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1. INTRODUCTION

Environmental policy in the 1970s and 1980s was almost wholly driven by systems of regulation of emissions and environmental quality, of processes and technologies. However, also during the 1980s the interest of policy-makers in environmental taxes and other market-based instruments of environmental policy (for example, tradable permits or deposit refunds) was kindled by a number of factors:

• Increased awareness of the power and potential of markets and a new orientation towards markets in public policy.
• Increased recognition of the limitations of government in general, and of traditional systems of environmental regulation in particular.
• Increased concern that such systems were not adequately coping with environmental problems but were imposing substantial economic costs, leading to a new interest in other instruments that might offer more cost effective environmental policy.
• Desire to make further progress with the implementation of the ‘polluter pays’ principle, to internalise environmental costs into the prices of the relevant products and activities, and increased desire (as part of a more cost effective approach) to integrate environmental policy into other policy areas.

In short, it became increasingly recognised that traditional regulatory environmental policy, despite some successes, was not managing to prevent further unacceptable environmental damage, and it was feared that the costs of attempting to make it do so would be great. Economists had long said that in many areas environmental goals could be achieved more cost effectively through appropriate taxes and charges. In the new market-oriented atmosphere of the 1980s, with its associated consciousness of cost and the need for competitiveness, policy-makers began to take them seriously.

2. RATIONALE FOR ENVIRONMENTAL TAXES

Environmental taxes (or, to be precise, environmentally related taxes) have come to be defined by the OECD, the International Energy Agency and the European Commission as: “Any compulsory, unrequited payment to general government levied on tax-bases deemed to be of particular environmental relevance”, where the tax bases “include energy products, motor vehicles, waste, measured or estimated emissions, natural resources etc.” (OECD 2006, p.26).

The basic rationale for the use of taxes and charges in environmental policy is provided by the existence of environmental externalities: impacts on the environment (and perhaps thence on people), which are side-effects of processes of production and consumption, and which do not enter into the calculations of those responsible for the processes. Where the effects are negative, externalities are costs. By levying a tax or charge on the activity giving rise to the effect, the external cost can be partially or wholly internalised. There is increasing evidence that environmental externalities, in terms of their effects on human health, buildings and ecosystems, are now very substantial. Stern (2007, p.xviii) called anthropogenic climate change as a result of greenhouse gas emissions “the greatest market failure the world has ever seen”, and estimated that, without mitigation action, it could result in the loss of 5-20% of global GDP (ibid., p.xv). Taxes on emissions or activities leading to environmental externalities are intended to internalise such externalities.

The essential elements of environmental taxes are that:

• They incorporate the costs of environmental damage into the prices of the goods, services or activities which give rise to them. Thereby they create incentives for producers and consumers to shift away from environmentally damaging behaviour, so reducing the damage. Evaluations suggest that these incentives change behaviour and improve the environment¹.
• Because each producer faces the same incentive, they act to equalise the marginal cost of environmental improvement across the tax base, thereby achieving the improvement at least cost to society as a whole².
• The incentive for environmental improvement is maintained at all levels of the taxed effect, unlike with conventional environmental regulation, when the improvement incentive ceases to operate once the regulatory standard has been reached.
• For producers they may act as a spur to innovation, as they seek to develop new products and processes to reduce their tax liability. With innovation the key to competitiveness, this stimulus to such an ‘ecological modernisation’ may yield economic as well as environmental benefits.
• They raise revenues which can be used for a variety of purposes, some of which improve the environment or give further incentives to do so. Alternatively the revenues may be used to reduce other taxes or to correct undesirable distributional effects.

Environmental taxes (and other market-based instruments such as emissions trading) depend fundamentally on the efficient working of the market system for their success. This efficiency has many requirements and implications. First, the legal and institutional structure needs to ensure that contracts are available, freely entered into by the relevant parties and enforceable under clear and widely accepted laws and rules. Thus countries beset by bribery and corruption may not be able to use taxation because the taxes will be evaded or become an excuse for further corruption.

Second, market prices should reflect costs to some degree, so that an environmental tax will increase the price of environmentally intensive production. Third, buyers and sellers should be well informed as to the costs and availability of alternatives, such that future outcomes (even if not known) should at least be considered. In some cases, especially among some socially disadvantaged groups such as the elderly, there may be an unwillingness to consider alternatives, so extra taxation may of itself (and before possible compensation measures are taken into account) have very inequitable effects.

Some of these issues are explored in later sections. First, however, it is worth setting out the basic neo-classical theory of environmental taxation.

3. THEORETICAL BASIS FOR ENVIRONMENTAL TAXES

The theoretical basis for environmental taxes is well developed. Thus it is generally agreed among economists that, in a situation where the production or consumption of some good results in a negative external effect (i.e. one that is not reflected in the price of the good in question), then social welfare can be improved by imposing a tax on the good. Moreover, there is general agreement that ideally environmental taxes should be levied directly on the emission or resource use that is causing external environmental costs. Thus, if it is carbon emissions from energy use that are the cause of concern, a carbon tax is to be preferred to an energy tax, which does not distinguish between the different carbon intensities of different fuels.

The neo-classical, optimization approach to environmental taxation recommends that the level of the environmental tax should be set so that it reflects the cost of the environmental externality it is seeking to address. This approach was conceived by Pigou (1932) and formalized by Baumol (1972) (one of many formalizations). It seeks to calculate a damage function for different rates of emission of the pollutant, and then to equate the marginal net private benefit (MNPB) of the activity causing the pollution (P) with the marginal external cost (MEC) to which it gives rise. The equality is achieved by imposing a tax equal to the difference between them at the optimal emission level. Figure 3.1 sets out this basic theoretical position, in which Q is the no tax pollution level, and Q* is the optimal pollution level. The optimal tax is then t*. The theory of environmental taxation has been much developed to take into account market situations other than perfect competition and other considerations (see, for example, Baumol & Oates 1988), but this is outside the scope of this paper.

While Baumol proved the theoretical validity of the Pigouvian optimising approach to environmental taxation, in practice this is often not possible because of the difficulty of valuing complex environmental effects. Baumol himself despaired of the prospects of making it operational, both because of the difficulty of calculating the marginal damage function and because the presence of multiple local maxima seemed to rule out an iterative approach to the optimal position, concluding: “All in all we are left with little confidence in the applicability of the Pigouvian approach … We do not how to calculate the required taxes and subsidies and we do not know how to approximate them by trial and error.” (Baumol 1972, p.318).

It was to address such considerations that Baumol & Oates (1971) proposed an alternative approach to implementing environmental taxes, which has come to be called the standard pricing approach after their article. The approach involves choosing environmental standards on the basis of their desired effects on, for example, human health, or on quality of life more generally, and then using environmental taxes on an iterative basis to bring levels of environmental damage down to the standards. Baumol & Oates showed that such environmental taxation had the property that it would achieve the desired environmental improvement at minimum cost to society at large. This has now become the principal approach to and justification of environmental taxes. For example, all the carbon taxes that have been implemented to date have been put in place in order to contribute to defined programmes of carbon dioxide (CO2) emission reduction, rather than on the basis of any optimality calculations.