Australia's Future Tax System

Final Report: Detailed Analysis

Chapter E: Enhancing social and market outcomes

E2. Taxes to improve the environment

E2–1 Why and how should environmental taxes be improved?

The environment directly contributes to the wellbeing of current and future Australians. It provides services critical to good health such as clean air and water, as well as public amenity, recreation and aesthetic pleasure. The environment also improves wellbeing indirectly by providing resources — such as land, timber, minerals and energy — that are necessary to produce goods and services (for example, food), as well as the ecosystems necessary to absorb and assimilate waste. The environment is a key underpinning of market and non-market activity.

As with all scarce resources, trade-offs are required in allocating the environment to different uses. When markets work properly, such trade-offs tend to see resources flowing to their highest value use; that is, the use that generates the highest monetary and social value. For example, a piece of farming land will tend to be used for the farming activity that generates the best return. However, many environmental goods are subject to market (and other) failures that result in over-exploitation. For example, people may use more land than necessary for farming if there is no market value placed on the environmental amenity that nature provides to society. These problems can be significant in terms of reduced wellbeing for society because in many cases the damage to the environment may be irreversible — a characteristic of many of Australia's most pressing environmental challenges, such as climate change and loss of biodiversity.

The need to correct for environmental spillovers

In relation to the environment, the most common form of market failure involves spillovers (sometimes called 'externalities'). A spillover occurs when individual decision-makers fail to take into account the impact of their actions on other parties. An example of a negative spillover is where a river is polluted by inappropriate use of a fertiliser, causing harm to downstream users of the water. But spillovers can be positive too — a farmer who maintains native vegetation may deliver biodiversity benefits for the community, but will generally not be compensated for this service.

Often, these problems arise because many aspects of the environment have public good qualities — that is, they are both non-rival (able to be enjoyed simultaneously by any number of people) and non-excludable (individuals cannot be excluded from enjoying them). Because no-one owns them, these environmental qualities are not priced by the market, and are often used without regard to the costs that may be imposed on others as a consequence. Similarly, because they are not priced, people have no way of making financial returns from providing an environment that benefits the community. As a consequence, the environment is allocated inefficiently between its different uses, resulting in excessive environmental degradation.

Where market failures occur, selective government intervention may result in an improvement in overall welfare. The use of environmental taxes is one way to correct for spillovers, by providing transparent price signals to purchasers of goods and services that reflect the environmental cost as well as the private costs.

This Section deals with the case for using taxation to address the problem of environmental spillovers and managing environmental public goods. A number of other specific environmental issues are addressed in other Sections in this report. In particular, noise and air pollution are discussed in Section E3 (Road transport taxes), and improving the use of community resources through better pricing of many common-property environmental goods is discussed in Section E1 (User charging).

There is a range of options to address environmental spillovers

The use of an environmental tax is only one option for correcting an environmental market failure, and is one example of a 'market instrument'. Other market instruments include permit trading schemes, tax concessions and establishing private property rights (see Box E2–1).

Box E2–1: Government intervention options to address environmental issues

Box E2–1: Government intervention options to address environmental issues

Permit trading schemes like the proposed Carbon Pollution Reduction Scheme (see Box E2–6) involve capping the desired level of pollution at the outset, issuing pollution permits up to the amount of the cap and allowing the price of the permits to be set in the market. Economically, the difference between trading schemes and environmental taxes is that fixed-rate taxes impose a price on pollution and the market determines the quantity, while a trading scheme controls quantity, creating an implicit tax (the revenue the government receives from the sale of permits) and the market determines the price of the permit.

If the world were perfectly predictable, if the government auctioned all permits, and if the CPRS were not linked with overseas abatement efforts, the economic outcome of a permit scheme would be identical to a corrective tax.3 In reality, however, where uncertainty is pervasive, trading schemes can be preferable to a tax in cases where the costs imposed by pollution are very sensitive to the level of pollution — and hence where the costs of getting the level of abatement wrong are high (Weitzman 1974).

Tax concessions (often referred to as tax expenditures) are a type of subsidy that aim to make an environmentally beneficial action by the private sector more financially attractive than otherwise. An example of such policies is the Landcare tax concession. Since they need to be available to any taxpayer who meets specified criteria, the challenge for such subsidies is to encourage more of the beneficial activity, and not merely to deliver a financial gain to those who would have undertaken the activity anyway.

An alternative market instrument is to establish, or strengthen, private property rights over a common resource. For example, a common forest would quickly be cleared by hunting and logging if no person owned the forest and could prevent the public from taking the timber without their consent.

In addition to market instruments, options available to government include non-market instruments like regulation, which may mandate abatement levels or technology standards for emitting industries or products. An example of this is the fuel standards that mandate the qualities of petrol or diesel used in transport.

Another non-market instrument is the public program, which refers to government spending to achieve a policy objective, such as the installation of photovoltaic panels on government buildings to generate electricity.

There is no single instrument suitable for all environmental issues. The nature and scope of the market failure in question will be critical to determining the best policy approach. The appropriate instrument in any particular case is one that maximises the net benefit to society, taking into account the extent to which the instrument can adequately deal with the environmental spillover (and hence deliver a gross environmental benefit) balanced against the costs imposed in addressing the spillover plus the costs of implementation (including administration and monitoring). The decision on what instrument to use is particularly difficult given that the costs and benefits should, in principle, take into account impacts on the present and all future generations (see Box E2–2).

Box E2–2: Reducing environmental damage through market-based mechanisms

When an activity damages the environment and the damage is not reflected in the market price, a 'spillover' (or 'externality') has arisen. Governments have a range of options to deal with spillovers and to ensure that consumers and producers take account of the environmental damage caused by an activity.

Various studies in Australia and other countries have canvassed the range of policy options that may be pursued to achieve improved environmental outcomes. A broad summary of the policy approaches available to government in the context of CO2 emissions was included in the Report of the task group on emissions trading (Australian Government 2007).

That report grouped policy options into four broad categories:

  • information and education campaigns;
  • various forms of regulation or standards;
  • fiscal measures, including grants, subsidies and rebates; and
  • market-based instruments, including environmental taxes and tradable property rights.

While each policy approach may have some role to play, the report considered that market-based instruments were superior in achieving large-scale improvements in environmental outcomes at least cost to the economy.

The report noted that although information and education campaigns can play an important role in alerting businesses and households to abatement opportunities, such campaigns on their own will not drive large-scale emissions reductions.

The report considered that implementing non-market approaches through regulations or standards was potentially viable when technologies are relatively standard and their environmental consequences known. The phasing in of new lighting standards is an example of this approach. However, the report noted that where technologies and production techniques vary widely, regulation will be inefficient in achieving environmental outcomes and likely to impose significant costs on businesses and households.

Another drawback of a pure regulatory approach, also highlighted in Box E2–3, is that it normally involves the government specifying outcomes regardless of the costs imposed. This limits incentives to innovate or undertake more abatement than the mandated level.

ABARE modelling commissioned by the Task Group showed that regulatory approaches can cost the economy substantially more than emissions pricing for the same abatement target — up to twice the GDP cost. This is broadly consistent with other modelling undertaken in this area.

The report also considered the merits of subsidising abatement from government budgets. However, this requires the government to pick winners or target specific projects. It could also involve high administrative overheads for the government and for project proponents, and impose higher costs on society from higher levels of taxation. If used extensively, significant losses in economic and administrative efficiency could arise.

Market-based approaches allow the market to determine the lowest-cost means of abatement. Such approaches therefore provide the opportunity to deliver improved environmental outcomes at the lowest economic cost. They also provide strong ongoing incentives for investment in technology research, development and deployment, and in efforts to improve energy efficiency. The report also noted that economic outcomes have often exceeded expectations as a result of market-oriented policy changes, as firms take up opportunities and incentives to innovate and improve productivity.

The community should be compensated for environmental damage

Governments should consider the environment as a community (or public) good that needs to be managed for the benefit of current and future Australians.

As a general rule, approaches that implement the 'polluter-pays' principle (including taxes and emissions trading schemes) are preferable to others on both efficiency and equity grounds. Imposing the cost of environmental harm on those responsible provides them with an incentive to modify their behaviour and reduce the damage their actions cause. From an equity perspective, it is appropriate that those responsible for the harm are required to bear the cost, rather than those forced to live with the consequences.4 For example, Australia's rich biodiversity can be appreciated by all Australians, regardless of where they live. Those who benefit from activities that harm the Australian community's ability to benefit from this biodiversity should compensate the community.

That said, in situations where it is impractical to introduce a polluter-pays approach — for instance, in situations where it is difficult to identify the polluter, or where equity considerations are outweighed by the costs involved in making the polluter pay — a beneficiary-pays principle could be applied (see Box E2–3).

Box E2–3: What are the benefits and costs of 'polluter pays'?

The 'polluter-pays' principle holds that the party responsible for undertaking an activity that causes spillover environmental damage should pay for that damage. This reflects the view that the environment is a community asset and that any party damaging that asset should pay compensation to the community for that damage.

Charging for environmental damage has three advantages. First, it can encourage appropriate use of environmental resources, since environmental damage should arise only where the value of the output associated with the damage is greater than the value the community places on the environment that was damaged by the activity. Second, because the environment is a community resource, there is inherent justice in the community receiving revenue as compensation for use of the environment. Third, people wishing to use the environment for private purposes should bear any transaction costs (such as legal fees) associated with undertaking an activity that may damage the environment.

However, 'polluter pays' may sometimes be difficult or inappropriate to apply. Some forms of environmental damage may be so severe and irreversible that it would not be appropriate to allow them to proceed at any price. In these cases, marginal trade-offs between some environment services or assets and other goods may not be acceptable. For that reason, for example, lead in petrol is simply banned, rather than priced.

At other times, someone other than the polluter may need to pay if the polluter is difficult to identify or to catch, particularly if someone else can reduce the environmental costs more cheaply. In such circumstances the government could impose costs on those best able to ameliorate the pollution, even if they do not cause it. For example, business owners may be required to keep their street frontage free from litter, even if they did not drop the litter. However, business owners may be able to pass forward the cost of keeping their street frontage free from litter to their customers.

Finally, it can sometimes be difficult to determine the 'just' allocation of rights to pollute between two parties. For example, when people build a house on cheap land near an existing airport, should they then be entitled to compensation for the aircraft noise? Compensation should not set up incentives for strategic behaviour that jeopardises good environmental outcomes. Clearly defined and enduring property rights help to overcome such problems.

If the community desires spending to repair environmental damage from past (lawful) pollution, it should not raise the tax rate on future emitters of that pollution simply to generate enough revenue for the task. If set this way, the tax rate will exceed the optimal rate (that which equalises marginal social cost and marginal abatement cost) for future emissions. The clean-up should be funded from efficient general revenue taxes (that is, funded by the beneficiaries).

Imposing an environmental tax

An environmental tax can be imposed on an environmentally damaging activity, thereby raising the cost of that activity to reflect the cost to society of lost environmental benefits.

The purpose of such a tax is to correct the market failure and reduce environmentally harmful actions to a level that yields the greatest benefit to society. While revenue will be raised through such taxes, this is a by-product, not the main policy purpose.

The imposition of the tax provides an incentive for polluters to use non-polluting inputs or processes rather than polluting ones, to the extent that doing so costs less than paying the tax. In addition, it encourages consumers to reduce demand for higher-priced products associated with pollution towards lower-priced, less environmentally damaging alternatives. Box E2–4 illustrates the theoretical underpinnings of an environmental tax.

Box E2–4: The operation of an environmental tax

Assume that a production process results in the emission of pollution as a by-product. This pollution could be reduced in a number of ways, including by adopting less polluting processes or equipment therefore reducing pollution per unit of production, by producing fewer units of production, or by putting in place mechanisms to capture the pollution.

The cost of avoiding each unit of pollution is called the marginal abatement cost. In the chart below, it is drawn as a line with downward slope, reflecting that the cost of reducing pollution increases as each unit of pollutant is abated. The cost increases because the cheaper abatement options are always taken before the expensive ones. Where the polluter pays nothing for polluting, quantity Q of the pollutant is produced (as the polluter chooses not to incur any abatement costs).

At Q, the environmental damage imposes a high cost on society (shown as the marginal external cost) but the polluter is not required to take this into account. Policy-makers note that reducing pollution by a unit would benefit society greatly and yet cost the polluter only a little.

If policy-makers have perfect information about abatement costs and the external cost of pollution, a tax of T would be imposed on each unit emitted. The polluter then has an incentive to adopt abatement measures if they are cheaper than paying the tax (reducing pollution from Q to Q*). The consequent increase in social welfare is represented by the triangular area B. The revenue raised by the tax (a transfer of wealth, not a net gain) is represented by shaded area A.

Chart E2–1: An environmental tax to reduce pollution

Chart E2–1: An environmental tax to reduce pollution

It is worth noting that, with perfect information, an identical economic outcome could be achieved through the use of other market instruments, including a permit trading scheme, where the quantity of pollution is capped at Q*, resulting in a permit price of T.

Unlike environmental taxes, environmental charges do not seek to improve environmental outcomes by reducing spillovers. Instead they impose a charge on an activity in order to raise revenue sufficient to finance the cost of providing the environmental service.5 In circumstances where the revenue raised funds the collective treatment of an environmental problem associated with the activity, such charges are consistent with a user-pays principle, and may be efficient. For example, national park access fees apply to users and pay for the maintenance of the park environment.

In situations where the service in question is used, either directly or indirectly, by a significant proportion of the population, equity considerations may be outweighed by the benefit of funding the service from general revenue.

In other cases, taxes or charges may be imposed that neither reflect the cost of environmental harm associated with an activity nor provide a service to address it, but are intended to fund environmental programs. For example, the Product Stewardship Oil Levy of 5.449 cents per litre of lubricating oil sold is used to help fund the oil recycling industry. The levy does not change the behaviour of oil consumers once the oil is purchased (that is, once you have paid the tax there is no incentive not to dispose of the oil inappropriately), nor is the associated program a cost-effective means of addressing the issue of inappropriate oil disposal (see Box E2–10).

While these charges are typically levied on narrow bases, there may be some cases where the tax and the associated spending are aligned and well-targeted, so such mechanisms can be used to deliver a 'polluter-pays' outcome and provide incentives for better environmental outcomes (see Box E2–3).

Environmental taxes can efficiently reduce environmental harm …

The key strength of environmental taxes (and emissions trading schemes) relative to other instruments is that they have the potential, if appropriately designed and targeted, to achieve a given level of pollution at a lower abatement cost.

Compared to regulations, which impose requirements such as uniform standards or abatement targets, market instruments can deliver:

  • allocative efficiency gains — in situations where the costs of abatement varies between polluters, the use of a tax can minimise the cost of abatement by providing an economic incentive to reduce pollution in the least expensive way (see Box E2–5); and
  • dynamic efficiency gains — because an environmental tax applies to each unit of pollution produced, it provides an incentive for polluters continually to seek low-cost abatement options to reduce their tax burden. By comparison, regulatory approaches may achieve compliance with a technology standard, for instance, but will not necessarily encourage polluters to make further abatement efforts.

Box E2–5: Allocative efficiency gain from the use of market instruments relative to regulation requiring uniform abatement

Assume there are two polluting firms whose marginal abatement costs differ and are represented below as MACA and MACB. The total abatement required is represented by the quantity OAOB in Chart E2–2 below.

The total abatement could be achieved through the introduction of a tax set at P*, or alternatively through the introduction of a permit system that results in an identical permit price. Under both approaches, firms will abate up to the level where their individual cost of abatement is equal to the cost of the tax (which in the case of permits is equal to the cost of a permit). As a consequence, Firm A undertakes a greater share (OAX*) of the abatement effort due to its lower marginal abatement costs.

By comparison, if firms were required by regulation to undertake a uniform reduction in pollution, then both firms would undertake the same level of abatement (that is, OAX, OBX), incurring an additional cost represented by the area A.

Chart E2–2: Lower abatement cost using market instrument

Chart E2–2: Lower abatement cost using market instrument

Another advantage of environmental taxes compared to many other instruments is that they raise revenue. While this is not the purpose of the tax, it is valuable in that it can be used to reduce other taxes or be used to fund additional government spending. The use of environmental tax revenues is discussed below.

… but the scope for using environmental taxes is limited

The scope for applying environmental taxes is limited by two significant practical concerns.

The environmental harm caused by the pollutant needs to be relatively uniform

In order for an environmental tax to reduce environmental harm in a cost-effective manner, the damage from each unit of the activity should be constant so that a constant tax rate can reflect the cost of the damage. Greenhouse gas emissions are one example of a uniform impact, as each 'unit' of gas contributes equally to climate change, regardless of where it is emitted.6 However, such situations are uncommon on a national scale. For instance, the human health costs imposed by air pollution are likely to be significantly greater in cities than in less populated areas.

Where the spillover cost of a unit of pollution varies across the area of concern, a uniform tax will be unable to capture these differences. Some sources of pollution would be over-taxed and others would be under-taxed. In net, the use of an environmental tax in such situations could be welfare-reducing and other options (for example, regulation) should be considered.

… and the pollutant needs to be measurable

To apply an environmental tax effectively, the environmentally damaging activity needs to be measurable and verifiable by both the tax authorities and polluters.

For many environmental problems, it is very difficult to measure environmentally damaging activity, particularly where the spillover effect comes from a large number of sources (for example, run-off from hundreds of farms may pollute a river).

Due to difficulties in measurement, some environmental taxes are better applied to a related input or output as a proxy for the pollution, rather than to the pollution itself. Using a similar principle, the Carbon Pollution Reduction Scheme (CPRS) would apply to the carbon content of fuel, avoiding the need for costly monitoring of actual carbon emissions from motor vehicles. While taxing a proxy may be more practical and less costly to implement, it is also less precisely targeted and, unless the pollution is highly correlated with the proxy, the environmental benefit that can be achieved from such an approach may be limited. The carbon content of fossil fuel is reasonably well correlated with actual emissions when it is burned. Taxing the amount of fuel supplied is therefore a relatively accurate way of taxing the amount of emissions. However, if technology develops to allow motor vehicles to capture and store emissions directly, then alternative arrangements will be needed to ensure that the incentive to deploy those technologies is not lost.

Taxing the production or consumption of a good to reduce the cost of its inappropriate disposal (by reducing overall demand for it) has an impact on beneficial uses of the good as well as its environmentally harmful uses. This increases the economic cost of the tax. For example, taxing plastic bags to reduce littering may reduce litter, but it will also impose costs on the many people who use plastic bags and dispose of them appropriately.

Where a tax is levied on a product that typically causes environmental damage, the tax will reduce the damage, but forgoes the opportunity to improve environmental outcomes by developing alternative production methods that do not use the damaging input. For example, some rechargeable batteries contain cadmium, which is a toxic heavy metal and may cause water or soil pollution if it leaches out of landfill. Hypothetically, if a government imposed a tax on the purchase of any rechargeable battery, this would reduce consumption (and therefore, disposal) of rechargeable batteries. But such a tax would provide no incentive for rechargeable battery manufacturers to reduce the level of cadmium in their product, nor would it provide any incentive for consumers to buy non-cadmium or low-cadmium rechargeable batteries.

Such limitations make it difficult, but not impossible, to use taxation to help solve environmental problems.

Principles

Environmental taxes (or emissions trading schemes) should:

  • be used to address environmental objectives, rather than raise revenue;
  • have their revenue recycled to reduce the associated tax (and transfer) distortions, should governments wish to avoid increasing the aggregate burden of tax; and
  • be integrated with existing taxes and transfers.

An environmental tax is more likely to be appropriate in situations where:

  • environmental damage due to economic activity is relatively constant (so that a constant per-unit tax reflects the cost);
  • the factors causing the environmental damage are measurable/verifiable by both the tax authorities and the agent causing the damage, or there is an input or output proxy that is closely correlated with the damage being targeted;
  • the only cost-effective way the taxpayer can reduce their tax liability is to reduce the activity causing the damage (rather than, say, simply dumping waste illegally); and
  • other instruments (such as spending and regulation) have been considered and found to be more costly.

Decisions to introduce a tax should be guided by cost–benefit analysis

Decisions about whether to intervene to correct an environmental market failure — and about whether to use a tax or some other policy instrument if the decision is to intervene — should be based on the relative costs and benefits of the available alternatives.

While the costs involved in introducing an environmental tax can be estimated with some degree of accuracy, calculating the benefits is more challenging because of the non-market values involved. The fact that many environmental problems extend over long timeframes, and can involve issues of inter-generational equity and transfers, further complicates cost-benefit analysis. Of course, the fact that such assessments are difficult does not mean that taxes should not be used, particularly if the risks of significant costs from environmental damage are high.

Environmental taxes also impose costs

If environmental taxes are used, the rate of tax needs to be set so as to achieve the amount of pollution that produces the highest net benefit for society as a whole. Environmental taxes, while potentially able to address an environmental spillover in a more cost-effective manner than other interventions, still impose costs. Pollution has a value to those producing it, as well as to those who benefit from the products or services produced from a polluting process. It is the cost of forgone production and/or consumption that needs to be weighed against the overall social benefit from taxes that successfully improve environmental outcomes. For this reason, an environmental tax is not intended to eliminate pollution completely, but rather to 'rebalance' the use of environmental resources to the point where the additional costs of reducing pollution further would outweigh the additional benefits such a reduction would deliver.

Is there a 'double dividend' from introducing a tax?

Intuitively, an environmental tax appears to have two benefits. The first is the benefit from increasing the price of an activity that damages the environment. Society overall is better off because the increase in price would cause a lessening of activity and hence a reduction in environmental damage. Damage reduction (not revenue-raising) should be the only reason an environmental tax is introduced.

The second apparent benefit is the opportunity to use the revenue raised by the tax for other social purposes, such as reducing other distortionary taxes (for example, labour taxes that reduce the incentive to work). In particular, environmental taxes could potentially provide a 'double dividend' of less pollution and less incentive-distorting taxes if the revenue were used to reduce existing labour income or corporation taxes (for example, Pearce 1991).

In the absence of other market distortions, an environmental tax set at a rate equal to the marginal external cost of an environmentally damaging activity would discourage inappropriate use of the environment. To the extent that market production falls, society is better off since less production means an improved environment. Before the tax, resources were misapplied to conducting socially damaging activities. At the margin, the value of lost market production — for example, the workers no longer employed in a polluting industry and the lower wages in other industries — would equal the value of improved environmental amenity. The tax effectively values the environment, generating revenue that would otherwise be appropriated by those continuing to damage the environment. This revenue could then be used by governments to achieve other social goals without any cost to the economy. In this sense, environmental taxes are 'costless' sources of revenue.

However, governments already collect taxes for general revenue-raising, such as the GST and income tax, as well as other purposes. And taxes interact in complex ways. Without understanding how the present tax system affects consumption and production decisions with environmental consequences, it is not possible to know whether a particular environmental tax proposal is actually welfare-enhancing. For example, an environmental tax may be passed on to consumers in higher prices and would add to tax distortions already in place.

There are some cases, however, where even in the presence of existing distortions an environmental tax can improve both environmental outcomes and the value of market production, delivering a 'double dividend'. Some environmental problems can directly affect work incentives. For example, recycling the toll revenue from a congestion charge as lower labour income taxes not only substantially improves environmental amenity, but also encourages people into work (Parry & Bento 1999). Some environmental problems can also have long-run feedback effects on health and productivity. Sometimes existing tax systems are so poor that an environmental tax or charge can raise revenue more efficiently. For example, the CPRS will apply to a broader range of fuels than the existing fuel excise. As the CPRS displaces some of the existing fuel excise, the overall economic cost of raising revenue from fuels should fall. This benefit is in addition to the environmental objective the CPRS aims to achieve.

Empirical studies suggest that, while there may be important exceptions, cases offering a 'double dividend' are not likely to be common (Bovenberg & Goulder 2002). Further, many of the 'second benefits' can be achieved without the need to use the explicit revenue from an environmental tax. Indeed, if there were no institutional constraints, this would ideally be the case. By using specific policy tools for specific targets, governments can ensure that the best instruments are used to most effectively tackle social problems. If there are better options for raising revenue more efficiently than current taxes, then they should be adopted. If there are better options for addressing environmental options than a tax, they too should be used. By mixing objectives in a single instrument — the environmental tax — governments might not use other instruments that could be better at addressing each objective individually.

Of course, environmental taxes should still be considered even where no double dividend exists. In such cases, an appropriately designed environmental tax would see the benefit to the community outweigh the costs.

Earmarking revenue constrains government spending choices

Several submissions to the review have argued that revenues raised by environmental taxes should be hypothecated or 'earmarked' to spending on related environmental programs.

While this may promote public acceptance of a tax, it constrains the ways in which the government can allocate limited revenue between competing priorities. It can result in revenue being spent on hypothecated programs when it could have delivered greater social benefit if directed elsewhere, including through lowering existing taxes.

Hypothecation also creates a risk that the rate of an environmental tax would be dictated by the expenditure requirements of the associated program, rather than by the marginal social cost of the environmentally harmful activity the tax is meant to address.

Hypothecation may be desirable if there is a close connection between the source of funds and their subsequent use. This is because the tax provides signals to producers about the demand for the environmental good or service. In such cases, the levy or charge effectively constitutes a user charge for the provision of goods or services (rather than an environmental tax), which promotes efficient resource allocation. Examples of such charges include national park charges and the Great Barrier Reef Environment Management Charge (for more examples see Section E1 User charging).

Additionally, if the environmental tax is set at the rate that reflects the marginal external cost of the targeted pollution, then net benefit is maximised and no further government spending on that environmental objective will deliver a further net benefit to society.

Even hypothecating the tax raised from ameliorating one environmental problem to fund a program aimed at overcoming another environmental problem is likely to lead to poor outcomes. This reflects that it is unlikely that the funding required for expenditure programs that would pass a social benefit–cost assessment will approximate the tax revenue collected by an environmental tax set at the marginal external cost.

Principle

There is no general case for hypothecating (that is, earmarking) environmental tax revenues to environmental spending programs. However, hypothecated user charges (as opposed to taxes) that reflect the true cost of providing a good or service can be an efficient means of funding environmental programs.

Using additional instruments is likely to be inefficient and costly

A well-targeted environmental tax addresses a spillover by providing a transparent price signal that reflects the marginal external cost of environmental harm. As noted above, once such a tax is applied, there is unlikely to be a need for additional instruments that target the same environmental issue. As a general rule, multiple instruments should be considered only if they complement each other in a predictable way to achieve the desired outcome, and if a single policy instrument could not achieve the outcome in a more efficient and effective way. In particular, supplementary measures may be needed when the measurement of pollution is uncertain or costly. For example, supplementary measures to reduce carbon emissions from sectors difficult to include in the CPRS may reduce the cost of overall abatement.

Principles

In general, a single policy instrument should be used to target a single objective.

Multiple instruments should be considered only where one instrument is not capable of achieving the desired objective, and where the instruments are complementary in nature.

Tax concessions are a blunt tool for dealing with environmental issues

The provision of concessional tax treatment for selected expenditure is another means by which government can give taxpayers an incentive to undertake environmentally beneficial activities.

A number of submissions to the Review have argued that existing tax concessions should be extended to encourage activities and investments to address local environmental issues, such as land degradation, inefficient water use and environmental conservation. Some submissions considered it inequitable that businesses enjoy concessional tax treatment for environmental expenditures while people who are solely doing conservation work do not.

Tax concessions or cash subsidies can, in principle, have equivalent allocative effects to environmental taxes but they have quite different distributional effects. Environmental taxes impose burdens on polluters whereas tax concessions and subsidies impose costs on the whole community through the higher taxes needed to fund them.

However, there are situations where providing a subsidy may be appropriate. These include situations where an effective 'polluter-pays' mechanism, such as regulation or taxation, is not practical — for example, where the polluter cannot be easily identified. Another situation where targeted subsidies may be appropriate is where a government wishes to 'purchase' environmental goods on behalf of the public. An example is the Australian government's Caring for our Country — Environmental Stewardship program, which involves direct payments to landholders in return for biodiversity conservation and improvement (see Box E2–9).

In such cases it is preferable that subsidies be provided directly through grants programs rather than through broad-based tax concessions. Direct grants can be more tightly targeted towards areas of public benefit, are more transparent, and allow for the merits of environmental subsidies to be compared directly with other spending priorities. Further, unlike tax concessions where the size of the benefit of any marginal expenditure is related to the taxpayer's marginal tax rate, a subsidy can be designed to reflect better the marginal benefit of the environmental outcome.

Principles

Since tax concessions with environmental objectives tend to lack transparency, be poorly targeted, impose costs on all the community rather than just polluters and reduce the efficiency of the taxation system, other more effective mechanisms should generally be preferred.

The environmental impact of any other tax concession should be evaluated before it is introduced. Existing concessions should also be evaluated for their environmental consequences.


3 For instance, in Box E2-4, a trading scheme would set the quantity of pollution at Q*. Polluters would pursue least-cost abatement to achieve this target, and the price of permits would rise to T — the same quantum as the environmental tax required to achieve a reduction in pollution to Q*.

4 While the legal incidence may be on the producer of the good or service, often the economic burden of the tax can be passed forward. To the extent that the burden is passed forward to the consumer who demands the product which causes the damage this can still be consistent with the polluter pays principle.

5 The OECD defines environmental charges as 'payments for which a good or service is rendered in return'.

6 While there are a number of greenhouse gases, their impact is compared using CO2 equivalent measurements.