5.2.1 ECONOMIC INSTRUMENTS: CAVEAT
It must be emphasised at this stage that much academic debate surrounds the issues summarised herein and it is not intended to further this debate. Classical economists
believed that leaving a free market to solve market problems would achieve the most efficient outcome, 40 though other economists later argued that Government intervention may
sometimes be necessary to avoid market failure.41
37 It is vital here to refer to Fisher who explains in more details the implications of the burden of the proof requirements under the precautionary principle. See Fisher E (ed.), Implementing the Precautionary Principle (UK: Edward Elgar, 2006).
Keynes advocated the idea that
38 See 1.8.
39 OECD, Environmentally Related Taxes in OECD Countries: Issue and Strategies (Paris: OECD Publishing, 2001) at 18.
40 The origins of this argument rest in Smith, see chapter 2, n.12. Coase further sought to prove that Government intervention was not required if private property rights could be clarified, in Coase RH, ‘The Problem of Social Cost’ (1960) J. Law Econ. 3, 1-44. Coase’s arguments were furthered in Cheung SNS, The Myth of Social Cost (London: Institute of Econ.Aff., 1978).
41 Mill JS, Principles of Political Economy with some of their Applications to Social Philosophy (London:
Longmans, Green and Co, 1871).
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Governments can take responsibility for leading the economy and could use interventionist methods and spending to correct negative externalities in the market.42
The thesis accepts as a starting point the view that Government intervention may be
necessary to overcome what is deemed to be a market failure, where the environment is not valued as a factor of production. However it is also accepted that intervention may not be appropriate in every case; sometimes it will be inefficient to intervene43 and international law supports the notion that environmental interests must be reasonably balanced against socio-economic interests.44 The stance taken within the thesis is that it is for the policymaker to determine the extent to which environmental interests will outweigh non-environmental interests. The purpose of the Universal Model is to provide a mechanism for policymakers to determine whether to, and how best to, intervene.
The policymaker will be faced with the challenge of extrapolating the most efficient solution.
Buchanan explained that since all solutions have costs, the true choice available when faced with an economic problem is to decide between a range of inefficient solutions.45 Various efficiency arguments are made to question whether it is efficient to intervene at all,46
42 Keynes JM, The General Theory of Employment, Interest and Money (London: Palgrave Macmillan, 1936).
and if
43 Prosser argues that society’s need for industry means some individuals may have to suffer a “not
unreasonable” private cost for the “general good”, in Prosser WL, Handbook on the Law of Torts (St. Paul: West Publishing Co., 1955) 398-412, at 412.
44 Principle 16 of the Rio Declaration requires national authorities when promoting the polluter-pays principle to have “due regard to the public interest…without distorting trade and investment”. Article 191(2).of the TFEU, provides a ‘Community inspection procedure’ for environmental actions provisionally taken by any Member State.
45 Brennan G and Buchanan JM, The Power to Tax: Analytical Foundations of a Fiscal Constitution (Indianapolis, IN: Liberty Fund, Inc., 1980).
46 Meade JE, ‘External Economies and Diseconomies in a Competitive Situation’ (1952) 52 Econ.J 54 at 56-57;
Cheung SNS, ‘The Fable of the Bees: An Economic Investigation’ (1973) 16 J. Law Econ. 11; Piguo AC, The Economics of Welfare (London: Macmillan & Co., 1920); Chen P, ‘Complexity of Transaction Costs and Evolution of Corporate Governance’ (2007) 76 The Kyoto Economic Review 2, 139-153; Chen P, ‘Coase Fantasy of Zero Transaction Costs And Asymmetric Bargaining in Social Conflicts’ (2008) Cornell University
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so, whether taxation or regulation47 is the most efficient measure – this will depend upon the type of problem.48 The thesis operates on the premise that the policymaker has decided taxation is the most efficient in a given case, and attempts to guide the policymaker in determining which method of tax can most effectively achieve a given environmental objective.49
5.2.2 ECONOMIC INSTRUMENTS
Law School; Stigler GJ, ‘The Economics of Information’ (1961) 69 J.Polit. Economy 3 pp.213-225; Halpin A,
‘Disproving the Coase Theorem?’ (2007) Econ. Philos. 23 321–341; Helm D and Pearce D, ‘Assessment:
Economic Policy towards the Environment’ (1990) 6 Oxford Rev. Econ. Pol. 1; Samuelson P, ‘Some
Uneasiness with the Coase Theorem’ (1995) Japan and the World Economy 7 1-7. Arguments that intervention may be paternalistic are debated in Galbraith JK, The Affluent Society (London : Penguin, 1999); Friedman M, Friedman on Galbraith, and on curing the British disease (Vancouver: Fraser Institute, 1977); Knight FH, Ethics of Competition (Chicago: University of Chicago Press, 1935).
47 Johnson explains that command and control regulation “provides no incentives to polluters to develop new strategies to reduce their pollution beyond the levels required by law.” Johnson SM, ‘Economics v. Equity: Do Market-Based Environmental Reforms Exacerbate Environmental Injustice?’ (1999) 56 Wash.& Lee L.Rev.
111, p. 112. See criticism of command-and-control style regulation in Ackerman C and Stewart R, ‘Reforming Environmental Law’ (1985) 37 Stan.L.Rev. 1333, at 1343. Nash demonstrates how, even when policy-makers opt to use regulatory regimes rather than environmental taxes to achieve environmental objectives, the tax considerations cannot be ignored. Nash JR, ‘Taxes and the Success of Non-Tax Market-Based Environmental Regulatory Regimes’ (2008) University of Chicago Law & Economics, Olin Working Paper No. 412.
48 For taxation versus regulation debates see: Turner K, Powell, J and Craighill A, ‘Green Taxes, Waste Management and Political Economy’ (1998) 53 Journal of Environmental Management 121–136, at 122-3;
Smith S, ‘Green’ Taxes and Charges: Policy and Practice in Britain and Germany (London: IFS, 1995) at 11;
Krupnick AJ, ‘Policies for controlling nitrogen dioxide in Baltimore’ (1986) 13 J. Environ. Econ. Manage. 189-97. Negative consequences of non-compliance due to regulation can be seen with the USA’s National
Prohibition Act 1919 (P.L. 66-66, 41 Stat. 305), which attempted to prohibit alcohol consumption, leading to an enormous increase in organised crime to meet demand for alcohol, and mass corruption in the Police: See Solomon RL, ‘Regulating the Regulators: Prohibition Enforcement in the Seventh Circuit’, in Kyvig DE, Law, Alcohol, and Order: Perspectives on National Prohibition (Westport, CT: Greenwood, 1985). Following its repeal in 1933, the illicit black market collapsed as legal sales were priced lower and avoided the threat of arrest, though the licensing of alcohol remained strict and allowed the authorities control in limiting alcohol use as opposed to prohibiting it: Warburton C, The Economics Results of Prohibition (New York: Columbia Press,1968). The tax code furthermore has been utilised to effectively regulate certain activities which go against Government policy. For example, in the tax year 1978-79, the left-wing British Government wanted to discourage unearned income, since they believed it unfair that a small number of the aristocracy did not need to work whilst much of the country was poor. Consequently they introduced a 15% surcharge on taxpayers with very high investment income, set above the maximum highest rate of income tax of 83%. This saw some taxpayers paying the extremely high rate of 98% of their income to HM Treasury, having similar consequences in reducing investments as regulation would have brought. Hence, whilst bans or regulations may be viewed by the public as a hindrance to freedoms, the continually changing rates of taxation can achieve the same affect of a ban without formally reducing the rights of the public. Adam S and Browne J, A Survey of the UK Tax System (London: IFS, 2006) Briefing Note No. 9, p. 27 and Table 14 <http://www.ifs.org.uk/bns/bn09.pdf> Accessed 22/6/2010.
49 Latin felt that throughout the debate on economic instruments there has been “an excessive preoccupation with theoretical efficiency” in Latin H, ‘Ideal Versus Real Regulatory Efficiency: Implementation of Uniform Standards and “Fine-Tuning” Regulatory Reforms’ (1985) 37 Stan.L.Rev. 1267, pp. 1270-71.
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In order to achieve the aims above, the type of legislation should be analysed to ascertain the way in which it will encourage taxpayer compliance.50 The traditional form of ensuring compliance whilst minimising undesirable side-effects has been in the ‘command and control’ model of environmental legislation. This can involve simply creating a law to limit the use of a pollutant and ensuring it is complied with - a regulatory technique.
However the OECD has for some time promoted the use of economic instruments to achieve environmental policy.51 The purpose of such instruments is to affect market costs in order to incentivise the use of non-pollutants over pollutants, for example, rather than simply forcing the change through regulation. These include techniques such as tax methods, grants and subsidies, and recently the area has developed the concept of carbon trading.52 If
environmental policy can be achieved via economic instruments in a less expensive manner than the command and control method, this is referred to by the OECD as ‘static
efficiency’.53 Indeed empirical studies have demonstrated that static efficiency benefits caused by economic instruments in the market can in some circumstances significantly minimise environmental protection costs.54
5.2.3 PIGOVIAN TAX THEORY
50 Turner et al name six principles behind economic instruments such as environmental taxes, depending on the political economy in which the tax serves, in Turner et al, see n.48 at 125.
51 “[Member countries should] make a greater and more consistent use of economic instruments as a complement or a substitute to other policy instruments…”; OECD, Council Recommendation on the Use of Economic Instruments in Environmental Policy (1991) [C(90)177/FINAL].
52 Smith S, ‘Environmentally Related Taxes and Tradable Permit Systems in Practice’ (Paris: OECD Environment Directorate Centre for Tax Policy and Administration, 2008)
COM/ENV/EPOC/CTPA/CFA(2007)31/FINAL
53 OECD, Environmental Taxes and Green Tax Reform (Paris: OECD, 1997) at 7.
54 Tietenberg TH, ‘Economic Instruments for Environmental Regulation’ in Helm D, Economic Policy Towards the Environment (Oxford: Blackwell Publishers, 1991).
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The traditional method of using taxation to achieve environmental policy goals other than simply command and control legislation is to create a tax on a pollutant and ensure
compliance. It is based on the Pigovian notion that a tax can correct negative externalities in a market.55 It will discourage the use of a pollutant in a way that the market would not, and in doing so make the taxpayer take into account the cost of the pollution in financial terms before using the pollutant.56 This is called external cost internalisation. The Stern Review describes that, “putting an appropriate price on carbon…through tax …means that people are faced with the full social cost of their actions.”57 The economic basis for this theory is accepted as a starting point, though is it acknowledged that there is academic debate in this area.58
The dictum that those who pollute should bear the cost of their pollution is enshrined in Article 191(2) of TFEU; the difficult question of identifying exactly who should bear the cost is dealt with in Chapter 7. However some industries must use pollutants anyway and will simply consider it as another tax with which they must comply. The incentive to comply in this case is to avoid any enforcement action such as further charges or even prosecution. Due to this the tax becomes a revenue-raising tax rather than a behaviour-changing tax.59
55 Piguo AC, Wealth and Welfare (London: Macmillan & Co., 1912).
An Asian Development Bank report acknowledges the weaknesses of achieving environmental policy through this ‘command’ approach since it only creates an incentive to comply with the
56 See Baumol, WJ ‘On Taxation and the Control of Externalities’ (1972) 3 Amer. Econ. Rev. 62 307-322.
57 Stern NH, Stern Review: The Economics of Climate Change (London: CUP, 2007) p.xviii.
58 Coase criticises the Pigovian logic which seeks to demonstrate how Government intervention can cause a nuisance in itself which then requires correction: see Coase, chapter 2, n.40, at 28. Where Pigou argued for internalisation of negative externalities, Coase contested that if somebody is using their land which produces an economic output but which causes some harm to their neighbour, it should not automatically be assumed that the use should be stopped in order to protect the neighbour. He argued that preventing the harm to the neighbour actually causes harm to the producer, and Coase believes that the required action depends on the balance between the private cost to the neighbour against the social gain from the production output.
59 See the discussion in Soares CD, ‘An 'Environmentally Related Tax' is not necessarily an 'Environmental Tax'’ London School of Economics <http://ecpr-sgeu.lboro.ac.uk/research/soares1.pdf> Accessed 16/6/2010.
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command, not go beyond it.60 Furthermore, the method of introducing severe penalties for breaching environmental legislation has been criticised. South Africa’s National
Environmental Management Amendment Bill (B36B-2007) which increased sanctions for non-compliance to a ZAR R10-million fine and/or 10 years in jail, arguably had “little effect”61 as the country still ranks lowly on an Environmental Performance Index.62
5.2.4 TAX INCENTIVISATION
A contemporary approach to ensuring compliance is ‘tax incentivisation’. The notion is to utilise taxation in order to give people an incentive to go beyond compliance. Put simply, a tax on a pollutant can encourage less use of the pollutant up to the point of compliance, where the tax will be minimal. Yet a tax credit or a significant reduction in taxation for going beyond compliance means that it is in the taxpayer’s financial interest to go beyond
compliance and actually reduce their overall pollution – and even invest in environmentally efficient technology.63 This is an economic point, based on the financial practices of the way businesses are run. The OECD refers to this type of “continuous incentive for pollution abatement and technical innovation” as ‘dynamic efficiency’.64
60 See eg. Asian Development Bank, ‘Thailand: Capacity Building for Pollution Taxation and Resource Mobilization for Environmental and Natural Resources Sectors — Phase II’ (2008) 4667 THA.
61 Gunn A, ‘On the right track? – South Africa’ (2008) <http://www.hg.org/article.asp?id=5628> Accessed 16/6/2010.
62 Produced from a study conducted by Yale and Columbia Universities; <http://epi.yale.edu/Home> Accessed 7/6/2010.
63 ‘Environmental efficiency’ means an action (such as production) which causes the least damage to the environmental objective given the available options.
64 OECD, see n.53 at 7.
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If a business is subject to taxation then it has an interest in arranging its affairs to reduce its tax liability, and the right to do so.65 By offering reliefs to reduce the liability, policymakers can encourage a certain form of positive activity. Hence, policymakers would not be forcing a business to do a certain activity and not do another. Instead they can charge the business an amount, justified as a necessary evil, but offer the business the option not to pay as much through certain schemes. As such, the business carries out a positive activity which the Government may have otherwise had to do, and is better off for it. The business chooses to do it and will likely be able to gain positive publicity from it. Equally the Government does not have to raise additional taxes to fund the positive activity. Thomas argues such measures can promote efficiency if activities with positive externalities are increased.66
Four models of tax incentivisation to achieve environmental objectives are considered below:-
5.2.4.1 OUTPUT RELATED TAX
An example of such a tax in operation is identified in First Principles of Economics, in a discussion related to a tax on a hypothetical factory’s pollution:
“If the pollution were related to the volume of factory output, for instance, a well targeted tax would be output-related, so that the incentive to reduce the amount of pollution was directly related to the tax burden. Such a tax would be more efficient than a tax on the profits of a
65 Commissioners of Inland Revenue v. Duke of Westminster (1936) App.Cas. 1, 19 T.C. 490.
66 Thomas KP, Investment Incentives: Growing use, Uncertain benefits, Uneven controls (Geneva: IISD, 2007) at 11.
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polluter, who might pollute no less. If a polluting firm was using the lowest cost methods of production before the tax, there is no reason why it should not continue to do so, being left merely with lower profits.”67
The notion here is that taxation can be targeted to fit in with the way that businesses operate.
By making businesses take taxes on pollution output into the cost of production, the cost of production becomes higher and they have a vested interest in reducing such costs. This provides both an incentive to reduce pollution output per se, as well as an incentive to invest in environmentally efficient technology which creates less pollution and therefore brings less pollution output into charge for tax.
An example of this kind of tax is the Landfill Tax in the UK, which creates a charge per tonne on waste when delivered to landfill sites. A higher rate68 applies to biodegradable waste than inactive waste, to further discourage landfill of the former.69 The Department of the Environment (as it was named then) set the prices based on the estimated external costs related to landfill, with the purpose of making those intending to use landfill sites take account of, and become responsible for, their environmental cost.70
Nevertheless, this model of taxation is questioned by Fullerton et al who argue that such taxes are frequently targeted in an imprecise manner which consequently provides inefficient
67 Lipsey RG and Harbury C, First Principles of Economics (London: OUP, 1993) at 230.
68 The rates are specified by FA 1996, s.42.
69 Inactive waste includes: rocks and soil, ceramic or concrete materials, minerals, furnace slags, ash, low activity inorganic compounds, calcium sulphate, calcium hydroxide and brine, water; Cabinet Office Strategy Unit, see chapter 2, n.30 at fn.100.
70 An explanation is given in Davies B and Doble M ‘The Development and Implementation of a Landfill Tax in the UK’ (2004) in OECD, Addressing the Economics of Waste (Paris: OECD 2004).
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welfare benefits.71 Indeed, the level of waste subject to the ‘standard rate’ of tax imposed on landfill in the UK was deemed to be static, signalling that this kind of output tax did not work successfully to reduce such levels of waste.72
Nevertheless, the tax significantly reduced landfill of inactive waste by 60%,
This is despite an increase in the tonnage tax from GBP £7 upon its introduction in 1996 to GBP £40 in 2009.
73 despite a rate of only GBP £2 – much lower than the charge for active waste – being charged until 2008.74 Hence an output tax can operate effectively but this is not guaranteed and it depends partly on the elasticity of demand of the subject of the tax.
5.2.4.2 TAX REDUCTIONS AND DEDUCTIONS
Even with the above output-related tax in operation, businesses would still have to bear the capital cost of investing in environmentally efficient technology in order to achieve the necessary tax savings. Tax incentivisation can go further than this and assist businesses in investing in capital expenditure on this ‘clean’ technology in order to make it financially attractive to do so.
In the UK, the Capital Allowances Act 2001 allows businesses to claim a FYE (First Year Allowance) of 100% on allowable capital expenditure on new energy-saving plant or machinery. This is a substantial incentive as businesses can then write off the cost of such
71 Fullerton D, Hong I and Metcalf G, ‘A Tax on Output of the Polluting Industry is Not a Tax on Pollution: The Importance of Hitting the Target’ (1999) National Bureau of Economic Research Working Paper No. W7259.
72 A Cabinet Office report called for an increased tax rate since the tax had been ineffective; see chapter 2, n.30 at para 6.54.
73 Ibid, para 6.47.
74 When it was increased to GBP £2.50.
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expenditure against their tax liability. Furthermore it promotes a demand for energy-saving plant and machinery which can help to reduce production costs as economies of scale develop and the market for such technology matures, and consequently reduces the overall cost to businesses of purchasing them.75 In doing so it encourages economic growth of businesses
expenditure against their tax liability. Furthermore it promotes a demand for energy-saving plant and machinery which can help to reduce production costs as economies of scale develop and the market for such technology matures, and consequently reduces the overall cost to businesses of purchasing them.75 In doing so it encourages economic growth of businesses