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Environmental tax reform in Europe

Author: EEA Technical report, 17/2012

Thursday 12 April 2012, by Carlos San Juan

Executive summary

Environmental taxation, innovation and the green economy ’Environmental taxation can spur innovation.’ This simple, compelling message was a central finding of a recent OECD study of taxation, innovation and the environment (OECD, 2010). It is an insight of profound importance. Environmental policy instruments are frequently characterised as obstacles to economic activity but the OECD analysis suggests that environmental taxes can, in fact, be the opposite — serving as catalysts for the creativity that underpins thriving economies. In the short term, such innovation can boost efficiency and competitiveness. In the long term it arguably holds the key to sustained prosperity by enabling economic growth to continue within environmental limits. Innovation, particularly the kinds of innovation stimulated by environmental policy, is essential in the process of creating ’green economies’ that can deliver growing incomes while preserving natural systems and social equity.

Environmental tax reform (ETR) appears to offer an attractive mix for policymakers. It deters environmentally damaging activities by making them more costly, while incentivising the creation and diffusion of new technologies. For advanced economies like the EU, eco-innovation can also create opportunities to export new tools and processes globally.

While increasing the costs of polluting and using resources is likely, by itself, to subdue economic output, governments can use the tax revenues accrued to reduce the fiscal burden elsewhere. (1) The project ’Resource productivity, environmental tax reform and sustainable growth in Europe’ (petre) was commissioned by the Anglo-German Foundation (AGF) in 2007.

It used econometric and resource flow modelling techniques, surveys, and interviews to explore the implications — for Europe and the rest of the world — of a large-scale ETR in Europe designed to achieve the EU’s 2020 greenhouse gas reduction targets. For more information see www.petre.org.uk or Ekins and Speck (2011).

Cutting labour taxes, for example, can help boost work incentives — potentially increasing employment and offsetting negative economic impacts. Moreover, as the recent petre project (1) has demonstrated, governments can potentially enhance net benefits further by reinvesting some of the revenues secured through ETR in eco-innovation.

In view of the potential gains, there is clear value for policymakers and society more broadly in expanding the knowledge base on ETR and innovation. The present report aims to do just that, using two approaches: a literature review and a scenario-based modelling exercise. Together the two analyses confirm the important interplay between environmental taxes, innovation and macroeconomic performance — and the potential role of ETR in shifting to a green economy in Europe.

The key findings are set out below. Key findings of the literature review The literature review identified four relevant groups of studies: assessments of environmental regulation’s impacts on innovation; theoretical analyses of how different policy instruments influence innovation; empirical studies using statistical and econometric techniques to assess the impacts of ’actual’ policy interventions; and case studies providing descriptive assessments of actual experiences.

In broad terms, the studies confirmed that environmental regulation in general, and price‑based policy instruments (such as environmental taxes and investment subsidies) in particular, can and do increase innovation and diffusion of environmental technologies. The studies of environmental regulation’s impacts on innovation suggest that greater regulatory stringency is associated with increased innovation, although the effect appears small.

The empirical studies and case studies reviewed provided more comprehensive evidence. The empirical studies, covering technology areas such as energy efficiency, renewable energy, and air and water pollution abatement, revealed that environmental taxes and energy prices have a significant positive impact on both innovation and diffusion of existing technologies. However, the effects of taxes or prices may vary somewhat across sectors and innovation types. The case studies likewise indicate that environmental taxes and investment subsidies have generally, although not universally, had a significant positive impact on innovation and diffusion.

The literature also provides valuable insights on the impact of environmental taxes compared to other instruments and the conditions that can enhance or limit an ETR’s impacts on innovation. For example, case studies focusing on the Netherlands and Germany highlighted the need for a tax rate that is sufficiently high to provide a meaningful incentive and signalling effect, and that is fixed for a sufficiently long period of time to reduce uncertainty about the future benefits of investment.

The theoretical studies reviewed indicate that the relative impacts of environmental taxes and other instruments on eco-innovation are far from clear cut. They often depend on the competitive structures of the markets and the ability of innovator firms to appropriate the benefits accruing to other firms during diffusion.

Other factors also play a role, however. For example, market failures such as information asymmetries, principle-agent problems, capital market failures and positive adoption spillovers can all influence technology diffusion. Similarly, uncertainty over future returns and the (associated) use of high discount rates for investment decisions can also undermine the effectiveness of price-based instruments in stimulating diffusion.

Taken together, the literature underscores the potential for environmental taxes to catalyse innovation. At the same time, it also highlights the complexity of the issues and the difficulties in making generalisations about the impacts of environmental taxes and alternative policy instruments.

The precise effects of environmental taxes and other measures on innovation are very specific to local realities and very much influenced by the stringency and point of incidence of the policy intervention. With this in mind, some authors stress that any analysis of policy impacts on innovation must be very nuanced, reflecting factors such as the direction, type and duration of innovation.

Assessments of policy effectiveness require indicators that can convey an accurate and detailed picture of innovation in all its forms. Key findings of the scenario analysis The modelling exercise builds on the findings of the petre project, using the GINFORS model to assess economic and environmental impacts of using the EU Emissions Trading System (ETS) and ETR to reach the EU’s 2020 GHG targets.

It evaluates the overall effects of a European ETR compared to a projected baseline and develops scenarios in which eco-innovation or renewable energy technologies are supported. The analysis employed three scenarios from the petre project. Together these illuminate the macroeconomic impacts of implementing an ETR designed to meet the EU’s 2020 GHG target with revenues recycled through reductions in income tax rates and social security contributions, and through investment of 10 % of revenues in eco-innovation measures.

In addition, the present study used two addition scenarios, both based on the assumption that 10 % of revenues are invested in eco-innovation. The first examines the macroeconomic impacts in EU Member States arising from increased exports of renewable energy technologies, which is a plausible scenario based on the strong EU policy effort to increase the share of renewable energy in final energy consumption and the possibility of very strong world market development in the sector until 2020.

The second analyses the macroeconomic effects of changes in the input structure of the energy sector, i.e. from conventional electricity production to renewables. Overall, the analysis revealed that the modelled reforms delivered positive employment effects and only small negative impacts on GDP in the EU-27 Member States.

The economic impacts depend on the levels of international energy prices used in the scenarios, the mechanism used to recycle revenues, and country specifics such as carbon and energy intensity and the structure of energy consumption.

At the EU level, the basic ETR scenario — assuming that revenues are only recycled via reduced income tax and social security contributions — results in EU GDP 0.57 % below the baseline in 2020. The additional assumptions in each of the alternative scenarios (investing 10 % of revenues in eco-innovation, increased exports of renewable technologies, and changes in energy sector inputs) each soften this negative impact on GDP. Whereas all the scenarios indicate a small negative impact on EU GDP relative to the baseline, the impact on employment is positive in all scenarios.

The scenario design implies that the structure of the EU economy shifts from energy-intensive to labour-intensive sectors. The magnitude of the employment gain is influenced by the carbon price and the tax shift, the underlying energy prices and the production loss. The largest part of the employment increase stems from the additional investment in eco-innovation, although a shift in industry structures and additional renewable technology exports are also positive for the labour market.

As ETR is directly aimed at reducing labour costs, it will create additional jobs in the short and medium term. In the longer term, the cost reduction and new technologies arising from eco-innovation will play a larger role.

The results indicate that environmental tax reform can deliver environmental objectives, create additional jobs and trigger eco-innovation, while having negligible negative impacts on GDP.

These findings are particularly evident in the scenario assuming that 10 % of revenues are invested in eco-innovation and EU exports of renewable technologies increase. In that case, EU GDP is just 0.04 % below the baseline in 2020 and employment is 0.51 % (or more than 1 million jobs) higher. Like all fiscal reforms, a major ETR in Europe will create winners and losers. At the sector level, carbon- and material-intensive industries will face economic losses.

At the country level, the carbon‑intensity and overall flexibility of economies is important. Clearly, structural change away from carbon-intensive industries, together with technological change, is inherent in any successful climate mitigation policy. However, international cooperation and the revenues gathered through ETR and the EU ETS can help soften negative economic and social impacts. Caution is needed in relating the findings of this study to the EU policy debate. In the model simulations, the single carbon price is the only instrument used to reach the EU’s 2020 GHG targets. In reality, of course, other renewable energy and efficiency policies will also contribute to carbon reduction and have to be taken into account when comparing the results (especially the high carbon prices) to other studies. Both reduce the potential revenues from fossil energy carriers and carbon emissions. A variety of renewable energy and efficiency policies could enable the climate and energy targets to be met while securing even better economic prospects. The results of the present study clearly indicate that the discussion on market-based instruments should be intensified. Ultimately, however, the EU will need a rich mix of policies to reach its GHG targets while maximising prosperity.


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