Australia's Future Tax System

Consultation Paper

Section 13: Tax-transfer impacts on the environment

Overview

Australia faces significant environmental challenges in the 21st century, ranging from global issues, such as climate change, to local issues, such as water scarcity, land degradation and species loss. Economic development must be undertaken in an environmentally sustainable way, while also recognising that the environment itself has value.

Taxes may provide one means of improving environmental amenity. The tax-transfer system can also detract from environmental outcomes through the incentives it creates. Such incentives need to be carefully evaluated against other policy objectives.

Consultation questions

Q13.1 Bearing in mind that tax is one of several possible instruments that can address environmental externalities, what opportunities exist to use specific environmental taxes to address Australia's environmental challenges?

Q13.2 Noting that many submissions raise concerns over unintended environmental consequences of taxes and transfers, such as the fringe benefits tax concession for cars, are there features of the tax-transfer system which encourage poor environmental outcomes and how might such outcomes be addressed?

Q13.3 Given the environmental challenges confronting Australian society, are there opportunities to shape tax-transfer policies which do not currently affect the environment in ways which could deliver better environmental outcomes?

Climate change is perhaps the most significant environmental risk to the future wellbeing of Australians. Left unaddressed, growth in worldwide carbon emissions is expected to have a severe and costly impact on agriculture, infrastructure, biodiversity and ecosystems in Australia (Garnaut 2008).

Climate change may also compound Australia's other environmental problems. While most environmental damage has resulted from agricultural development and the exploitation of native forests, most future damage is expected to occur around urban areas and water resources. Evidence suggests Australia's waterways are continuing to decline. In 2000, even before the current drought, about a quarter of Australia's surface water management areas were classed as highly used or overused, which may be contributing to the continued increase in the rate of threatened mammals and birds (ABS 2006b).

On the positive side, the amenity of some parts of the environment may not be declining as fast as in the past while other parts of the environment may actually be improving. For example, land clearing rates appear to be slowing and Australia's air remains relatively clean despite increases in motor vehicle usage (ABS 2006b). Indeed, technological developments may allow some forms of environmental degradation to be reversed, such as by directly pricing road congestion and noise (see Section 12).

This section discusses the impact of the tax-transfer system on the environment and the potential role of taxation in managing environmental issues. Approaches to improving natural resource management are covered in Section 14.

13.1 Using the tax-transfer system to manage environmental issues

The scale of many environmental problems could be reduced if the costs of environmental damage caused by production and consumption of goods were incorporated into prices. Although such costs are often difficult to quantify, one potential solution is to impose a tax on the damaging activity to give people a price signal about the costs they are imposing on the environment.

The Australian tax-transfer system employs a number of environmental taxes. Some are intended to target specific environmental impacts (for example, the Aircraft Noise Levy), while others have impacts on the environment but primarily serve other purposes (for example, fuel excise discourages the consumption of taxed fuels but its primary purpose is to raise revenue).

The concept of an 'environmental tax' is imprecise. The OECD (1993) notes that the term may encompass:

  • indirect taxes introduced with a specific environmental objective (for example, taxes on plastic bags in Italy and on fertilizers in Sweden);
  • indirect taxes which have been introduced for non-environmental reasons, but for which environmental considerations are now taken into account in setting the level or structure of the tax (for example, taxes on energy in general or the balance between 'lump-sum' and 'use-related' taxes on motor vehicles);
  • changes to the direct tax system introduced for environmental reasons (for example, favouring or discouraging certain activities such as farming, forestry, particular industrial processes or nuclear power); and
  • charges, fees or levies used to provide direct control over certain environmentally damaging activities (for example, aircraft noise and waterway pollution).

There are other ways of categorising environmental taxes (for example, European Environment Agency 2000), but in general environmental taxes either impose a cost on some products or activities that are environmentally damaging, or give a benefit to some products or activities that are environmentally beneficial.

Corrective taxation is most efficient when the activity generating the external cost is taxed directly, for example, actual pollution emissions. However, this is not always administratively feasible. Accurate and cost effective monitoring may not be possible with existing technology. In such cases a key input (for example, a particular fuel) or output (for example, a particular manufactured product) associated with the activity may be a more practical means of imposing the corrective tax.

Some environmental strategies do not rely only on corrective taxes. For example, the Australian Government's product stewardship oil levy is an excise on motor oil and lubricants which raised $23 million in 2006-07. Its objective is to help fund an expenditure program, worth $32 million in 2006-07, which subsidises used oil recycling. This policy reflects a concern over the manner of disposal of used oil, rather than the production and consumption of oil itself. The environmental objective of the program could be achieved even in the absence of the associated levy.

In some cases tax policy can contribute to the management of environmental issues by changing the incentives faced by individuals, firms and other economic factors. However, in other cases non-tax policy responses may be more effective.

For example, the Carbon Pollution Reduction Scheme will set a limit on the nation's emissions of greenhouse gases by issuing a limited number of tradeable emission permits with effect from 2010. Similarly, reform of water entitlements and an improved balance between domestic, commercial and environmental water use is likely to see significant improvements to water management.

In some areas, land management issues may be better addressed through regulatory duty of care arrangements, allowing greater local involvement in land management than would be possible under a tax approach.

The choice of policy to manage a particular environmental issue will depend on the science of the issue, the incentives faced by the people involved and the information and technology available to government (see Box 13.1).

Summary of key messages from submissions

An important theme in submissions from environmental groups is that, given its central importance to economic decision making, the tax-transfer system needs to be consistent with achieving environmentally sustainable economic growth.

Some suggest that, in addition to a Carbon Pollution Reduction Scheme, tax concessions should be implemented to further reduce the carbon emissions of the Australian economy, by encouraging non-polluting transport modes, renewable energy generation and energy efficiency investments.

The potential costs of environmental protection are also a focus of attention, with a number of submissions arguing taxes relating to the Carbon Pollution Reduction Scheme should be designed to minimise the costs imposed on business.

Submissions also propose a range of tax concessions should be provided for activities and investments that address local environmental problems such as land remediation investments, water use efficiency and native species conservation. These could include incentives to promote the pursuit of conservation activities on private land, particularly farmland.

A large number of submissions indicate that state vehicle transfer and annual registration taxes should be concessional for more fuel-efficient vehicles.

Common arguments in favour of environmental taxes

The 'double dividend hypothesis' suggests that in addition to the reduction in environmental damage, environmental taxes provide a second dividend. The first dividend is that the environmental tax reduces environmental damage to a more sustainable level. The second dividend is that the environmental tax generates revenue which can be used to reduce the already existing distortions in the remainder of the tax system.

Bovenberg and Goulder (2002) note that the second dividend will generally depend on the environmental tax being more efficient than the tax its revenue is used to reduce. They also note that environmental taxes are often levied on narrow bases and hence the second dividend does not usually arise.

Consultation question

Q13.1 Bearing in mind that tax is one of several possible instruments that can address environmental externalities, what opportunities exist to use specific environmental taxes to address Australia's environmental challenges?

Box 13.1: Assessing whether environmental taxes are an appropriate policy option

Economic tools, such as taxes, may reduce the costs of achieving a given level of environmental protection. However, not all environmental problems are best addressed in this way. Regulation may be preferable in some cases (Fullerton et al 2008).

Economic tools include the use of taxes and property rights such as permits. Determining clear property rights to develop markets may be particularly effective where environmental problems are at least partly due to unclear or common property rights. For example, reform of water entitlements is likely to see significant structural improvements to water management as trade in permanent entitlements in the southern Murray Darling Basin increases (Peterson et al 2004).

In theory, with perfect information, the Government could design a tax or a pollution permit trading scheme for which the economic and environmental effects would be the same. However, in practice, it may be more appropriate to control the price (by using a tax) or the quantity (by using a trading scheme). For example, a trading scheme may be preferred where the costs to the environment increase steeply or are uncertain.

Australia's international climate change obligations are specified in terms of quantity of carbon dioxide equivalent emissions. The Government's proposed Carbon Pollution Reduction Scheme will set caps on emissions in line with these quantitative targets. However, the Carbon Pollution Reduction Scheme will also contain a price cap to limit extreme upside price risks (Australian Government 2008b).

Economic tools do not prohibit an environmentally damaging activity. They seek only to limit the level of damage to the point where the social cost of additional environmental damage exceeds the social value of the goods and services being produced, including by innovating and investing in alternative technologies through time.

Government spending can also address environmental problems, especially where potential polluters have more information than governments. For example, spending to protect endangered species may sometimes be more effective than a corrective tax or regulatory penalty since the spending strategy gives people an incentive to 'come forward' with information about their actions. An example of such a strategy is the Environmental Stewardship Program, which allows landholders to bid for Australian Government funding to undertake endangered species conservation.

By contrast, under a 'command and control' regulatory approach, government not only identifies environmental targets but also specifies how these targets are to be achieved and, usually, by whom. For example, in order to control sulphur dioxide levels in populated areas, regulations may require specific power stations to install emission scrubbing devices. Such regulations raise prices for consumers in a non-transparent way and lead to a risk that polluters may develop influence over regulators.

Still, in some cases, command and control approaches may be more successful than economic tools, particularly where certain forms of pollution have significant social costs (such as the banning of leaded petrol). Where pollution damage varies depending on the location of the pollution, uniform pollution taxes may be relatively inefficient.

13.2 Environmental impacts of the current tax-transfer system

Since the tax-transfer system impacts on the everyday decisions of individuals and businesses, certain policies may create incentives that impact adversely on environmental outcomes. Reforms to such policies have the potential to improve both environmental outcomes and the efficiency of the tax-transfer system.

For example, most state governments provide energy concessions (such as electricity and gas) and vehicle registration discounts for pensioners, seniors and low income earners. While the objective of these policies is to assist these people in meeting the cost of essential services, lowering the relative prices of these goods inevitably increases their consumption, which increases greenhouse gas emissions. Providing direct financial assistance would help recipients to pay their energy bills without increasing their consumption of energy relative to other goods and services.

Summary of key messages from submissions

A large number of submissions collectively propose a range of tax concessions to encourage taxpayers to undertake environmentally beneficial activities, such as improving energy efficiency and rehabilitating degraded agricultural land.

Around a third of submissions expressing concern about the environment discuss the fringe benefits tax arrangements for motor vehicles. Most oppose a tax system that encourages people to drive more and contribute to noise and air pollution, greenhouse gas emissions and urban traffic congestion. While one submission suggests that the current fringe benefits tax arrangements do not encourage people to drive more to achieve tax savings, others provide anecdotal evidence to the contrary. Many submissions indicate they would like a tax system which offers some support to sustainable urban transport modes such as cycling, walking or using public transport, while recognising people outside urban areas have limited alternatives to private car travel.

Many submissions also propose that tax expenditures be reviewed to identify those with environmental consequences, and reformed to eliminate any negative impacts. For example, the fuel tax credits scheme, which refunds fuel excise used for business purposes, is seen by many as providing an incentive to generate carbon emissions.

Notwithstanding the proposed introduction of the Carbon Pollution Reduction Scheme, some submissions have argued that this alone will not be enough to achieve deep cuts in Australia's carbon emissions, and have proposed additional tax incentives such as accelerated depreciation for investments which reduce carbon emissions as an adjunct.

Submissions identify characteristics of the income tax system that discourage land owners from undertaking expenditure that would improve or protect ecological assets, unless there is a connection with a profit making enterprise.

The tax-transfer system affects every industry, region and demographic group in Australia and influences the allocation of resources in the economy, so there is a potentially wide range of tax-transfer settings that affect environmental outcomes. The Panel will commission research on the impact that the tax-transfer system has on the environment.

One example cited in submissions is the treatment of car fringe benefits (Box 13.3).

Box 13.3: Fringe benefits tax (FBT) treatment of car benefits

The statutory formula method for valuing car fringe benefits applies a declining taxable value the further the car is driven in a year. The original purpose of this policy was to apply tax to the private use of the vehicle, not its use for work purposes, and distance travelled was used as a proxy for the proportion of business travel. The value of the car for FBT purposes is its cost multiplied by a 'statutory fraction' which depends on how far the car is driven in the relevant tax year. The statutory fraction, and hence the taxable value of the car benefit, reduces as the number of kilometres driven increases (Table 13.1).

Table 13.1: Distance thresholds for the FBT statutory fraction

Number of kilometres driven Statutory fraction
< 15,000 0.26
15,000 to 24,999 0.20
25,000 to 40,000 0.11
> 40,000 0.07

This valuation formula has two main impacts on incentives. It reduces the overall cost of car ownership and provides employees with an incentive to drive additional kilometres to reduce the amount of FBT payable. These incentives indirectly encourage increased greenhouse gas emissions, pollution and congestion through increased car use.

The Australian Treasury estimates the tax expenditure associated with this concession to be $1.6 billion (Australian Treasury 2007).

There are also some elements of the current system designed to provide tax advantages to environmentally beneficial activities. For example, some states charge lower registration fees or transfer stamp duties for smaller-engine or hybrid vehicles.

There may be other opportunities to use the tax-transfer system to promote better environmental outcomes, although Box 13.1 cautions that tax-transfer approaches will not always be the most efficient way of pursuing environmental objectives.

Consultation questions

Q13.2 Noting that many submissions raise concerns over unintended environmental consequences of taxes and transfers, such as the fringe benefits tax concession for cars, are there features of the tax-transfer system which encourage poor environmental outcomes and how might such outcomes be addressed?

Q13.3 Given the environmental challenges confronting Australian society, are there opportunities to shape tax-transfer policies which do not currently affect the environment in ways which could deliver better environmental outcomes?