Would the replacement of income tax with an energy tax be socially justifiable?
It has now become clear that the greenhouse gas emissions resulting from energy use are inflicting costly damage upon the global environment (Stern 2006). Taxation of energy provides a possible means of internalising this cost, reducing energy demand and the resulting environmental burden. Ideally, this tax would be based on carbon emissions rather than on energy per se, encouraging a long-term shift towards lower-carbon energy sources (RCEP 2000), although the short-term economic impacts are likely to be similar in either case (Symons et al 2000). The analysis below draws upon both the energy-tax and the carbon-tax literature, focusing on the present situation in the UK but incorporating evidence from other developed countries.
It has been widely speculated that if the revenue from an energy tax were used to finance the reduction of taxes that currently distort the economy, the change would enhance welfare by means other than simply protecting the environment, an idea known as the 'double dividend hypothesis'. In particular, the use of energy tax revenues to reduce income tax would be expected to improve labour market efficiency, thereby boosting employment. Goulder (1995) distinguished a 'strong' form of the double dividend hypothesis, which asserts that such a tax change would be worthwhile regardless of environmental considerations, and a 'weak' form, which asserts merely that the use of environmental tax revenues to reduce income tax is beneficial when compared with a scenario in which revenues from the tax are recycled in a lump sum fashion.
Many studies have investigated the extent to which the double dividend would actually be realised in different scenarios, and thus the extent to which replacement of income tax with energy taxation might enhance social welfare. Their conclusions are summarised below.
The first dividend: environmental benefits
The most obvious social argument for an energy tax is to ensure that consumers of energy bear the full cost of their actions. The idea of using taxation to correct for an externality such as pollution dates back to Pigou (1932), who proposed that taxes on socially-damaging activities should be set at a level which reflects their marginal social cost. Based on Stern's (2006) estimate that the social cost of CO2 emissions is $85 (approximately £52) per tonne, a 'Pigovian' tax on energy in the UK would have been expected to raise £28.4 billion in 2007, the most recent year for which precise data are available (Jackson et al 2009). The actual revenue in that year from what the British government defines as energy-related 'environmental taxes', primarily fuel duty, totalled £28.2 billion (ONS 2009), a remarkably similar figure. Although this analysis can be criticised on the grounds that estimates of emissions costs are highly uncertain (Tol 2005) and do not take into account other negative externalities such as sulphur dioxide emissions (e.g. Ekins 1996), and that present taxes do not effectively target the most carbon-intensive energy sources (Newbery 2005), it suggests that overall energy taxation in the UK is already at approximately the right level to correct for the negative externality arising from greenhouse gas emissions. Whilst somewhat higher energy taxes might be advocated on precautionary grounds, the cost of £1,096 per ton of CO2 that would be implied if UK income taxes were replaced in their entirety by a tax aimed at reducing greenhouse gas emissions (HMRC 2009) is almost certainly far too large.
Evidence from countries that have implemented carbon/energy taxes suggests that they do reduce energy consumption to some extent (Bosquet 2000). However, in many areas of energy use, such as motoring in the UK (Leicester 2005), price elasticity of demand is low and the decrease in consumption achieved is therefore very small. In these cases the main effect of the tax is not to prevent energy users from damaging the environment but to compensate the rest of society for the damage that they cause.
The second dividend: broader economic benefit
It is generally accepted that income taxes increase unemployment by distorting the market for labour (e.g. Koskela & Schöb 1999). A shift from income tax to energy taxation would therefore be expected to improve welfare by increasing employment. Numerous models have sought to test this hypothesis, and whilst many have supported it, others have highlighted circumstances in which the expected benefit does not materialise. Some, beginning with Bovenberg & De Mooij (1994), have suggested that replacing income tax with an energy tax would actually decrease employment, since the rise in the cost of goods resulting from the energy tax would reduce real wages and thus the incentive to work.
A survey by Bosquet (2000) of different models found that 73% predict a gain in employment if labour taxes are replaced with environmental ones (of which energy tax is a typical example), but that this gain relies on labour markets being flexible enough to allow a fall in real wages. If wages rise in line with prices, an energy tax will simply translate into inflation.
To ascertain the effect of tax changes on welfare, we need to consider their impact not only on employment but also on overall economic activity. Just over half of the models surveyed by Bosquet (2000) predict that environmental tax reform would reduce GDP, although in the majority of cases the change is not large in either direction (less than ±0.5%). Babiker et al (2003) modelled the economic effect in various developed countries, including the UK, of different environmental tax reforms aimed at achieving Kyoto Protocol targets on greenhouse gas emissions. In all cases, the tax reforms reduce GNP, but the effect is slightly less severe when the revenues from the environmental tax are used to reduce income taxes compared with lump sum recycling (Figure 1). In other words, a weak double dividend exists but a strong double dividend does not.
Figure 1: Predicted economic effect of a carbon tax in the UK, and in an average OECD country, with different methods of revenue recycling (based on Babiker et al 2003).
In country with an open economy such as the UK, it might be expected that the taxation of energy (a mobile factor) rather than labour would reduce national welfare by driving investment abroad. However, Koskela et al (2001) argue that replacement of income tax with energy tax can enhance national welfare, by encouraging the replacement of energy with labour as a factor of production. Since labour, unlike energy, is priced above its opportunity cost, benefit is obtained from this substitution.
Another concern about energy taxation is that it would be regressive, hitting poorer members of society disproportionately hard, with negative consequences for social welfare. As Figure 2 illustrates, replacing current UK income taxes with a tax levied in proportion to energy expenditure (assuming no shift in consumption) would increase almost tenfold the share paid by households in the poorest decile, while substantially reducing the tax burden of the rich. Furthermore, whilst rich households may be able to decrease their exposure to the energy tax by substituting away from high energy consumption (for example, by investing in home insulation), poorer households typically have fewer such options (Johnstone & Alavalapati 1998). Symons et al (1994) estimate that a simple carbon tax sufficient to reduce UK emissions by 20% would increase the Gini coefficient (a measure of inequality) from 0.386 to 0.397, although they do not consider a scenario in which the revenues are used to reduce income tax. Their model demonstrates that it is possible to design an energy tax that is not regressive if part of the revenue is used to increase benefits for the poorest households, but this diminishes the tax's effectiveness as an environmental measure.
Figure 2: The distribution of income tax and energy expenditure among UK households, by income group, 2007 (Barnard 2009, ONS 2009).
Even an energy tax that was progressive in its overall effect on income distribution might have a negative impact on particular householders who currently live in 'fuel poverty' (needing to spend 10% or more of their income to obtain adequate heating) due to factors such as poor insulation. However, this downside could be avoided if the tax change were accompanied by vigorous measures to encourage improvements in household energy efficiency (Ekins & Dresner 2004).
It should be noted that reducing income tax is not the only way in which the revenues from an energy tax might beneficially be recycled. Babiker et al (2003) also model the effect of using the revenue to reduce non-energy consumption taxes (such as VAT) and conclude that in some countries, including the UK, this would yield a greater double dividend than income tax reduction (Figure 1).
Conclusions
In theory, replacing income taxes with energy taxes could offer a double benefit to society, internalising the environmental costs associated with energy use whilst boosting employment by reducing the distortion in the labour market created by income taxes. The first benefit is uncontroversial, although there is uncertainty about the environmental costs of energy use and thus the appropriate level of tax. The second benefit may occur, but is likely to be small and should not be taken for granted, depending critically upon conditions such as flexibility in the labour market.
When broader economic factors such as employment are taken into account, the optimal level of energy taxation may differ from that required simply to internalise environmental costs. However, wholesale replacement of income taxes with an energy tax in the UK would almost certainly set the level far too high, creating rather than correcting an economic distortion. Higher energy taxation would also have a severely negative impact upon the welfare of poorer households unless it was combined with carefully-targeted measures to alleviate fuel poverty.
Social welfare has many components, and tax changes may improve one aspect of it, such as employment, while worsening another, such as equality. Bosquet (2000) makes the useful suggestion that the impact of environmental taxes could be evaluated using measures such as the Index of Sustainable Economic Welfare (ISEW) or the Genuine Progress Indicator (GPI), which not only draw together a variety of economic and social indicators but also take environmental degradation into account, combining the effects of the first and second dividends into a single statistic. However, these measures are notoriously difficult to calculate reliably (Lawn 2003). The table below summarises the positive (+) and negative (-) components of the GPI that would be most obviously affected by a shift from income tax to energy taxation, illustrating the mixed effect that the tax change would have on overall welfare:
| Component of GPI | Effect of tax shift on this indicator | Effect on welfare |
|---|---|---|
| + Personal consumption | Reduced, if overall GDP can be taken as an indication of personal consumption levels (see above). | Harmful |
| + Capital investment | Uncertain, with lower investment in energy-intensive industries but higher investment in energy substitutes. The majority of models predict that the net effect on investment would be negative (Bosquet 2000). | Likely to be harmful |
| - Inequality | Likely to be increased, due to the regressive nature of the tax change (see above). | Probably harmful |
| - Unemployment and underemployment | Likely to be slightly reduced, provided that conditions are right (see above). | Likely to be beneficial |
| - Negative effects of transport use (commuting time, vehicle accidents, noise pollution) | Reduced, to the extent that the energy tax increased the financial cost of transportation and thus reduced demand for it. | Beneficial |
| - Resource depletion | Reduced, to the extent that the energy tax decreased consumption of non-renewable fuels. | Beneficial |
| - Air pollution and long-term environmental damage | Reduced, to the extent that the energy tax decreased energy use and thus lowered emissions of greenhouse gases and other pollutants. | Beneficial |
The desire for social equality is central to any debate over taxation. However, in the choice between income tax and energy tax, there is a conflict between inter-generational equality, which requires that energy use be taxed at a level commensurate with the environmental degradation that it causes, and equality within present-day society, which energy taxation would tend to worsen. How to balance these two considerations is ultimately a moral question, to which economic analysis alone cannot provide an answer.
References
Barnard, A., 2009. The effects of taxes and benefits on household income, 2007/08. Economic and Labour Market Review 3(8):56-66.
Babiker, M. H., Metcalf, G.E. & Reilly, J. 2003. Tax distortions and global climate policy. Journal of Environmental Economics and Management 46 pp. 269-287.
Bosquet, B., 2000. Environmental tax reform: does it work? A survey of the empirical evidence. Ecological Economics 34, pp. 19-32.
Bovenberg, A. L. & De Mooij, R. A., 1994. Environmental Levies and Distortionary Taxation. The American Economic Review 84(4), pp. 1085-1089.
Ekins, P., 1996. How large a carbon tax is justified by the secondary benefits of CO2 abatement? Resource and Energy Economics 18(2), pp. 161-187.
Ekins, P. & Dresner, S., 2004. Green taxes and charges: Reducing their impact on low-income households. Joseph Rowntree Foundation.
Goulder, L. H., 1995. Environmental Taxation and the 'Double Dividend': A Reader's Guide. International Tax and Public Finance 2, pp. 157-183.
HMRC 2009. Table 1.2: HM Revenue and Customs annual receipts.
IPCC [Intergovernmental Panel on Climate Change], 2007. Climate change 2007: synthesis report.
Jackson, J., Choudrie, S., Thistlethwaite, G., Passant, N., Murrells, T., Watterson, J., Mobbs, D., Cardenas, L., Thomson, A., Leech, A., 2009. UK Greenhouse Gas Inventory 1990 to 2007: Annual Report for submission under the Framework Convention on Climate Change.
Johnstone, N. & Alavalapati, J., 1998. The Distributional Effects of Environmental Tax Reform. Discussion Paper 24140, International Institute for Environment and Development, Environmental Economics Programme.
Koskela, E. & Schöb, R., 1999. Alleviating unemployment: The case for green tax reforms. European Economic Review 43, pp. 1723-1746.
Koskela, E., Schöb, R., & Sinn, H-W., 2001. Green tax reform and competitiveness. German Economic Review 2, pp. 19-30.
Lawn, P. A., 2003. A theoretical foundation to support the Index of Sustainable Economic Welfare (ISEW), Genuine Progress Indicator (GPI), and other related indexes. Ecological Economics 44, pp. 105-118.
Leicester, A., 2005. Fuel Taxation. Briefing note 55, Institute of Fiscal Studies, London.
Newbery, D., 2005. Why tax energy? Towards a more rational policy. The Energy Journal 26(3), pp. 1-39.
ONS, 2008. Family Spending: A report on the 2007 Expenditure and Food Survey. Office for National Statistics, UK.
ONS, 2009. Government revenues from environmental taxes, 1993 to 2008. Office for National Statistics, UK.
Pigou, A. C., 1932. The economics of welfare. MacMillan, London.
RCEP, 2000. Energy - the changing climate. Royal Commission on Environmental Pollution, UK.
Stern, N., 2006, Review on the Economics of Climate Change, H.M. Treasury, UK.
Symons, E., Proops, J. & Gay, P., 1994. Carbon Taxes, Consumer Demand and Carbon Dioxide Emissions: A Simulation Analysis for the UK. Fiscal Studies 15(2), pp. 19-43.
Symons, E. J., Speck, S., & Proops, L. R., 2000. The Effects of Pollution and Energy Taxes across the European Income Distribution. Keele Department of Economics Discussion Papers 2000/05.
Tol, R., 2005. The marginal damage costs of carbon dioxide emissions: an assessment of the uncertainties. Energy Policy 33(16):2064-2074.
This was originally written as an essay for MSc Ecological Economics at the University of Edinburgh