Hurdles on the Way to Ecological Tax Reform

The fundamental logic behind reforming tax on ecological principles is as simple as it is alluring: because polluters only pay for the direct costs of their actions and ignore the wider impact on society, more environmental damage is caused than desirable from a social point of view. Taxing emissions would reflect the full financial harm. Better still: actually reducing emissions would boost broader environmental goals. An “ecological steering tax” thus causes fewer economic costs than technical standards.

Leading via price

Switzerland’s planned referendum on “Energy rather than Sales Tax” (Energie- statt Mehrwertsteuer) reflects this thinking. The idea is that an ecological incentive tax could boost renewable energy and cut CO2 emissions exclusively through pricing power, avoiding outright prohibitions or rules. But achieving the right degree of “steering” requires the amount of any emissions tax to correspond to the external costs – for example, the impact on climate change of the CO2 released.

In practice, however, such costs are virtually impossible to calculate. Everyday political reality means the amount of levy tends instead to be measured in terms of broad financial targets: in the referendum’s case, the aim is for tax receipts equalling 3.5 per cent of gross domestic product, or around SFr 22bn – the same as today’s proceeds from Value Added Tax. But if the cost of the steering measures exceeds that of the external costs, their impact is excessive, with resultant harm to the economy.

That is evident in the second awkward feature of any ecological tax reform: how to embed it in the existing fiscal system. Keeping the total burden of taxes and incentives constant would require corresponding relief in other levies. Most sensible would be reducing other taxes deemed particularly harmful. But Value Added Tax – the levy targeted by the initiative – is not one of them.

True, VAT creates distortions and can hobble growth – for example via the so called “taxe occulte” on what should be tax free investment items. But that’s even more the case for other taxes, like those on company profits or personal incomes, where the effective double taxation of capital gains means all investments are affected.

What’s also important is the social acceptability of any new tax. Generally speaking, energy levies are regressive – meaning they tend to affect lower earners more than the better off. Broader consumption taxes like VAT are also regarded as regressive because higher earners are less affected, relatively speaking, owing to their greater ability to save. But the impact here tends to be temporary: sooner or later, those savings will also be used for consumption and taxed. So in that sense, VAT is broadly speaking a proportional levy.

Finally, any ambitious ecological tax reform must take due account of international factors. A comprehensive energy levy can’t be imposed without taxing “grey market” energy imports or reimbursing tax paid on energy sold abroad, otherwise the competitive disadvantage to companies in Switzerland would be too great.

Obviously, existing cross-border rules for VAT could be a model. But these apply to easily measurable values, like sales and tax prepayments. The “Border Tax Adjustment” contained in the proposed new energy tax has no such data set as its basis. The amount of “grey” energy in millions of products, for example, is neither accurately measured nor calculable via a product’s characteristics. Instead, any assessment must be modelled and based on differing forms of production. But which one in particular? That’s a complex and politically controversial task – and more bureaucratic than any cross border VAT system.

Market distortions

There are also major risks of distorting the market. Just look at the electricity generation. Achieving the political goal of boosting renewables and cutting CO2 emissions requires an ecological steering tax that’s able to differentiate between different sources of electricity and CO2 emissions. Practically speaking, however, that’s a massive challenge, because electricity – not least because of the rising proportion of (inevitably seesawing) renewable – is increasingly traded over anonymous and closely intertwined international spot markets. To make life easier, an average rate of CO2 emissions could be assumed for imported power and taxed accordingly. But such a mechanism would invariably raise wholesale electricity prices in Switzerland. That would allow all Switzerland’s current and future power stations a windfall profit while at the same time distorting production decisions.

On the one hand, the (tax-increased) domestic wholesale price would incentivise production if peaks in foreign renewable output briefly pushed prices down to zero. On the other hand, it would be benefit investors in Swiss generating capacity to plan production and spending to maximise the need for imports, as only then would the steering tax boost the domestic wholesale tariff and thereby maximise their prices and profits.

So the apparent advantages of ecological tax reform diminish on closer examination. Implementation is complex and could open the door to significant distortions of the free market and competition.

This artcile first appeared in the Neue Zürcher Zeitung on 13 February 2015.