By J. Andrew Hoerner and Benoit Bosquet
This paper surveys the experience of environmental tax reform (ETR) in Europe. When the revenue from taxes on pollution or natural resource depletion is used to lower taxes on valuable economic activities, such as employment or investment, we refer to this as "environmental tax reform" (ETR). We describe in detail the reforms enacted in the eight nations to adopt such reforms (Denmark, Finland, Germany, Italy, the Netherlands, Norway, Sweden, and the United Kingdom) and other nations that have announced that they will adopt such reforms or have adopted elements of such reforms (Austria and Belgium).
Several observations can be made about the ETR packages that have been adopted in the eight European countries that have carried out some form of explicit ETR.
- Explicit ETR is a recent political phenomenon: all ETRs enacted have occurred in the past decade.
The Nordic countries were the pioneers of the movement, but larger economies in western and southern Europe have since followed suit.
- ETR packages have tended to reduce the tax burden placed on labor, primarily by cutting non-wage labor costs in the form of social security contributions paid by employers.
- ETR packages have tended to focus on the energy sector as the locus of new or higher green taxes. This is mainly owed to the need for curbing the risk of global climate change induced by greenhouse gases emitted upon combustion of fossil fuels, as well as the revenue potential of energy taxes compared to other green taxes.
- The financial magnitude of ETR packages varies from small in Italy and the United Kingdom to significant in Denmark. The magnitude shown for these ETRs, however, underestimates the importance of environmental taxes in Europe. European countries have enacted many environmental taxes that do not fall within the definition of explicit environmental tax reform because the revenues from those taxes are not recycled to the economy through reductions in other taxes. If these are included, the magnitude of environmental taxes as a percentage of total tax revenues or of GDP is actually quite substantial. For instance, in the Netherlands, the revenue from all green taxes together constituted over 9% of total tax revenues in 1997, but the revenue of only a few of those taxes—0.5% of total tax revenues—is explicitly recycled through the reduction of taxes on labor or capital.
In addition to describing the reforms, the paper comprehensively surveys the literature assessing the economic impact of such reforms. Based on 44 studies containing 104 distinct simulations of environmental tax reform, we found when the revenues of environmental taxes are used to reduce other distorting taxes, the economic outcome is better than if those revenues are not so distributed, in terms of impacts on both employment and GDP.
Seventy-eight percent of the simulations predict that ETR will create employment. The best results in terms of employment are obtained when recycling occurs through cuts in social security contributions, with 86% showing positive employment results, as opposed to, e.g., 35% positive results for income tax cuts.
One hundred and four simulations return quantified results of the impact of ETR on gross domestic product (GDP). These range between +2.5% and – 5%. (See figure below, based on 100 simulations excluding one negative and two positive outliers.) Almost three-quarters of the simulations predict an impact of +0.5% to – 0.5 of GDP, i.e., a change of less than 0.5% of GDP by the end of the period modeled, relative to the reference scenario. Thus it appears that the impact of ETR on GDP, whether negative or positive, is likely to be small.
Over two-thirds of the simulations returning a positive impact on output assume recycling through cuts in employers’ social security contributions. In our sample of simulation results, 35% of the ETR simulations based on cuts in payroll taxes (social security contributions) resulted in net GDP losses, while 65% showed net gains or no net impact. This contrasts with simulations returning eco-tax revenue through personal income tax cuts, where 75% of the simulations showed net GDP losses. Value-added tax cuts and lump-sum transfers of the revenue to households showed intermediate results.
Virtually all nations that have adopted ETR have also adopted measures to promote new clean energy technologies at the same time. Austria, Denmark, Germany, the Netherlands, Norway, and Sweden explicitly included tax incentives for efficiency technologies in their ETR packages, and other nations have included exemptions from their carbon or energy taxes for efficient technologies such as district heating or super-efficient electrical plants. Studies on the impact of hybrid packages including both ETR and tax or non-tax measures to promote efficiency technologies—from Austria, Denmark, and the U.K., and a multinational study using the Hermes model—all found that the net economic effect of such packages was both positive and preferable to ETR alone. An older Belgian study, also using the Hermes model, found that using 30% of the revenue to fund energy efficiency slightly reduced the GDP gain but greatly increased the emissions savings. Our survey suggests that policy packages that include the use of a portion of the environmental tax revenues to finance energy efficiency or renewable energy improvements are more likely to result in positive employment and GDP impacts. The study also surveys results on sectoral and income distribution impacts, and a variety of implementation issues.
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Abbreviations: CPT=Corporate profit tax; GDP=Gross domestic product; PIT=Personal income tax; SSC=Social security contributions; CO2= Carbon dioxide; SO2=Sulphur dioxide.