Environmental Taxation

1. Environmental Taxation Don Fullerton (Texas) Andrew Leicester (IFS) Stephen Smith (UCL)

2. Introduction • Key part of policy agenda across OECD • New UK taxes on landfill, business energy, aggregates extraction • How to minimise cost of meeting major environmental goals? • Can environmental tax revenues substitute for other sources of revenue?

3. Approximate UK taxes, 2005 • Landfill ~ £18/tonne (£733m) • Climate Levy ~ 0.43p/kWh (£744m) • Aggregates Levy ~ £1.60/tonne (£326m) • Motor fuel ~ 47p/litre (£24b, 5% of tot.rev.) • Motor vehicles ~ up to £200/yr • London Congestion ~ £8/day (£122m)

4. Outline and key issues • Why use market mechanisms in environmental policy? • Environmental tax bases in practice • Revenues and the ‘double dividend’ • Applications: • Road transport • Energy • Household waste

5. Principles: Choice of instrument • Market instrument or regulation? • Advantages of taxes: • Static efficiency gains • Reallocation of abatement to those with low cost • Performance incentives: using technology properly • Dynamic incentives: innovation • Low risk of regulatory capture • Cost-limiting • Tax rate as upper limit on per-unit emission cost

6. Principles: Choice of Instrument • Limitations of taxes: • Uncertain environmental impact • Prefer regulation if ‘threshold’ effect? • Incompatible with firm decision-making? • Still little direct experience for evaluation • Hard to target emissions directly • Geographical variations in damage • Costly evasion activities • Political economy & distributional effects • Legitimisation of polluting behaviour?

7. Principles: Choice of Instrument • Balance of those costs and benefits in selecting instrument • Taxes valuable when need to change behaviour across many different production / consumption activities • But danger of overly complex tax structure • Small taxes may not have much impact

8. Environmental tax design 1. Tax on measured emissions • Direct incentives for abatement • Tax needs to absorb measurement cost • Scale of costs, need to consider: • Type of emission (flow, stock) and available measurement technology • Number of sources (point-source easier) • Integrate measurement with market activities? • Trade-off between incentive targeting (“linkage”) and administration cost • Do we know the right tax rate for each emission?

9. Environmental tax design 2. Tax on a proxy (emission-related input) • Piggy-back incentives onto existing tax • Can apply to market transactions • Saves administration costs and complexity • How closely is it linked to emissions? • Does higher tax lead to some other tax-avoidance? • Examples • Advanced disposal fee (paid at the store) • Tax on carbon content of fuel • Tax on petrol

10. Environmental tax design 3. Multi-Part Instrument • Combine indirect taxes on transactions, to better approximate the ideal emissions tax • Improves the “linkage” to emissions • Generalizes the Deposit-Refund System • A DRS combines a tax on output and a subsidy to recycling, leaving tax only on units not recycled • Tax on carbon content of fuels, plus a subsidy for research into carbon scrubbing technology • Combine a tax on petrol, subsidy for pollution control equipment, tax on big cars, subsidy for new cars …

11. Environmental Tax Revenue • Revenues depend on elasticities of demand and supply • “Effective” incentive tax may therefore see revenues erode over time • Revenue effects are hard to anticipate – impact of economic climate? • e.g. energy tax: low price elasticity, high income elasticity – need to increase tax rate just to “stand still” if economy grows

12. Double Dividend • Oft-argued as reason to favour “tax swap” (new green tax revenue to cut other tax) • Efficient tax system has equal marginal excess burden from each revenue source • Suppose EB is defined to exclude gain from environmental protection • Raise environmental tax rate to the point where its marginal EB equals that of other sources – or higher?

13. Double Dividend • ‘Weak double dividend’ (Goulder, 1995) • Welfare gain from using green tax revenues to reduce existing distortionary taxes exceeds welfare gain from lump-sum redistribution of revenue • Pollution restriction can create scarcity rents, and welfare is higher if gov’t can capture those rents via taxes or auctioned permits, to reduce other taxes • ‘Strong double dividend’ • Welfare gain from green tax plus reduction in distortionary tax is positive, even excluding environmental benefits • No regrets policy

14. Double Dividend • Environmental taxes themselves distortionary • e.g. energy tax raises consumer prices, reduces the real net wage, and affects labour supply • Need to evaluate each reform, case-by-case, in context of existing taxes and enviro policy • Must consider proposed use of revenue • If a small CAC mandate does not create scarcity rents, it can cut pollution without exacerbating labour supply distortions, equivalent to tax swap • Thus, focus on revenues misplaced; key is not to create scarcity rents without capturing them

15. Applications: Road Transport • Vehicle standards guarantee emissions reduction but are inflexible, same for all • Ideal tax on vehicle emissions would allow choice of cheapest ways to abate (list) • Technologically complex at the moment • To what extent can existing taxes be used to mimic the ideal?

16. Road Transport • In a GE model where heterogeneous agents make different fuel and car choices: • Tax on car type that depends on distance achieves the same outcome as the ideal emissions tax • Or a tax on petrol that depends on the car, but needs chip to identify car type (Fullerton and West, 2002) • Uniform rate on petrol and rates on car types cannot • In a computational model, using data on different cars with utility-maximising owners: • Second best set of taxes on petrol, engine size, and vehicle age; obtains 71% of welfare gain of ideal tax • Petrol tax alone can generate 62% of maximum welfare gain (Fullerton and West, 2000)

17. Road Transport • Petrol taxes regressive: income elasticity typically low (West, 2004: 0.23) • Price elasticity also typically small (-0.67) • Regressivity offset by lower rates of car ownership amongst poorest households • Use rest of tax/benefit system to compensate low-income motorists? • Exemptions for poor reduce effectiveness

18. Applications: Energy Use • Ideal tax is on all CO2 emissions at the household/firm level • Direct measurement of individual emissions is not practical • “Carbon tax” on carbon content of fuel – indirect input tax, but good proxy • Could tax at time of extraction or time of purchase for final use • “primary” tax is on fewer numbers, lower admin costs • final use tax omits emissions during extraction

19. Setting a carbon tax rate • Rate should equate marginal external damage cost of each fuel • But damage from CO2 depends on stock of emissions – multi-period problem • Taxing non-renewable energy sources at constant ad valorem rate has no effect on time profile of resource use • But increasing rate over time might lead to higher energy use and emissions today • Reducing current emissions requires falling rate • Optimal time profile of rate is complex

20. Other issues in carbon tax design • How do CO2 taxes interact with the rest of the tax system? • How should they be co-ordinated internationally? • CO2 damage is a global issue • Is it better to set international targets only, or also to agree on policy (easier to monitor policy implementation?) • Can we learn from variation in oil prices about behavioural responses? • Variation in carbon tax rates across energy sources is not the same as impact of oil prices • How to isolate from macroeconomic situation the accompanying high oil prices?

21. Other carbon tax considerations • Adjustment costs • Higher if market failure prevents optimal energy use adjustment (e.g. credit market fails w.r.t. energy efficiency measures in homes) • Competitiveness • Return revenues to business? • Exempt energy-intensive sectors? (Reduces impact!) • Tariffs on imports from countries with no carbon tax? • Distributional • Domestic energy is necessity, carbon tax regressive • Use revenue to transfer to poorer agents? • Are market failures greater for poorer households?

22. Waste management • UK 2004/5: around 65% of municipal waste landfilled, 10% incinerated, and 25% recycled • Each generates externalities (e.g. methane gas) • Domestic waste disposal typically funded by local taxes, not per unit  excess waste generated • Marginal cost pricing may lead to costly avoidance behaviour (e.g. flytipping) • Consider possible welfare gains vs. administrative cost of marginal cost pricing • Ideal would be different tax on each type of waste – but higher cost to collect and enforce • Almost all studies suggest behavioural response to higher price (reduction in waste generated) very small.

23. External costs of landfill • CSERGE (1993) estimates externality at around £7/tonne for active waste and £2/tonne for inert waste, including disamenity cost of landfill sites • Estimates used to set initial Landfill Tax rate in 1996 • EU Landfill Directive: UK to reduce biodegradable municipal waste to 1/3 of 1995 level by 2020 • Landfill Tax rates increased year-on-year since 1999 as a way to help hit that target • Medium term objective: £35/tonne for active waste – far above estimated external cost • Miranda & Hale (1999) estimate external cost at $7.5 - $73.4 / tonne – lower cost if methane flaring, and large uncertainties over quantity and effect of gases produced