Climate Change, Carbon Pricing and Energy Tax Expenditures

Climate Change, Carbon Pricing and Energy Tax Expenditures

By Dr. Agustin Redonda, Council on Economic Policies

Climate change is moving up policy agendas worldwide. Last year’s COP21 was yet another wake-up call that the international community needs to take urgent action to reduce greenhouse gas (GHG) emissions. Carbon pricing will be critical to reach the objectives defined during the Paris meeting, e.g. keeping global temperature increase “well below” 2 Degrees Celsius.

There exists a broad consensus about the high effectiveness and efficiency of putting a price on carbon compared to other environmental policy instruments. Strikingly though, as discussed by a recent OECD report, putting a price on carbon is still a highly neglected policy instrument worldwide. Indeed, carbon prices are often zero or very low (OECD, 2016). 

Low effective carbon prices in the context of energy taxation are the results of two factors. One is obvious: zero or low statutory rates on carbon and energy. The other one is more opaque, but significant: tax expenditures (TEs), i.e. government benefits granted through the tax code (such as exemptions, deductions, credits, rate reliefs or deferrals) that target a specific group of taxpayers as well as specific activities or regions.

The Controversial Case for Energy Tax Expenditures

Policymakers frequently seek to make the case for TEs on energy taxation based on the potential negative effects of energy taxes both on equity and competitiveness.

Nonetheless, when it comes to equity, evidence shows that a significant share of TEs on energy is captured by high-income households (Di Bella et al., 2015). This leakage considerably jeopardizes their primary goal (i.e. increase the affordability of energy for lower income households) and, at the same time, exacerbates inequality.

As for competitiveness, the argumentation is similar, but gets a bit trickier because of the higher mobility of capital and, hence, the role of tax competition between countries. Energy-intensive, trade-exposed (EITE) sectors may decide to relocate if they consider effective energy tax rates to be too burdensome (Metcalf, 2013). This, in turn, erodes the national tax bases, and significantly jeopardizes the reduction of global GHG emissions because of carbon emissions leaking to lower tax jurisdictions (Reinaud, 2008).

While concerns around carbon leakage are well founded, TEs to compensate EITE sectors or firms often benefit the least productive among them (Albrizio et al., 2014). Moreover, TEs for energy intensive sectors run counter to the “polluter pays principle”, and hence against the primary goal of the tax scheme, i.e. to cut GHG emissions.

Energy Taxation is Critical. Energy Tax Expenditures Weaken Its Impact

Energy taxation is a critical pillar to mitigate climate change. TEs on energy taxes weaken its impact. Even if their stated goals – e.g. energy access for the poor, international competitiveness, economic development – appear to be benign, TEs on energy taxes are often costly, poorly targeted, ineffective in reaching their objectives, and create several negative distributional and environmental externalities.

International coordination in the reduction of harmful TEs will be essential. Moreover, as suggested by a 2015 IMF working paper, “energy pricing reform is largely in countries’ own domestic interest and therefore is beneficial even in the absence of globally coordinated action.” (Coady et al., 2015).

Such reforms need to have energy TEs within scope. This does not imply that these schemes should never be used. But they should be better scrutinized in terms of their fiscal cost as well as their goal alignment, effectiveness and efficiency. They should also be made transparent to allow for an open debate and distinction between those privileges that we indeed want to grant through the tax system, and those that are not consistent with our policy goals – including the ones we committed to in Paris last year.


A longer version of this blog was published earlier in CEP’s blog