Is a global Environmental Fiscal Reform effective? And what about the economic costs?

An Environmental Tax Reform (ETR) consists in transitioning the national taxation system from current pre-existing taxes on labor (personal income tax and social contributions), capital and consumption (VAT and other indirect taxes) to consumption and production activities that generate environmental pressures, without affecting the overall government revenues coming from taxation. This shift could provide better signals to economic agents and therefore, leading to a better functioning of markets. In a more general way, an Environmental Fiscal Reform (EFR) also includes the elimination of environmental harmful subsides.

But what would happen with the economic costs of such a reform? As stated in previous posts, the ‘double dividend hypothesis’ suggests that introducing environmental taxes and, at the same time using its revenues to reduce other taxes not only reduces environmental problems but also has a positive impact on the economy, if maintaining a constant level of total revenue and/or government expenditure. We showed a double dividend is possible by introducing a carbon tax, but what if we consider a broader fiscal reform?

Two big questions arise here: (1) Can an EFR be effective in terms of reduction of environmental loads? (2) Can an EFR trigger economic benefits (or at least no costs) if revenues from the reform are wisely used?

We used the dynamic computable general equilibrium model developed for the Spanish economy in the context of the METRES project, in order to test the double dividend hypothesis of an EFR. The model includes a sub-model describing the energy use and the emissions of 31 different pollutants. The EFR we simulated included adding/increasing a tax on 39 different industry outputs (out of 101 industries we detailed in our model), as well as reducing/eliminating subsides in the same industries. Specifically, this new tax would represent a 20% of total industry output, and subsides would be reduced by 20% of their total output too. Levied industries are related to energy sectors, water supply, sale of motor vehicles, water and air transport and waste treatment activities.

We set four different scenarios, related to revenue recycling: a reduction of taxes on capital, a reduction of taxes on labor, a reduction of value added taxes, and a scenario where revenues are not recycled, so there is more government spending. Environmental impacts are shown in figure 1 and economic effects in figure 2.

 

PollutantsFig. 1. Average annual percentage variation of different pollutant emissions under an EFR.

 

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Fig. 1. Percentage variation of GDP of an EFR under different tax recycling scenarios.

GDP is higher than the base case after the 3-4th year of implementation when revenues are used to reduce other taxes. All revenue recycling options provide economic and environmental benefits, suggesting that the ‘double dividend’ can be achieved.

A full article, describing the model, more results and implications of the research, have been prepared and will be soon submitted to a scientific Journal.

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Economic and environmental effects of a carbon tax

Getting back to previous posts, the implementation of carbon tax could be a good policy to reduce CO2 emissions and thus, to tackle climate change. There is even, some theoretical and empirical literature suggesting than an efficient use of revenues from this tax could bring economic benefits too. The achievement of economic and environmental benefits would sustain the ‘double dividend’ hypothesis of environmental taxation.

A detailed dynamic energy-environment-economy model has been developed in the context of the METRES project, funded by Marie Sklodowska-Curie Actions of the European Commission (H2020 research program). We have added some specifications to this model to test the environmental and economic impacts of a carbon tax in Spain.

Three different taxes have been simulated: 10, 20 and 30 €/ton of CO2. In order to test the ‘double dividend’ hypothesis, we have recycled the government revenues obtained from the tax to reduce other pre-existing taxes: (1) a scenario with no recycling, (2) a scenario with reducing taxes on capital; (3) a scenario with reducing taxes on labor, and (4) a scenario with reducing taxes on value added. After running the model with these scenarios, we have compared simulations with the base case outcome.

 

fig 1Fig 1. Percentage variation in GDP under different carbon taxes and tax recycling options.

 

fig 2

Figure 2. Percentage variation of CO2 emissions for different carbon taxes.

Figure 1 and figure 2 show that an economic and environmental benefit can be achieved for low carbon taxes, by recycling revenues in other pre-existing taxes, such as capital, labor and value added taxes. However, there are costs the first years of implementation. The implementation of a carbon tax of 20€/ton and reducing at the same time capital and labor taxes would reduce carbon emissions around 17% annually with no or very low cost in terms of GDP, after the first years of implementation. The most costly option is to not recycle revenues.

An extensive article, describing the model, results and implications of the research, have been prepared and it is going to be submitted soon to a scientific Journal.

Is a carbon tax a good policy to tackle climate change?

A carbon tax is a tax specifically levied on the carbon content of fuels. It is usually designed in terms of currency/tons of CO2, so it generates incentives to the reduction of carbon emissions in a Pigouvian sense. Given that carbon is present in hydrocarbons (coal, oil and natural gas), the economic sectors focused on the extraction and the use of these fuels are the directly affected economic activities. However, there are indirect and economy-wide effects through all the economic system. The objective of a carbon tax is to reduce the levels of CO2 emissions and then, internalize a negative externality (global warming and climate change). In this sense, the social benefits of this tax could overpass its costs. It is considered by many economists as one of the best cost-effective economic instruments to fight against climate change.

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Although most countries apply taxes on energy products or motor vehicles to tackle emissions of pollutants related to global warming, some countries have implemented different forms of carbon taxes. In Europe we can find several countries: Finland (1990), Sweden (1991), Norway (1991), Denmark (1992), Latvia (1995), Slovenia (1997), United Kingdom (1998), Estonia (2000), Croatia (2007), Switzerland (2008), Iceland (2010), Ireland (2010), France (2014), Portugal (2014). Similar to an environmental tax reform, revenues from this tax can be used to cut other pre-existing taxes, and therefore, boost the economy, overcoming potential costs of its implementation and obtaining a double dividend: reduce emissions and improve the economy.

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A potential revenue-neutral carbon tax is being modelled into the energy-environment-economy model developed for the METRES project, in order to specifically test the effect of different carbon tax rates. One objective of this is to know how to design an effective carbon tax in reducing carbon emissions with low or non-damage to the economic system.

Advances in the energy-environment-economic model

A first model has been balanced for the Spanish economy. This is an economic model with an energy and environmental module that will be the base for conducting different tests on tax reforms. It has been balanced for one single year. This is an important milestone of the project, as balancing a model like this is a time-consuming and tough job. Once done this, we can move on to further steps.

However, the aim of the project in this current outgoing phase in Harvard is to develop a dynamic, recursive general equilibrium model, where economic growth is driven by growth of labor, capital accumulation, and the growth in total factor productivity, so we are already working now on the dynamics of the model, by setting different assumptions on exogenous variables, mostly on population, labor force, evolution of imports, exports and consumption patterns.

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In this first version of the model, technology is represented by Cobb-Douglas production functions in all industries.

This model gives an emphasis to energy consumption (coal, oil and natural gas) and CO2 emissions. This is relevant as we will be able to assess how changes in taxation (or other variables) variate the use of energy and carbon emissions, beyond the short-term and long-term impacts on different economic variables.

Social Accounting Matrix completed

After some months of struggling with data from different sources, a first version of a Social Accounting Matrix (SAM) for the Spanish economy has been completed. This will be primarily used to feed the model that is going to test different environmental taxation policies under the METRES project. This matrix, however, will be upgraded/updated for more periods/industries/commodities as the development of the project requires it and more information is available. This is an important milestone of the METRES project.

A SAM is a central piece of a general equilibrium model, and represents the flows of all economic transactions that take place within an economy and between all economic agents. It contains the basic information on the economic structure for a specific period. Beyond being used for modeling purposes, it is a fantastic source of economic information, as it summarizes the National Accounts for a given economy, providing information of monetary flows between agents.

The main source to develop it have been the National Accounts from the INE, and the supply and use tables from Exiobase, although other data has been used too.

The developed SAM contains a highly detailed information on industry/commodity supply and use tables. Specifically, for 101 industries and the same number of commodities, with a high disaggregation of the electricity sector for different production technologies (coal, gas, nuclear, hydro, wind, petroleum, biomass, solar photovoltaic, solar thermal, transmission and distribution); and also for the waste management sector (incineration, biogasification, composting and landfill for different fractions). This detail will allow to test different environmental taxes on specific electricity and waste technologies, and to show the specific effect on them.

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The way it has been developed allows for the inclusion of environmental accounts for many different resources use (with special emphasis on fossil fuels use) and pollutant emissions from different sources and initiatives like Exiobase. This inclusion will provide simulations not only on the economic effects but also the environmental effects of different proposed policies, like an Environmental Tax Reform.

It has been developed in collaboration with Mun Ho (Harvard – Resources for the future).

Some thoughts on economics, climate change and politicians

Until approximately mid last century, economists had traditionally analyzed the economy as something independent of the environment. There were no environmental constraints in terms of the use of energy or natural resources. So for their analyses, there were unlimited resources and environmental externalities did not suppose costs for agents and for the economies. This might had happened because of the lack of awareness due to the dimension of the global economy at that time. The global resources and energy needs at the period before the two world wars was not big enough to think that natural resources are scarce. Regarding the effects of pollution on human heath, although known, there were not considered important enough compared to progress, as they thought was mostly affecting working class (not middle class yet).

Whatever the reason, environmental economics, ecological economics, natural resources management, industrial ecology, political ecology, and other academic disciplines related to the economy, society and environment are still young. However, it is naïve nowadays to think that the environment does not affect economic activities and that the economic activities does not affect the environment in multiple ways. There is a huge corpus of theoretical and empirical work, coming from all natural sciences and social sciences that support it.

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Related to this, scientists have been alerting us during at least the last four decades that there is no doubt on the existence of an anthropogenic climate change, i.e. caused by human activities. There is a huge consensus among the scientific community on this issue. GHG emissions need to be cut right now. It is a survival issue for our specie. However, some politicians, probably influenced by petrol lobbies, seem to deny it. Climate change is a non-evident to human eye, complex problem. It is easier to believe in quick and easy-to-understand things, but even though we do not deeply understand quantum mechanics, we do not deny Einstein’s work if scientists say it works.

Why energy efficiency is still misunderstood?

Energy efficiency is misunderstood by many policy-makers, despite the large amount of scientific studies trying to explain how it works at micro and macroeconomic levels. At policy level, the effect of energy efficiency measures is mostly estimated through the use of engineering calculus. Let’s start with an example. Suppose that the government initiates an investment plan to improve isolation at households. This measure will improve the efficiency in providing heating and cooling (known as energy services), less effort will be needed to provide the same amount of these energy services.  Government technicians roughly estimate the efficacy of this measure in terms of new energy consumption by estimating how much isolation material will be purchased with the funds and what is the actual isolation provided by this material in a controlled environment. This would be quite accurate in a single timeless dwelling without intelligent life living in it. However, social sciences show us this is not the way it works.

Theoretical and empirical studies show that the installation of the isolation material (or whatever the efficiency measure is) triggers changes that make people react. There is an individual and social behavior beyond the engineering models. First, the energy service (heating or cooling) becomes cheaper. Some households that were concerned about the expensive price of this service no longer are. These households used to turn off the heating or cooling system at night or other specific times, or maybe they did not acclimate some rooms. They may save some energy but not as much as expected. Besides, even if they try to keep the same behavior patterns previous to the efficiency improvement, they save money.

If we go beyond in the analysis of economic and social behavior, we will notice that there is an extra income in households. Households can spend this extra income buying goods and services or can save it. Both options lead to an increase in energy consumption. Goods and services need energy to be produced, distributed and consumed; and banks (or financial system in general) turn savings into investments, loans, mortgages or other assets that also have physical goods and services behind, that require energy in all the production and consumption chain.

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This is known as rebound effect among economists and social scientists. They all agree on its existence; the discussion is on how large it is. Policy-makers have to be aware of this effect, start conducting rigorous assessments on energy efficiency measures and implement additional measures to control it if they want to fight climate change.

References:

Font Vivanco, D., McDowall, W., Freire-González, J., Kemp, R., van der Voet, E., 2016. The foundations of the environmental rebound effect and its contribution towards a general framework. Ecological Economics 125, 60–69.

Freire-González, J., Puig-Ventosa, I., 2015. Energy Efficiency Policies and the Jevons Paradox. International Journal of Energy Economics and Policy 5(1), 69–79.

Jevons, W. S., 1865. The Coal Question. London: Macmillan and Co.

Ruzzenenti, F., Basosi, R., 2008. The rebound effect: An evolutionary perspective. Ecological Economics 67, 526–537.

Saunders, H.D., 1992. The Khazzoom-Brookes Postulate & Neoclassical Growth. The Energy Journal 13(4), 131–148.

Sorrell, S., 2007. The rebound effect: an assessment of the evidence for economy-wide energy savings from improved energy efficiency. UK Energy Research Centre.

On the costs and benefits of environmental taxes

Environmental taxes are a useful economic tool that reduces pollution and resources use. This is something widely recognized amongst economists. The concept is simple and intuitive, if you increase the price of a good or service by imposing a tax, its demand gets reduced. Moreover, if the supply of a specific good or service implies some kind of environmental damage, it may be desirable to reduce it from a societal point of view. On the other side, some economists argue that, in general, taxes provoke costs and distortions. The economy is less efficient in allocating resources, so imposing a new tax is costly. All these arguments are backed by theory and empirical evidence.

Thousands rally for climate action and a carbon price

However, some questions can be arisen in this discussion: what is the cost of environmental damages produced by some economic activities? It might worth paying today the cost and avoiding the future consequences of for instance, climate change, that is likely to provoke future tremendous costs, as scientists are alerting. Moreover, what if revenues from environmental taxes are used to reduce other pre-existing taxes? Can be the cost compensated or even exceeded by benefits in this case? What if the reduction is on taxes on primary inputs, like labor or capital taxes? These and other questions of an environmental taxation reform are being studied in METRES project.

 

Nobel Prize Reception at Harvard

One of the great things of doing research at an institution like Harvard University is the incredible academic environment you can breathe here. We are surrounded by outstanding academics in different disciplines and you can feel it. Their work is sometimes recognized and they are usually awarded for it. However, this time a Nobel Prize landed over my department. This is probably the most important academic award in the world, so the repercussion is extraordinary.

Dr. Oliver Hart was co-awarded for his work on contract theory. The name of the award is actually Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (also known as Nobel Prize in Economics). As a member of the Department of Economics I received an invitation to attend a reception, including a toast with the nominee, at the Faculty Room of the University Hall. I attended and it was a unique experience.