Tax and the Environment

Author: Richard Denniss is a Senior Research Fellow at The Australia Institute. This paper was presented at the 2003 AFS Conference: Investing in Ourselves: Fair and Effective Taxation for an Enterprising Australia.



There are few greater stimuli to human ingenuity than the prospect of avoiding fiscal liability. Experience shows that under this stimulus human ingenuity outreaches Parliamentary prescience. - Lord Justice Diplock


Why do Government's need our money? They don't. They just use it to provide the services we want or need. Taxation and government spending are used to divert the necessary amount of resources away from private consumption expenditure and towards the delivery of government services. In doing so, they can also implement the redistribution policies the public collectively desires.

But taxation is not the only mechanism available to the Government to divert resources. Consider, for example, the issue of conscription. Conscripts are required to provide labour services to the Government on behalf of the population. Does that mean that conscription is a tax? If so, what would an increase in conscription do to the budget, to interest rates, to the competitiveness of business?

It wouldn't do anything that a reduction in the labour force participation rate wouldn't do.

Before moving on to talk about environmental taxes, I would like to give you one more thing to think about. The Government could build giant pyramids in every town and city without spending a cent from the budget, without increasing interest rates, and without reducing Australia's 'competitiveness'.

Imagine this. The Australian Government requires all adults to provide 100 hours per year of their labour. All individuals aged over 15 are required to present at their local pyramid building centre where they will, having provided an hours work, be presented with a certificate to that effect. At the end of the year, all citizens are required to present 100 hours worth of certificates to the pyramid building authority or face sanction.

Certificates do not provide any information other than the number of labour hours provided. They are therefore tradeable. Individuals who are unwilling or unable to perform their community service can therefore offer to pay people who value their time less highly to obtain certificates on their behalf.

If 10 million people participated in the scheme, providing 100 hours of labour each per year the amount of labour supplied, at no cost to the budget, would be equal to 1 billion hours, the equivalent of more than 480,000 full time jobs.

The purpose of this example is to highlight that taxes are not a 'cost' to the economy, they are a form of redistribution. While the focus of individuals is on the money that is redistributed through taxes, it must be remembered that the primary objective of taxation is the redistribution of economic resources.

The purpose of tax is to substitute the consumption of education for the consumption of new DVD players. Taxation is the means by which the government diverts resources from one desire towards the provision of another. The existence of government expenditure without the existence of taxation would therefore be inflationary, as it would represent an attempt by society to allocate 100 per cent of its income to personal consumption while still expecting public services to be provided.

Taxes as price signals

Taxes also have the capacity to change the relative price of products. Economists place much faith in the capacity of changes in relative prices to influence consumer behaviour, and in turn, much policy advocacy from the environment movement has centred on tax reform in recent years.

Carbon taxes, petrol taxes, water charges, congestion pricing, and mass-distance charging for heavy vehicles have all been promoted as mechanisms to ensure that economic growth does not come at the expense of the environment.

However, the pursuit of optimal taxes to solve environmental problems may be a dead end for those seeking improved environmental outcomes. My concern is that those who have invested heavily in the debate about marginal social costs, valuation techniques for assessing environmental damage, and the pursuit of 'optimal' outcomes through the implementation of Pigouvian taxes have been misled about the reality of the policy formulation process. That is, my concern is that too much intellectual and political effort is being invested into a process that was designed to achieve the counter-objectives of the environmentalists in question.

Economic rationalism, broadly defined as the construction of policy based primarily on the policy recommendations of neoclassical economics, can be seen as either a philosophical guide to policy formulation or as a rhetorical justification for the implementation of a raft of policies based on a separate underlying political platform.

Proponents of environmental tax reform often appear frustrated that the 'economic rationalists' are unwilling to take seriously the serious economic issues of externalities or other market failures. Why are the rationalists so unable to see that economic efficiency would be improved, from the rationalist own perspective, if carbon taxes were introduced or farmers were asked to pay the full economic cost for the water they use?

My view is that this frustration is a direct result of listening to what the rationalists say they want rather than watching what the 'rationalists' actually do. Before going on to discuss what the rationalists do, I need to distinguish between two different groups of economic rationalists, the puppets and the puppet masters.

The puppets often believe that neo-classical economics has all the answers. They extend and refine the methodological approach and perform the public role of explaining the economic rationale behind policy decisions. They provide the 'intellectual rigour' upon which the politicians can publicly base their preferred policy outcomes.

Some functionaries are no doubt aware of the limitations of their approach. Their silence either represents a desire to achieve personal advancement or an awareness, and acceptance, of the broader political objective.

The puppet masters, on the other hand, are indifferent about the intellectual or practical merits of economic rationalism. They are fully aware, however, of the rhetorical and political advantages of linking their policy reforms to an 'objective' science rather than fight for ideological supremacy.

Evidence of the puppet masters lack of attachment to the underlying philosophical underpinnings of economic rationalism is widely available.

1) Inconsistent statements about the role of Government in industry policy. On the one hand the Government repeatedly says it will not 'pick winners' while it proceeds to provide billions of dollars in Government assistance to private health insurance, agriculture, pharmaceuticals, and the car industry (Baragwanath and Howe 2000).

2) The growing acceptance within the Government that 'national champions', rather than fierce competitors, are the best way to achieve economic growth in stark contrast to the underlying principles of National Competition Policy.

3) The refusal to use economic instruments to solve environmental problems ranging from greenhouse gas emissions to plastic bag use. When it comes to the environment 'voluntary' schemes are seen as more appropriate.

4) The halving capital gains tax. The whole economic case for the GST was based on reducing distortions in the taxation system.

Politics or economics?

Environmental tax reform is a political not an economic problem. The economics of environmental protection are breathtakingly simple. When negative externalities exist, the market price will be lower than the socially efficient price. The imposition of a Pigouvian tax equal to the size of the externality will bring the market outcome into line with the economically efficient outcome.

The methodological difficulty is not determining whether a tax should be implemented, but in determining the size of the tax that should be implemented. Every day that the tax remains set at zero is an additional day further away from the efficient outcome than necessary occurs.

Rather than spend years considering complex questions about the value of a human life and how to incorporate the risk adjusted cost of a reduction in species diversity into the analysis, efficient policy would implement a 'small' tax with a built in escalator. The debate about the size of the tax should be conducted while the tax is moving closer towards its optimal value.

The advantages of such an approach are numerous:

1) By implementing a tax at a low rate the initial disruption, to both firms and to the price level is minimised.

2) It allows the market to react gradually to changing economic conditions, providing firms with a longer timeline over which to make decisions about whether to make new investments or not.

3) It creates an incentive for firms to participate meaningfully in the debate about the size of environmental costs. The longer the process of determining the optimal tax takes, the higher the tax will be.

4) It shifts the onus of proof. Individuals or groups adversely affected by economic activity would no longer be required to determine the extent of the damage themselves. Only the existence of damage would need to be identified to initiate a tax escalator.

The existence of such advantages, however, should not be confused with the likelihood of the adoption of such an approach. On the issue of environmental policy reform there is one thing that the government and most researchers can agree on, the need for further research.

The academic interest in environmental policy design centres on the estimation, by increasingly complex means, of increasingly sophisticated measures of marginal social cost or the refinement of the precision of the likely economic impact of changes in policy. For those seeking to maintain the status quo, such research is essential, as it continues to provide a justification for the failure to act in the short term. It is only in the future, when (if) the refinement ceases that those opposed to environmental tax reform will be forced to actually say so. In the mean time, the search for perfect information comes at the cost of inaction.