ENVIRONMENTAL AND PUBLIC FINANCE ASPECTS OF THE TAXATION OF ENERGY.

This paper reviews potential applications of environmental taxes in the energy sector. Theoretical and practical arguments for using environmental taxes are reviewed, and possible arrangements outlined for levying environmental taxes on energy. In contrast to most environmental taxes, taxes on energy have the potential to raise revenues sufficient to alter the constraints and opportunities in fiscal policy. A carbon tax levied at a rate of 200 [pounds sterling] per tonne could raise revenues equivalent to about 11 per cent of total UK tax receipts, allowing income tax to be halved, or corporation tax abolished. Inappropriate use of the revenues, or their unnecessary dissipation, can greatly add to the costs of environmental policy. But, environmental taxes are unlikely reduce the overall excess burden from taxation below the current level, and the case for ecotaxes must thus primarily be made in terms of their environmental benefits.

I. INTRODUCTION

`Ecotax reform' has become a catchphrase with considerable political resonance in many European countries. In Germany it is championed by a research institute--the Wuppertal Institute--devoted to this topic, and appears to have been one of the major issues in political bargaining over coalition terms between the Greens and the SPD. In the UK, too, the arguments for ecotax reform--in various guises--have been adopted right across the political spectrum: both Conservative and Labour Chancellors of the Exchequer have taken tax policy measures which they justified by using some of the arguments used by the supporters of ecotax reform, and the Liberal Democrats have adopted a more fundamental ecotax programme as party policy.

Part of the impetus for ecotax reform comes from the recognition of the limitations of environmental policies pursued solely through conventional regulatory instruments. Increasingly, there is a recognition that some environmental problems cannot be tackled purely as technical issues, to be resolved straightforwardly through regulations requiring the use of appropriate abatement technologies. To make any serious impact on some of the major environmental problems now facing policy-makers--acid rain, global warming, traffic congestion--environmental policies will need to achieve extensive and far-reaching changes to existing patterns of production and consumption. Achieving the necessary changes will inevitably entail substantial economic costs. The search for instruments capable of minimizing the costs, and capable of achieving behavioural changes across all sectors, has led policy-makers in the last decade to pay much closer attention to the potential for incentive-based environmental regulation, through taxes, charges, tradable permits, and other `economic instruments'.

Another part of the impetus for ecotax reform has come from the side of tax-policy-makers and Ministries of Finance, through the recognition that some ecotaxes could have the potential for raising significant revenues. Some countries that have been concerned about the impact--either economic or political--of high taxes on labour income, have considered ecotax reforms in which the revenue raised from new environmental tax measures would permit reductions in income tax rates. Sweden, for example, actually implemented such a reform package in 1991, in which revenues from new environmental taxes on energy were used to finance cuts in labour income taxes. The political attractions of `packaging' environmental taxes and tax reform in this way are, perhaps, obvious. The environmental gains, too, are relatively clear-cut, but the fiscal benefits of this type of tax substitution are much more contentious.

An important ingredient in the discussion of ecotax reform is the scale of the tax changes that would be involved, and the notion that the introduction of new environmental taxes might significantly alter the constraints and opportunities in tax policy-making. In practice, however, many environmentally motivated tax measures that might be contemplated do not have the potential to raise significant tax revenues. The tax bases involved are insufficiently large to yield revenues that significantly alter the overall tax structure. Taxes on certain types of battery, for example, or on plastic carrier bags, or on household purchases of garden fertilizers and pesticides, have all been employed in some European countries. In each case, they may have appreciable merit as an instrument of environmental policy, but their revenues are negligible in the context of the overall public finances. Even the substantial tax introduced by the UK on the use of landfill sites for dumping waste, which currently yields about 400 million [pounds sterling], contributes little more than 0.1 per cent of total revenues. In addition, of course, some environmental taxes may achieve highly elastic polluter responses, eroding the revenue yield. Thus, for example, the tax differential introduced between leaded and unleaded petrol in many European countries has been followed by quite rapid fuel substitution, as consumers have shifted to the lower-taxed fuel.

In practice, significant scope for major tax reform financed by the revenues derived from ecotaxes is only likely to arise in the case of two potential environmental tax bases--taxes on road transport, and on energy. Congestion charges on private motoring could, for example, be a major source of tax revenues, if levied at a rate reflecting the congestion externality imposed by each individual motorist on other road users. In an earlier issue of this review, for example, Newbery (1990) estimated that the congestion cost per vehicle-kilometre averaged some 3.4 pence across the UK. If this was fully reflected in a congestion charge, it would imply revenues of some 18 billion [pounds sterling] annually at current values, some 6 per cent of total fiscal receipts (or about one-quarter of the revenues from income tax). On the other hand, if congestion externalities are separately taxed, other taxes on motoring may be higher than can be justified in terms of the remaining motoring externalities, and so the overall revenue gain from moving to an efficient structure of externality taxes and changes on motoring would be substantially lower.

The taxation of energy, to reflect the environmental externalities involved in energy use, is the other area with potential to raise major tax revenues. Energy taxes, in the form of a carbon tax, were the main ingredient in Sweden's ecotax reform, and the European Commission's proposal for a carbon-energy tax in the early 1990s would have likewise generated appreciable revenues--between 1 and 3 per cent of total fiscal receipts in member states. In 1994, the UK government ended VAT zero-rating on domestic energy as one of a package of revenue-raising measures. The initial proposal to tax energy at the standard VAT rate of 17.5 per cent would have raised some 3 billion [pounds sterling] of revenues annually, some 1 per cent of total fiscal receipts, but subsequent modifications have reduced the tax rate to 5 per cent, and annual revenues to around one-third of the original projection.

More recently, the government has been giving serious consideration to the possibility of taxing industrial energy use. During 1998 the Chancellor of the Exchequer set up a Task Force, chaired by Lord Marshall, to consider the possibilities for using economic instruments to reduce energy use and emissions of greenhouse gases by the industrial and commercial sectors. The report of the Task Force, published in November 1998 (Marshall Report, 1998), argued that a `mixed approach' will have to be taken in order to achieve the UK's current commitments for reductions in greenhouse-gas emissions and to provide clear signals for longer-term emissions reductions beyond those currently agreed. Within this mixed approach, economic instruments would have a role to play. The report investigated the possible uses that could be made of two possible groups of economic instruments--tradable emissions permits and taxes--and concluded that there was a useful role for both as part of a wider package of measures, `subject to careful design in order to protect the competitiveness of British industry and maximize the environmental benefit' (Marshall Report, 1998, p. 10).

How much revenue would be derived from an industrial energy tax would depend on the rate set, and the argument for a mixed approach implies that, initially at least, the rate might be relatively modest. Concerns about the impact on industrial competitiveness--whether well-founded or not--will obviously constrain the tax rate. Nevertheless, it is reasonable to suppose that in the longer run, if more stringent reductions in energy-related emissions are needed, an increasing role may need to be played by energy-pricing measures, and correspondingly large revenues would be raised.

This paper considers a number of aspects of the taxation of energy for environmental reasons. First, it reviews briefly the arguments for using taxes in environmental policy. These arguments form the backdrop to any discussion of energy-related environmental taxes, and neglecting the basic principles they embody could lead to inefficiently designed instruments, or excessive long-run cost. Second, it reviews potential applications of environmental taxes in the energy sector--their purpose, their design, and their revenue contribution. Third, it considers the value of the revenue contribution from environmental taxes on energy. Where would ecotax reform fit into the current pattern of British tax policy, and how far would it alter the constraints and problems which the tax system currently faces? Would an ecotax reform provide a substantial `double dividend', in the form of a less distortionary tax system, as well as a cleaner environment? How would these arguments be affected by some of the choices that would have to be made about the design and introduction of energy taxes along the broad lines envisaged in the Marshall Report?

II. THE CASE FOR ENVIRONMENTAL TAXES

There is now an extensive literature on the potential for taxes to contribute to more efficient and more effective environmental policy (e.g. Smith, 1992; OECD, 1993, 1996; Bovenberg and Cnossen, 1995; O'Riordan 1997). In comparison with `conventional' regulatory policies based on technology or emissions standards, ecotaxes may be able to reduce the costs of achieving a given standard of environmental protection (or, alternatively, can achieve a greater environmental impact for a given economic cost). However, environmental taxes are far from being a panacea for all environmental problems. Consideration of their advantages and disadvantages, as compared with other instruments, suggests that there is a group of environmental problems for which taxes, of various sorts, may be the best instrument available. There are other environmental problems which would be better tackled by other approaches, including other `economic instruments', such as tradable permits, or various forms of command-and-control regulation.

(i) Advantages of Ecotaxes

From the perspective of environmental policy, environmental taxes have attractions for a number of reasons.

`Static' efficiency gains through reallocation of abatement

Where the costs of pollution abatement vary across firms or individuals, environmental taxes have the potential to minimize costs, for one of two possible reasons. Where other policy instruments cannot fully differentiate between polluters with different marginal costs of abatement, taxes can achieve a given level of abatement at lower total abatement cost. On the other hand, where other policy instruments take account of differences in polluter abatement costs, taxes can sidestep the need for the regulatory authority to acquire detailed information on individual sources' abatement costs, and can thus lower costs of regulation from the side of the public sector.

`Static' efficiency gains through performance incentives

Taxes levied on emissions provide an incentive for care and attention in the operation of mandated technologies. In many cases, use of a given abatement technology does not guarantee a precise emissions level; instead, much depends on how the technology is used. Providing businesses with an incentive to cut emissions can be translated into providing individuals within the business with similar incentives, and some individuals may be in a position to take actions which greatly affect the emissions performance of a …