Europe’s fiscal blind spot

Smarter taxes on energy and emissions to reduce public deficits

As European governments desperately try to plug public deficits, restore competitiveness, employment and growth, the tendency would seem to be towards less environmental policies. What if more environmental protection and putting a price on pollution was actually the way to go?

As governments look for new streams of funding, taxes on carbon reappear on the political agenda. In Norway, the government doubled earlier this month the carbon tax on offshore oil companies (now €55 per ton, NOK410), suggested to add a €6.75 (NOK50) tax per ton of CO2 onto its fishing industry, and set aside €1.4bn (NOK10bn) for a new fund for climate change mitigation, renewable energy and energy conversion.[1] In France, François Hollande announced “ecological” tax reforms in mid-September. The US Congressional Research Office recently concluded that a $20 tax per metric ton of carbon could reduce the country’s budget deficit by 50% over the next 10 years and Conservative think tanks are considering the possibility.[2] And South Korea just announced that it may link an energy taxation system to emissions as part of efforts to reduce greenhouse gases.[3]

In many places, however, such taxes face recurring opposition, being criticised as damaging to the economy. The opponents should reconsider. A recent report by Vivid Economics concludes in fact that a carbon tax could generate significant income while having a lower impact on GDP, employment and social cost compared to other forms of direct or indirect taxation that are currently envisaged by governments around the EU to generate revenue.[4]

Still, carbon taxes currently represent a modest share of the taxation of European countries. Examples from Sweden, Denmark and Germany, however, show that energy taxes, while stimulating innovation in this sector and leading to an emission reduction of greenhouse gases, have a smaller impact than income taxes on purchasing power.

From a purely theoretical perspective, any tax increase has an immediate cost. But both theory and reality, also show that taxation can help correct dysfunctions that are not been taken into account by the market such as pollution and greenhouse gas emissions. In countries that rely heavily on energy imports, such taxes have indeed resulted in redirecting spending from imports onto domestic goods and services, which stimulates the economy. Vivid Economics concludes that energy taxes would cause less economic harm per unit of revenue than direct (i.e. income) or indirect taxes, while also producing other benefits. In fact, their models show that energy taxes could have half the negative impact on GDP as direct taxes while raising the same revenues between 2013 and 2020. Indirect taxes (VAT), though less damaging than direct taxes, still tend to do slightly worse than energy taxes. As energy taxes lead to a reduction in energy imports, they also improve energy security. All taxes have similar employment impacts, although indirect taxes (VAT), which particularly penalise the labour-intensive retail sector, tend to perform worst.

The economic benefits of energy tax reform however remains largely neglected and as a result are poorly developed in the budgetary strategy of most EU administrations. Moreover, according to the report, fears about energy taxes having a regressive social impact are misplaced. The implementation of feasible solutions by various governments in Europe shows that this problem can be solved extensively by using a small portion of the revenue to offset the impact on low-income groups income.

And of course, energy taxation allows a more important reduction of CO2 emissions compared to other taxes. The authors of the report assess that tangible tax reforms could lead to an additional decrease of CO2 emissions in 2020 of between 1.5 and 2.5% compared to 1990. Effective taxation of energy must ensure that all energy consumers bear the costs of carbon emissions produced by energy consumption, which, due to the many exceptions and subsidies, is not the case today.

In the current context, governments more than ever wish to preserve their national industry’s competitiveness. The study confirms that a system of ‘smart’ border tax adjustments (BTAs) could both protect European countries and encourage measures in the fight against climate change for EU’s trading partners, while generating a net budgetary contribution instead of costs. Smart BTAs are calibrated to a trading partner’s income level and take into account capacity to mitigate emissions. They also benchmark against other countries, comparing their carbon prices. The report explains some relatively simple mechanisms that could achieve these benefits.

While the costs and sacrifices for restoring budget balance are high in these times of recession, governments must leave no option unconsidered to encourage sustainable and inclusive growth while reducing the debt.

If the beneficial effects of taxing carbon emissions were acknowledged more widely, it might be easier to get an agreement that would benefit everyone. Taxes on carbon emissions are generally regarded as an instrument of environmental policy, not fiscal policy. It’s time to revise that judgment.