alternative forms of production and therefore avoid paying the tax. This increasing elasticity of the tax base over time will reduce revenues, however, should not be of great concern to ministries. First of all, these effects are generally very slow, especially if the tax base is broad, and can be easily anticipated by adjusting rates upwards if the base erodes. One option to offset a possibly shrinking energy tax base is to increase tax rates by the rate of energy productivity increase of the previous year so that the revenues can be kept stable. Secondly, ministries can always find new externalities to tax, if an EFR should really prove so dangerously successful.
Step 5: Minimze administration costs
Next on the list are administrative costs. One should think of administrative costs as the bureaucratic cost per unit of tax revenue. These costs arise in the processes of assessing, paying & collecting, and monitoring & enforcing payment of revenues and essentially depend on the design of the EFR and the administrative capacity within each country. Generally, administrative costs of EFR are very small compared to other taxes. Using exisiting administrative structures for an EFR, Germany managed to enact an ecologic tax reform (1999-2003) where only 0.13 % of the revenues raised were spent on administration. Income ad value added taxes tend to perfrom much worse on administratie efficiency. Given the possibility to tax professional industries, such as energy importers and producers, EFR is especially attractive in developing countries, where large informal sectors prohibit an effective taxation of labour and profits.
Step 6: Keep in mind possible costs of compensatory spending
Last on the list of revenue reducing items is compensatory spending. This form of spending is comparable to revenues lost due to exemptions and reductions, as it heavily depends on the specific political situation in a given country. Sometimes, EFR instruments undermine the economic well-being of low-income households. This problem can be solved by compensating certain actors (e.g. poor households or vulnerable firms) through price-independent transfers. The size of these transfers differs in practice. In order to increase the political backing for subsidiy cuts to fuel, Indonesia introduced the compensation program Bantuan Langsung Tunai (BLT), through which more than 50 % of added revenues were recycled to low-income households in 2005. An even more extreme example is Sweden’s NOx–charge, where all revenue is recycled back to the taxed companies. Usually, compensation plays a less significant role, however, from a political economy perspective one should beware of who needs to be “bribed” in order to gather sufficient political support for reform. It is also important to understand that compensation is to be preferred to exemptions and reductions, because compensations do not destroy environmentally valuable price signals. Furthermore compensation payments are more transparent and therefore more subject to scrutiny, which makes it easier to phase them out in the long term, whereas exemptions and reductions unnecessarily complicate the policy instrument, which makes room for obscure lobbying and political horse trading.
Sum up your calculation
Having considered all these steps brings the evaluation process to a close. If the goal is to excite a Finance Minister for an EFR – and this has to be the goal as this Minister is normally leading on all fiscal aspects – it is probably best to offer a low marginal tax, reflecting external costs, on a broad tax base, which is not prone to react strongly to price changes in the short run. It would be ideal if the tax burdens various groups lightly and broadly, so that no or minimal exemptions and reductions are necessary. The tax should not lead to large-scale distortions, which would cause unforeseeable external revenue effects and it should be automatically adjusted for inflation so that it doesn’t lose its bite over time. Taxing few and professional actors preferably high up the supply chain could further reduce administrative costs and make this instrument especially attractive for burdened administrations. Ideally, the tax does not cause concentrated harm, which would allow to bypass compensatory spending. A tax on CO2 and or energy meets these criteria and should therefore enlighten any Finance Minister wishing to generate easy and consistent revenues. Having shown you the money, the question arises, how all this revenue should be spent. Generally Finance Ministers are surrounded by cabinet colleagues with countless potential answers. In this sense, EFR revenues can turn the Finance Minister into the most desirable person in the room.