Tax Expenditures and the Environment: Strengthening the Spotlight

This post was first published by the Green Fiscal Policy Network here.

Tax expenditures – government spending through deductions, exemptions, and other benefits granted through the tax code – are significant and have wide ranging environmental implications. A stronger green fiscal policy spotlight on them is critical.

Fossil fuel subsidies are the most evident case in point. Around 60% of all policies that the OECD identified in its 2015 “Inventory of Support Measures for Fossil Fuels” are tax concessions, including reduced excise rates on aviation fuel in Australia, a special tax regime for goods used in the exploration and production of fossil fuels in Brazil, and an energy tax refund for diesel used in agriculture and forestry in Germany. At the same time, the OECD reports that “a limiting factor in respect of tax expenditures relating to fossil fuels is the extent to which countries release such estimates already”, and highlights that “more work should be conducted in this area”.

Against this backdrop, tax expenditures related to fossil fuels have moved-up in the climate change agenda. The explicit call for a rationalization of “…inefficient fossil-fuel subsidies…” (SDG12) as well as the inclusion of Indicator 12.c.1: Amount of fossil-fuel subsidies per unit of GDP (production and consumption) and as proportion of total national expenditure on fossil fuels, in the context of the Sustainable Development Goals are cases in point.

Although there is still a long way to go, the momentum for Fossil Fuel Subsidy reform has been growing. This momentum should not stop there and be expanded to cover the potential impact of tax expenditures on the environment beyond those in the context of fossil fuel subsidies.

Why tax expenditures?

Tax expenditures are used widely and cover the entire tax system, including personal and corporate income taxes as well as energy taxation and VAT. Their impact on government revenues is substantial. In the US, the federal government is estimated to have foregone USD 1.4 trillion through 167 tax expenditures in 2016, i.e. roughly 7.5% of GDP. In Australia, the largest 25 tax expenditures in 2015 accounted for 9% of GDP.

Strikingly though, in contrast to direct government spending – for which there are annual budgets and annual parliamentary debates – tax expenditures are often opaque, with the quality and scope of reporting varying considerably among countries. In a recent article, I describe the worrisome situation in Switzerland, where the last comprehensive federal report on tax expenditures dates back to 2011 and provides estimates of revenue foregone mainly based on 2005 figures from the canton of Bern, extrapolated to the rest of the country.

Tax expenditures also raise significant concerns regarding the effectiveness in achieving their stated goals as well as their efficiency, as they are very often prone to negative side effects. Alstadsaeter et al. (2015) show that patent and IP boxes create incentives for MNEs to shift their location of patents rather than their real activities, i.e. there is no effect on boosting R&D or innovation, the primary goal of these schemes. The regressive impact of the pension income splitting scheme in Canada illustrates one of the main side effects that is often triggered by tax incentives for pension savings – see also, e.g. Delisle and Dancy (2015) on the (in)effectiveness of education tax credits in the US and IMF et al. (2015) on the issues around tax incentives for investment in developing economies.

Against this background, calls for more and better scrutiny of tax expenditures are getting louder – also from an environmental perspective.

Environmentally harmful tax expenditures

Many tax expenditures – including, but not limited to fossil fuels – have a significant negative impact on the environment. Take, for instance, the US mortgage interest deduction (MID) – a scheme allowing mortgage interest payments to be deducted to foster homeownership. The MID is among the costliest federal tax expenditures (the Joint Committee on Taxation estimates its cost to be USD 63.6 billion in 2017 and USD 357 billion for the 2016-2020 period), and also among the most controversial. Its primary goal – boosting homeownership – is far from indisputable per se.Moreover, empirical evidence shows that it is ineffective in promoting homeownership and highly regressive – i.e. if anything, it mainly boosts ownership among the rich as they lie in higher tax brackets, and hence get bigger deductions. In addition, it incentivizes the acquisition of larger and more expensive houses, which in turn raises concerns regarding its impact on the environment through, e.g. land use. As stated by the Tax Foundation, the MID creates several “negative externalities (i.e. pollution or greenhouse gas emissions) that likely exceed any positive external social benefit from marginally larger homes”, and is also likely to exacerbate regional inequality, as 5 of the 10 counties with the highest MID claims are also among the ten wealthiest.

The tax treatment of company cars and commuting expenses provides another example. “Because of its disproportionate impact on total distance driven and its components, the under taxation of company cars is likely to result in disproportionately large impacts on most relevant environmental pressures…” (Roy (2014), p.10). Heuermann et al. (2017) show that the preferential tax treatment of commuting expenses is both regressive and environmentally harmful.

Green Tax Expenditures: Not All That Glitters Is (Green) Gold

While the case against environmentally harmful tax expenditures appears to be straightforward, I would be more cautious regarding the implementation of tax expenditures that incentivize positive environmental outcomes. Even if their primary goals (e.g. increasing energy efficiency, energy security and spurring green technology growth) are worth pursuing, the same caveats regarding transparency, effectiveness and efficiency may also apply to green tax benefits.

In that context, Murray et al (2014)  report that tax credits in the US for renewable energy investments as well as for the production and use of biofuels “have a very small impact on GHG emissions and, in some cases, may actually increase emissions.” Moreover, Borenstein and Davis (2015) assess the distributional impact of several federal income tax credits for weatherizing homes, installing solar panels, buying hybrid and electric vehicles, and other clean energy investments. The authors show that all have been disproportionally captured by higher-income households, with the bottom three income quintiles receiving around 10% of the total, and the top 20% receiving roughly 60%.

Nonetheless – as shown in Figure 1 – the US Congressional Research Service estimates that, in recent years, the revenue foregone through tax incentives for renewables has exceeded the cost of tax incentives for fossil fuels.

Figure 1. Projected Annual Cost of Energy-Related Tax Incentives (FY1978-FY2020)

Source: Sherlock, M. (2017). “The Value of Energy Tax Incentives for Different Types of Energy Resources: In Brief”, Congressional Research Service

Strengthening the green fiscal policy spotlight

To foster better alignment between tax expenditures, green objectives and a wider sustainability agenda, governments must significantly improve their reporting on tax expenditures. They should not only provide more and better estimates of the revenue foregone through these schemes, but also deliver comprehensive assessments of their effectiveness and potential negative externalities. Without robust and comprehensive data on tax expenditures for fossil fuels, their elimination remains an elusive task. Without additional transparency on other environmentally harmful tax expenditures, green fiscal policy reforms will fall short. And without adequate scrutiny of green tax expenditures, their impact will be constrained.

A stronger green fiscal policy spotlight on tax expenditures is a necessary – although not sufficient – condition to better align fiscal policy with a broad sustainability agenda.