How to Design Environmentally Beneficial Tax Incentives

This blog is based on a WIFO working paper by the authors (here).

The fight against climate change requires effective economic policy instruments. In addition to environmental taxes, such as a carbon tax, environmentally beneficial tax incentives that favour less polluting consumption and investment activities can be used to promote climate-friendly behaviour. As governments around the world search for measures to counter the negative economic effects of the COVID-19 pandemic, environmentally beneficial tax incentives combining potential stimulus effects with climate protection, thus supporting a green recovery, have been moving up agendas recently: Austria, for example, implemented a reduced VAT rate for small repairs, Italy introduced a tax incentive for energy efficient renovation, and the UK is currently considering proposals to cut VAT for green home improvements.

According to the OECD, an environmental tax relief or tax incentive is a government measure that aims at steering expenditure of individuals and businesses away from environmental “bads” towards environmental “goods” by reducing the amount of tax that they have to pay for the latter compared to the former. Tax incentives thus imply that the government foregoes tax revenues to favour less polluting consumption and investment in order to achieve environmental policy goals and thus address positive externalities. In other words, a beneficial tax incentive encourages behaviour that generates additional social benefits which would not have been created without the subsidy.

In general, there are several aspects that should be considered in the decision whether to implement tax incentives and how to design them. In contrast to environmental taxes, environmentally beneficial tax incentives are often discussed as a complementary instrument in order to tackle specific environmental problems. The argument is that a combination of instruments, such as a tax in combination with a tax relief, can achieve a policy objective at lower costs than a stand-alone tax. In general, which policy instrument or which instrument mix is ultimately chosen should be based on a thorough analysis of different aspects, such as tax policy arguments, or how a specific policy objective can be achieved at the lowest cost and with the highest probability of achieving a stated goal. Finally, aspects of political acceptance also play a role. In particular, a combination of a tax incentive and an environmental tax can increase the acceptance of the latter and prepare the ground for its implementation.

The Diversity of Environmental Tax Incentives

Tax incentives to support environmentally friendly behaviour are much more diverse across countries than environmental taxes, in particular with regard to:

• the supported economic activity (consumption versus investment)
• the concrete environmentally relevant activity they try to influence (e.g. purchase and use of cars, use of public transport, use of biofuels and renewable energy, investment and research in energy efficiency and clean technologies)
• the economic actors they benefit (private households versus firms)
• the concrete tax they are built into (direct taxes, i.e. personal and corporate income tax, versus indirect taxes, i.e. consumption taxes), as well as
• their concrete design (direct taxes: reduced tax rates, tax allowances reducing taxable income versus tax credits reducing tax liability; indirect taxes: reduced tax rates, total or partial exemption of tax base).

Tax incentives are but one instrument to further environmentally beneficial behaviour and decisions. The existing theoretical and empirical literature suggests that other fiscal incentives, in particular grants, direct subsidies, and preferential loans, are more prevalent than tax incentives.

Analysing the Effects of Environmental Tax Incentives

Compared to the large body of empirical evidence on the effects of environmental taxes in general and taxes addressing greenhouse gas emissions in particular, the number of empirical analyses of environmentally beneficial tax incentives is rather limited. Many of these analyses evaluate individual measures in single countries (in the EU mostly “old” Member States), while cross-country comparative analyses are less common. Part of these studies analyse a given tax incentive isolatedly, i.e. without evaluating it against alternative policy instruments and thus without assessing the benefits of alternative policy measures to reduce emissions. However, there is a growing body of comparative evaluations of alternative policy interventions. The bulk of analyses consists of ex-post evaluations, there are only few ex-ante simulations of hypothetical scenarios.

These limitations notwithstanding, the existing analysis allows to derive some general, structural aspects concerning the effects of environmental tax incentives.

First, tax incentives must be salient to change behaviour. Tax rebates and exemptions granted at the time of sale are more effective than complex income tax incentives as the latter have to be applied for by consumers and bring about financial relief with a delay only, which therefore may be undervalued due to consumer myopia.

Second, tax incentives are often problematic from a distributional point of view. For example, subsidies for low-carbon technology granted to private households (e.g. for electric vehicles, building insulation, or roof-top solar) can be assumed to be rather regressive, as higher income households are more likely to invest in low-carbon durables. The scarce empirical evidence suggests that the regressive effects of carbon pricing policies are less pronounced than those of environmentally motivated tax exemptions.

A third, related aspect is free-riding and the question of additionality, i.e. whether a tax incentive is granted for an activity that would have taken place anyway. The more prevalent free-riding is, the less cost-effective a given tax incentive is. Generally, tax incentives are often found to be not very cost effective, which is why some authors argue that carbon pricing should be preferred to tax incentives. Tax incentives are generally perceived as being prone to free-rider aspects.

Finally, there is evidence supporting the consideration that “package solutions” combining several climate policies in general, and carbon pricing and tax incentives in particular, may be more effective than single measures as outlined above.

To conclude, environmentally beneficial tax incentives imply foregone public revenues to favour less polluting consumption and investment activities in order to achieve environmental policy goals. They should be reviewed prior to their introduction in view of their expected effects. As environmentally beneficial tax incentives are tailored to specific circumstances, generalisable conclusions regarding their effect are difficult to draw. However, there are a number of aspects (e.g. windfall profits, picking winners, necessary budgetary means) that should be analysed carefully before implementation. If designed carefully, environmentally beneficial tax incentives can increase the overall effectiveness of a coordinated environmental policy mix.