Tax policy analysis

Taxation and Environmental Policies


The OECD has worked on issues related to environmental taxes for many years. From 1999 to 2000, it reviewed environmentally related taxes in OECD countries and prepared a report on Environmentally Related Taxes in OECD Countries: Issues and Strategies. The main lessons that can be drawn from this report are outlined below.

OECD Member-countries face a number of environmental challenges, including the protection of the ozone layer, local air quality, acidification and eutrophication, water supply and water quality, waste management and biodiversity losses. An issue currently high on the agenda in most Member countries is how to reduce greenhouse gas emissions.

Over the last decade, economic instruments have been playing a growing role in environmental policies of OECD countries. In this context, a distinctive feature is the increasing role of environmentally related taxes. All countries have introduced environmental taxes to a varying extent, and an increasing number of countries are implementing comprehensive green-tax reforms, while others are contemplating doing so. Depending on design features, environmental taxes support the 'polluter pays principle' under which the costs of pollution prevention and control should be reflected in the price and output of goods and services which cause pollution as a result of their production and/or consumption.

The revenue from environmentally related taxes averages roughly 2% of GDP in Member countries (see also the OECD/EU database on environmentally related taxes and charges). These taxes are introduced in support of a number of policy objectives, where policy choices typically depend on a balancing of conflicting goals. In the context of environmental concerns, environmentally related taxes introduce a price signal that helps ensure that polluters take into account the costs of pollution on the environment when they make production and consumption decisions. Taxes are a flexible policy instrument that can minimise control costs for achieving a given pollution target and provide incentives for technological innovation and further reductions in polluting emissions.

Taxes on the purchase or use of motor vehicles and fuels, including taxes on petrol and diesel, generate most of the revenues from environmentally related taxes. In some countries taxes are also used to address a broad spectre of other environmental problems. Nevertheless, in many countries there is scope for expanding the use of environmentally related taxes.

There is growing evidence on the effectiveness of environmentally related taxes in OECD countries as a means to reduce damage to the environment. There are also indications that adjustments of tax rates for competing energy sources can cause significant fuel-switching to take place if tax rates on energy products are re-modulated according to environmental criteria.

Green-tax reforms can be implemented by a series of complementary measures, such as introducing new taxes or restructuring existing taxes, for example on energy or transport, to reflect the polluting characteristics of the taxed products or activities. It is also most important to remove or adjust environmentally harmful fiscal provisions, such as tax exemptions or subsidies having detrimental effects on the environment, while giving due notice to the non-environmental objectives the provisions were meant to serve.

A major obstacle to the implementation of environmentally related taxes in certain cases is the fear of reduced international competitiveness in energy intensive sectors of the economy. To date, environmentally related taxes currently imposed by OECD countries have not been identified as causing significant reductions in the competitiveness of any sector. This is consistent with research on economic performance that shows that skills and capital investment largely determine sectoral competitiveness. Also, different sectors within countries differ in terms of their exposure to international trade and competition. The finding is also not surprising given the numerous forms of exemptions and rebates currently granted to business. Indeed, the OECD/EU database shows that environmentally related taxes are levied almost exclusively on households and the transport sector. These exemptions and rebates undermine application of the polluter pay's principle (PPP) and create inefficiencies in pollution abatement.

Blanket exemptions for polluting products along with rebates for heavy polluting industries can significantly reduce the effectiveness of environmentally related taxes in curbing pollution and similarly reduce incentives for developing and introducing new technologies. Consideration might be given to a dual (two-tier) rate structure, rather than the use of full exemptions, with lower rates for the more internationally exposed sectors, as a possible alternative. The negative environmental effect of exemptions and rate reductions can also be limited by ensuring that exempted firms sign up to stringent mitigation measures. Furthermore, in instances where exemptions and rebates are currently given for competitiveness reasons, countries examining revenue recycling as an option should consider imposing environmental taxes on industry while introducing innovative methods to channel part of the environmental tax revenues back to industry in such a way that marginal abatement incentives are not reduced.

Pre-announcing the introduction of environmentally related taxes and tax rate increases, and a gradual reduction or phasing out of rebates and exemptions, are two policy options that could ease implementation, make environmental taxes more effective, while also addressing competitiveness concerns. In some countries, there is also scope for improving the design of tax provisions to ensure that any remaining exemptions and refund mechanisms are properly targeted to achieve their stated objectives. Careful design and targeting would reduce the economic costs of achieving a given environmental target.

Alternative policy instruments used to reduce environmental pollution, such as regulations, would also affect firm's costs and impact on the competitiveness position of individual sectors and the country as a whole. By enhancing the economic efficiency by which a given target is reached, properly designed environmentally related taxes will help minimise adverse effects on competitiveness nation-wide.
One way to address international competitiveness concerns is for countries to share information, experiences and best practices as regards possible options and opportunities for expanding the application of environmentally related taxes. Countries concerned with competitiveness implications of adjusting certain environmentally related taxes on a unilateral basis may also wish to consider possible concerted policy options and changes, decided and implemented at the national level, but within a framework which provides for a multilateral dialogue.

The distributional incidence of environmental policy measures has become a key issue in the policy debate. The data show that some environmentally related taxes can be regressive at least to some extent, impacting more on low-income households, and can also increase regional income disparities in some countries. However, a complete assessment of distributional effects would also include the secondary impact of any compensation payments, tax reductions, and the induced employment effects. It should also take into account the distribution of the environmental benefits resulting from the tax.

Mitigation measures (e.g. reduced environmentally related tax rates for lower incomes) to address the regressivity concerns can reduce the environmental effectiveness of the taxes. Other and more direct measures, such as transfers, can compensate low-income households. Such compensation measures can maintain the price signal of the tax, whilst reducing the impact of the tax on household income.

While the advantages of environmentally related taxes have been demonstrated, the problems of international competitiveness and income distribution need to be taken seriously. It is only when these problems are solved that one can expect countries to take full advantage of economic instruments in improving the environment. Current work at the OECD is focussing on how to overcome these obstacles.


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