Rethinking Energy Taxation and Subsidies in the LAC region: Achieving More than One Goal

Energy is critical for development on a livable planet. In most countries of the world, energy is taxed differently than other goods or services. Latin America and the Caribbean (LAC) is no exception in this regard. 

Historically, the most important reason to tax energy is domestic resource mobilization, which is crucial for countries to lay the foundations for job creation by investing in key areas such as infrastructure, health and education. Fuels are easy to tax (even in countries with high informality), as their supply chain can be monitored closely, and their price elasticity is comparatively low, which tends to lower taxation inefficiency. However, other energy policy goals –such as fuel independence, improving energy access for poor households, or promoting certain industries– often conflict with the revenue motivation, and have led countries to subsidize some fuels, making them artificially cheap.

More recently, the use of direct carbon tax instruments (levied on the CO2 content of each fuel) has increased. Direct carbon taxes are a way to internalize the costs of climate change and reduce greenhouse gas emissions. These conflicting forces have resulted in a complex system with various tax instruments and subsidies that differ significantly across fuels and sectors within each country.  

The question is: are these taxes and subsidies contributing to LAC countries’ needs, both fiscal and energy-related? A useful way to think about this is to focus on final energy prices, analyzing the tax burden (net of subsidies) paid by final users of each fuel and then compare it with the counterfactual that would apply if energy was taxed as any other good in the economy.

To compare across fuels, the net tax burden must be expressed in a common unit. This is the only way we can answer questions like: is a 10-cent tax per liter on gasoline higher or lower than a 10 dollar per Megawatt-hour on natural gas? When the net tax burden is normalized using the CO2 content of each fuel, the result is the Total Carbon Price (TCP). Intuitively, the TCP measures how much the fiscal system increases (or reduces, if negative) the price of each fuel’s CO2 emissions. Fuel TCPs can be averaged to obtain a country-level TCP estimate, as well as broken down by sector to reflect specific sector policies. 

Our recent report Taxing and Subsidizing Energy in LAC: Insights from a Total Carbon Price Approach provides a detailed bottom-up analysis of energy taxes and subsidies to estimate comparable TCPs for 11 LAC countries from 2017 to 2024. On average, the country-level Total Carbon Prices in LAC are positive at around 25US$/tCO2 in 2023, with substantial heterogeneity across countries. When looking across fuels, LAC countries tend to tax gasoline emissions the most, while diesel emissions are comparatively “cheaper”. Natural gas and liquified petroleum gas (LPG) are frequently subsidized in the region, so that their net tax burden is often negative. 

A main insight from the report is that aligning fuel taxation with the cost of CO2 emissions is a sound fiscal policy. First, spending large amounts on poorly targeted fuel subsidies is a waste of public resources. These are not justified from a social standpoint, since there are better policy options to protect vulnerable households, nor for industrial reasons, since it fosters an excessive dependence on artificially cheap fuels, which is not sustainable and inefficient. Second, an alignment policy could raise domestic revenue by gradually increasing the tax burden on those fuels that are currently taxed below what would be warranted by the cost of their emissions, contributing to domestic resource mobilization.  

The report estimates that raising the TCP for all fuels to U$60 per ton of CO2 (a commonly used international benchmark) would result in additional fiscal space of 0.5% to 1% of GDP on average in 2030, depending on the starting point of each country. There is nothing magical in the U$60 reference, and the choice of an appropriate target will depend on both global and domestic factors. For countries in LAC facing pressure for fiscal consolidation and/or with very low government revenue ratios, raising TCP may allow them to improve their fiscal balances and increase investment in key areas. While these tax increases would be contractionary if revenues were not recycled, their multipliers may be better than for other tax instruments.  

Aligning fuel taxes with emissions also makes sense from a productivity, technological, and energy perspective. The energy sector is undergoing drastic changes as low-carbon technologies become more competitive. Renewable electricity generation is already cheaper than other options in many LAC countries, and electric buses can serve LAC urban centers with potentially lower lifetime costs than diesel alternatives. Where fuel subsidies (and other regulations) are hindering the adoption of these technologies, there are potential productivity gains from removing them. 

Reforms on energy taxes and subsidies often face political backlash. To minimize this risk and achieve maximum impact, governments should pursue tax reform as part of broader roadmaps for transforming energy systems for growth. For instance, by removing barriers for competitive renewable electricity where it can result in lower electricity prices or recycling revenue from increased diesel taxation into modernizing transport fleets to improve logistic costs. Also, the use of compensatory policies as part of these reform roadmaps can help offset the distributional impacts of energy tax reforms on households.