Environmental Tax Reform: Experience in Europe and Implications for East Asia

As noted in the introduction, the European Environment Agency has defined 
ETR as ‘a reform of the national tax system where there is a shift of the burden 
of taxes from conventional taxes such as labour to environmentally damaging 
activities, such as resource use or pollution’ (EEA 2005, p. 84). ETR is therefore 
a particular kind of policy instrument, which seeks to apply revenue-raising economic instruments (which may be taxes or auctioned permits in an emissions 
trading scheme) to resource use and pollution, in order to increase the efficiency 
of resource use (resource productivity) and improve the environment, and reduce 
other taxes such that the policy is revenue neutral overall. ETR in this interpretation is therefore a tax shift, rather than a tax increase, whereby taxation is shifted 
from ‘goods’ such as labour (e.g. income taxes, social security contributions) or 
capital (e.g. corporation taxes) to ‘bads’ (pollution, resource depletion). As will 
be seen, ETR was implemented on a relatively small scale in a number of North 
European countries in the 1990s and early 2000s, with broadly positive results.
 ETR is hypothesised to increase human well-being through the economic and 
environmental pathways illustrated in Figure 6.1.
 This suggests that environmentally ETR will reduce pollution and resource 
use; economically it will increase output and employment directly, and stimulate 
green innovation that will do so further indirectly, as well as bringing about 
further environmental improvement. In themselves, both these economic and 
environmental impacts will increase human well-being; but the economic impact 
will be decoupled from environmental damage, so it is more likely to have a 
positive net impact on human well-being than much current economic growth.
 There are good theoretical reasons for supposing that ETR will have the 
effects shown in Figure 6.1. These have been briefly reviewed in the Introduction to this book, as well as being extensively covered in the environmental economics literature (see Ekins and Barker 2001 for a survey). Very briefly, because 
many environmental impacts are not priced, they do not enter into market decisions and they are therefore greater, and have a greater negative impact onhuman welfare, than is desirable. Environmental taxes give a price (explicitly or 
implicitly), or a cost, to these impacts, therefore encouraging their reduction, 
which increases human welfare. This is the rationale for supposing that ETR will 
lead to increased human welfare from environmental benefits.
 The environmental taxes also raise revenues which, for a given level of total 
tax revenue, allow other taxes to be reduced. Taxes on labour and profits are 
known to have disincentive effects and cause economic output to be lower than 
it would otherwise be. Reducing such taxes can therefore, other things being 
equal, increase output. However, increasing energy taxes, other things being 
equal, is likely to reduce output. The balance of these two effects (and a key 
strand of the academic literature explores how different kinds of taxes interact) 
will determine whether the tax shift will reduce or increase output overall.
 A further effect on output may come from the impact of the tax shift on 
employment. If employers’ labour taxes have been reduced as part of the tax 
shift (and this has often been the case where such shifts have been implemented), 
this may increase employers’ labour demand. If there is unemployment in the 
economy, this may lead to more people being employed who were formerly 
unemployed. This would result in an increase in output.
 Finally, the shift in the relative prices of carbon/energy and labour or profits 
will result in a shift in the relative benefits of labour-saving carbon/energysaving technical change. Because carbon/energy is made relatively more 
expensive, more technological and innovation effort is likely to be directed to 
using less of it, thereby raising its productivity. If this process reveals opportunities for carbon/energy saving that were cost effective even before the 
carbon/energy tax increase, or have become so (and there is substantial evidence of the existence of such opportunities, even in well run and profitable 
firms), or if it channels innovation into directions that enable other resource 
savings and product improvements, then the tax shift could also lead to 
increases in output and employment through this route (the middle pathway in 
Figure 6.1.