A tree growing out of a stack of coins in front of a blurred yellow and green background.
Too many governments are living paycheck-to-paycheck, borrowing unsustainably, and desperately needing to shore up their finances. Inflation and interest rates are spiking, bringing the global economy to the brink of recession. Amid all of this, decarbonization efforts may look terribly expensive.
Our research suggests the opposite is true. If they’re smart about it, countries can combine decarbonization efforts and improve fiscal space relatively cheaply.
The conventional wisdom is that higher taxes hurt growth—not a desirable outcome at a time when recession looms. But that effect can be overcome simply by shifting the tax burden in a revenue-neutral way from personal income to carbon emissions. Specifically, a government that lowers personal income taxes by the equivalent of 1 percent of gross domestic product (GDP) while simultaneously raising energy taxes by the same amount can actually boost GDP growth. The evidence from 75 countries from 1994 through 2018 underscores the effectiveness of this “green tax switch.”
Of course, a revenue-neutral approach does little in the short run to balance government budgets. COVID-19 depleted the fiscal buffers of most developing economies—and those buffers must be restored if countries are to tackle new economic challenges now coming into view.
Here again, the evidence favors energy taxes over other taxes. Using the same data mentioned earlier, we find that raising energy taxes is significantly less costly (in terms of the hit to GDP) than increasing personal income taxes by the same amount.
These results hold for rich and poor countries and for countries in different geographic regions.
In both scenarios carbon-intensive economies that levied energy taxes saw less of a hit to their output than the average (baseline) economy. That’s because carbon-intensive economies tend to use old equipment even when newer and lower-carbon technology is available. Imposing even a small cost on the use of older equipment—through a fuel or carbon tax, for example—would create incentives for companies to switch to low-carbon alternatives.
Moreover, economies that either haven’t started the process of decarbonization—or are just getting started—can make these substitutions more easily. That’s because there are relatively more clean technologies available that have not yet been used locally.
There’s a good reason why energy taxes have a smaller effect on GDP than income taxes. Income taxes directly reduce the purchasing power of households. When households see their take-home pay shrink, they cut spending. That directly affects GDP. There’s also a knock-on effect: As consumers reduce their spending, firms will take notice of reduced demand for their goods and services. Those firms will, in turn, reduce their investments, adding more downward pressure on GDP.
By contrast, energy taxes do not directly affect the purchasing power of households. Instead, they increase the cost of some goods (like fuel-driven cars) and production inputs (like fossil fuels). In doing so, they shift the incentives: Firms and households can lower their costs, by switching to low-carbon alternatives. For example, they might opt to use public transit or buy a more energy-efficient car. Such choices do not exist when overall pay is reduced.
Several countries have successfully implemented the green tax switch.
Sweden pulled it off in 1991, amid its worst economic crisis since World War II. As with all tax policy, the details are nuanced, but in summary, Sweden levied a carbon tax while reducing personal income and corporate taxes. Over the next three decades, emissions fell and GDP rose, as the Tax Foundation, a think tank, explains in this report that details the Swedish switch.
Join the Conversation