Can fiscal instruments turn a crisis into opportunity?

This blog was originally published on Green Fiscal Policy Network.

More than a year since the beginning of the COVID-19 pandemic, the global economy is recovering from a deep economic crisis that significantly shrank global GDP, disrupted global supply chains, and plunged 100 million people into extreme poverty worldwide.[1] A reduction in global carbon emissions in 2020, the one bright spot in the COVID crisis, has proved short-lived as projections by the International Energy Agency anticipate that carbon emissions will record the largest annual rise in 2021.

Many have argued that the COVID-19 crisis is an opportunity to “build back better,” emerging from the crisis on a stronger, more inclusive, and more sustainable growth path by expanding public health and social welfare systems and investing in green activities. The rationale for green public investment is clear: On one hand, public intervention is necessary as various market failures prevent the private sector from providing the optimum amount of green investment. On the other hand, when aggregate demand falls below the economy’s capacity to supply goods and services, appropriately designed green public investment can boost aggregate demand and create jobs while furthering environmental objectives. Batini et al. (2021) found that every dollar spent on a variety of green activities in both developed and developing countries — from zero-emission power plants to the protection of wildlife and ecosystems — generated more than a dollar’s worth of economic activity. The estimated multipliers associated with green spending were about two to seven times larger than those associated with non-eco-friendly expenditure, depending on sectors, technologies, and horizons.

Regrettably, the response to the COVID-19 has not been commensurate with the magnitude of the climate crisis. Many governments have used post-COVID recovery measures to roll back existing environmental regulations and to invest in fossil-fuel intensive infrastructure and energy. Only a tiny fraction of the massive fiscal stimulus packages — a total of $19.8 trillion, from March 2020 to May 2021[2] — has been aligned with the objectives of the Paris Agreement. Even the few countries with significant green spending have allocated an equivalent amount or more to brown investment, thus “neutralizing” the overall positive impact on emissions.

Is there still a possibility to turn this crisis into an opportunity by using fiscal policy instruments? Besides green investment, which fiscal instruments can engender a process of structural change leading to a more sustainable growth model? 

One often forgotten way for governments to build back better is to align policies of state-owned enterprises (SOEs) with national climate objectives. Globally, SOEs remain heavily vested in fossil fuels: They account for around two-fifths of coal powered capacity and over half of new projects in the pipeline for coal plants. And while SOEs are investing in renewables, they are also investing much more in coal plants. But there are encouraging examples: In Sweden, for example, SOEs are explicitly required to identify their impacts and goals to meet the national environmental and climate objectives under the Paris Agreement. Moreover, enterprises are required to act transparently regarding their handling of climate risks and opportunities by conducting an open and constructive dialogue with their most important stakeholders. Since 2010, China’s SOE oversight commission requires all central enterprises to formulate specific plans to determine internal responsibilities for energy conservation and emission reduction; it also directs enterprises to support the development of renewable energy, including by contributing to R&D, and to set their own targets for conservation and emission reduction.

Furthermore, governments have many instruments to ensure that private investment is greener and that fiscal incentives help private sectors to “build back better” after a crisis. First, they can provide supportive macroeconomic, institutional, and regulatory frameworks to make it attractive for private companies to invest in green solutions and technologies. Second, consolidating tax incentives in tax laws would enhance transparency and reduce potential overlaps across different sectors. Third, they can put green conditions on subsidies to industries affected by the crisis (e.g., aviation) and change some tax provisions in non-environmental taxes, e.g., allowing expenditures on green research and development programs and spending in clean energy to be deducted from corporate income taxes. Fourth, reducing fossil fuels subsidies and introducing or raising environmental taxation can change relative prices in favor of green investment and raise revenues. Recent research[3] suggests that on average environmental tax multipliers are around zero if the tax increase is implemented when output is expanding. Thus, environmental taxes are a better instrument to mobilize revenues than, for example, personal income taxes. Environmental tax reforms that shift the tax burden from labor to carbon emissions are likely to support both a job-intensive recovery and the environment.

Unlike most taxes, which reduce economic efficiency, taxes on goods and activities that produce negative externalities — such as pollution — increase economic efficiency. In light of the benefits of environmental taxation, it is striking that environmental taxes account for just more than 2 percent of GDP and 7 percent of total tax revenue among OECD countries.[4] Environmental taxes are therefore a priority measure for raising revenue and changing economic behavior.  Paradoxically, coal and gas are generally untaxed. In many countries coal is taxed at low or zero rates, despite its harmful climate and air pollution impacts. Given the global imperative to address climate change, there is a need both to broaden the base of existing energy taxes to cover all fossil fuel use and to rationalize energy tax rates to fully reflect those fuels’ environmental costs.

On the positive side, several innovations are improving the ability of governments to channel private incentives toward more sustainable activities. For example, policy makers can commit to raising environmental taxes in the future rather than during the recovery — thus influencing expectations for the future viability of green investment undertaken today. Pollution taxes (solid waste, wastewater, air pollution, hazardous chemicals, and noise) serve as quasi-regulatory instruments to help reduce environmental externalities from various activities and alter consumer behavior, while also raising revenues. Some relatively new taxes have had an extraordinary success and could be mainstreamed in other countries. For example, the plastic bag tax introduced in Ireland in 2002 succeeded in reducing discarded plastic bags from 5% of total litter pollution in 2001 to 0.13% in 2015 while raising a good share of revenues. The landfill tax introduced in the United Kingdom in 1996 to reduce GHG emissions and waste generation succeeded in reducing the amount of waste sent to landfill from 50 million tonnes in 2001 to 12 million tonnes in 2015.

Environmental “feebates” have worked successfully in many sectors and are now being piloted in forestry. Under a timber commodity feebate, timber would face an environmental tax based on the assumption that the timber production was not sustainable (i.e., involved clear-cutting or other unsustainable methods). If producers can show that the timber has been produced more sustainably, they are offered a tax rebate. This mechanism provides a direct fiscal incentive for forestry operators to adopt more sustainable production methods. Vehicle taxation has also advanced in its quest to influence behavior and to tackle both environmental (climate change, local air, and noise pollution, etc.) and social (congestion, road accidents, health impacts) externalities. For example, vehicle purchase or registration taxes (and even annual circulation taxes) can be differentiated according to vehicle fuel efficiency or emissions, thus giving consumers an immediate incentive to purchase a less polluting and/or more fuel-efficient vehicle. A new approach is to impose a proportional tax on CO2 emissions per mile, thus providing incentives to continually reduce CO2 even in vehicles that are already relatively fuel-efficient. A further approach, successfully used in France, is represented by a CO2 bonus-malus system, which rewards purchases of less polluting new vehicles with a subsidy (bonus), while more polluting vehicles are charged a higher vehicle tax (malus) for several years.

As many of these proposals affect production costs, incentives to work and invest in particular sectors, and economic behavior more broadly (that is indeed their intention), fiscal and growth trade-offs could appear. However, for the initiatives where this could be the case, policy actions can be calibrated to be neutral on fiscal revenues and coupled with reductions in distortionary taxes or other growth-reducing distortions. Political economy obstacles to introducing some of the measures discussed here can be more serious as they affect social groups differently. It is high time society discusses how to compensate losers and build consensus to bring about change toward sustainable development.