Possibilities of Environmental Fiscal Reform in Developing Countries
Stefan Speck1
On behalf of GTZ (Deutsche Gesellschaft für Technische Zusammenarbeit), Germany
Paper to be presented at the
Bank Indonesia Annual International Seminar
Macroeconomic Impact of Climate Change: “Opportunities and Challenges” Nusa Dua, Bali, August 1-2, 2008
The concept of an environmental fiscal reform (EFR) has been on the political agenda for more than 15 years. The notion behind the concept of an EFR is the same in developed and developing countries - as the OECD states in a recent report: ‘“Environmental fiscal reform” (EFR) refers to a range of taxation and pricing measures which can raise fiscal revenues while furthering environmental goals (OECD, 2005, p.12)’.
In other words, EFR describes any policy measure in the overlap between environmental and fiscal policy and its implementation is not limited to developed European countries but may also be implemented in transition or developing countries as stated in recent reports published by international organisations, such as the OECD (2005) and the World Bank (2005). Although the underlying concept may show some similarities when implemented in developed and developing countries, the rationale for implementation may differ. The exact design of this policy measure obviously depends on the prevailing economic, social, institutional and political situation in the countries and, in particular, what policy objectives are addressed and aimed to be achieved when an EFR is launched. This concept is known as ‘tax shifting programmes’ in developed countries (EEA, 2005) whereas the key underlying reason in developing countries is to raise revenues which can then be used for infrastructure investment in water and sanitation as well as support for poverty reduction programmes.
The concept of Environmental Fiscal Reform (EFR)
Developing countries are facing major challenges in balancing the three pillars of sustainable development – economic, environmental and social objectives – as established at the 1992 Earth Summit in Rio de Janeiro. These objectives and halving
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extreme poverty by the year 2015, were reaffirmed in the Millennium Declaration and the Millennium Development Goals (MDGs) and at the World Summit on Sustainable Development in Johannesburg in 2002. Significant financial resources are necessary to achieve the objectives of sustainable development and those of the MDGs, and consequently the mobilisation of domestic resources is one of the major challenges facing developing countries.
In this context it is worthwhile to discuss the option linking these challenges with the application of market based instruments (also called economic instruments) for environmental policy. The more widespread use of market based (i.e. incentive based) instruments was promoted at the international forums for many years (for example, Earth Summit of Rio in 1992 and the Financing or Development Conference in Mexico 2001, as well as by international organisations, such as the OECD, World Bank). These instruments have experienced increased attention as an important tool in environmental policy both in developed and developing countries in recent years (OECD, 2006). Their advantages - when compared to command and control (regulatory) policy measures - encompass the provision of economic incentives aiming to change behaviour and the generation of revenue which can be used either for financing environmental investments or for pro-poor investments.
Environmental Fiscal Reform is a wide concept with regard to policy measures to be implemented. It includes taxes levied on the extraction of natural resources, such as timber or fish, as well as taxes or charges on energy use, air or water emissions as well as reforming of water and energy subsidies. Furthermore, user charges for water supply services, sanitation and waste are also often included in the concept of EFR. One of the striking differences between the policy measures is the fact that taxes and charges will raise revenues and reforming subsidies will stop the use of scarce financial means which then can be used for other policies which could be more welfare increasing.
The revenue generating effect of market based instruments is of particular relevance in this framework as it could create additional financial resources to be used by governments in developing countries, such as Sri Lanka, South Africa and Indonesia, for concrete actions to protect the environment (Ministry of Environment and Natural Resources of Sri Lanka, forthcoming, and Speck and Datta, 2007)2.
Experiences with EFR in developed countries - the European context
The underlying thought of implementing an EFR in developed countries – as it has been done in several European countries – is to reform the national fiscal system by shifting the burden of taxes from conventional taxes, such as those levied on labour, to environmentally damaging activities, such as resource use or pollution. The rationale of this concept is that the burden of taxes should fall more on ‘bads’ (environmental pollution) than ‘goods’ (labour), thereby giving price signals to consumers and producers with the aim of influencing and changing their behaviour. This policy measure should therefore permit the achievement of environmental benefits with economic/employment benefits simultaneously. Furthermore, this policy measure guarantees that the total tax
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burden is distributed fairer and better from an environmental and indeed also sustainable development perspective while keeping the total tax burden constant.
An important aspect behind such tax shifting programmes implemented in several EU member states is the principle of ‘revenue neutrality’, meaning that the increase in the tax revenues generated by environmental taxes is offset by the reduction of other taxes or charges. This should guarantee that, at least at the national level, there is no change in the overall tax burden. This policy will undoubtedly have the consequence that some economic sectors will be ‘net losers’ in the sense that their tax burden increases as compared to other economic sectors which will be ‘net winners’, i.e. their tax burden will be reduced. Apart from an environmental benefit, an economic benefit may be achieved, as the reduction of labour taxes may lead to increased employment – high labour costs are seen as one of the main reasons for high unemployment rates in countries such as Germany3.
Whilst focusing on the possible benefits of market based instruments, it is important not to polarise between these types of a policy instrument and regulatory, command-and-control measures. Market based instruments and regulatory measures are crucial tools of government policy and have a critical role to play in ensuring markets function as efficiently and effectively as possible.
Experiences with EFR in developing countries
The revenue generating capacity of environmental taxes is clearly of significance in the context of implementing EFR in developed countries. The same aspect must also be considered crucial when discussing the potential of this concept for developing countries, as the World Bank stated in a recent report (World Bank, 2005, p.ii):
To help achieve the MDGs, developing country governments need to raise revenues to invest in schools, healthcare, infrastructure and the environment. As recognised at the Financing for Development Conference in Monterrey, equitable and efficient tax systems, as well as improvements in the pattern of domestic public spending are essential to meeting the MDGs. …
Environmental Fiscal Reform (EFR) can play an important role in this regard, helping countries raise revenues, while creating incentives that generate environmental benefits and support poverty reduction efforts. EFR has the potential to free-up economic resources and generate revenues that can help finance poverty reduction measures, for example infrastructure that improves access of the poor to water, sanitation and energy services.
Although unemployment (one of the big challenges in developed countries addressed in many EFR packages) may also be a major issue in developing countries, the underlying rationale concerning the adoption of an EFR in the context of developing countries is slightly different, as they are faced with solving other major challenges which may be even higher on the political agenda4. For example, to fulfil the MDGs countries have to
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For a more detailed discussion on the EFRs implemented in Europe: EEA, 2005 and Speck, 2007. 4
increase their spending on health care and education and to invest in environmental infrastructure, such as water supply and sanitation. Environmental infrastructure investments are evidently an integral part of achieving the MDGs, while they can contribute to poverty reduction at the same time as they improve the environmental situation, as the poor are mostly affected by environmental problems. Investments in water infrastructure leading to an increase in the connection rate will benefit the poor as they often have no access to the water supply and therefore relying on private water vendors who are charging higher prices than the piped water rates.
Therefore, it can be summarised that – although the concept of an EFR is rather similar in developed and developing countries – the actual design differs. One of the main differences between the two EFR approaches is that while in developed countries the focus is on keeping the total tax burden constant (i.e. a tax shifting programme), in developing countries the revenue raising potential of environmental taxes is at the fore as a means of mobilising domestic resources (see for example, World Bank, 2005).
However, the question of how to use the revenues generated either by environmental taxes or by reforming or abolishing subsidies is of crucial interest. In general, several different ways of revenue allocation, which are not necessarily mutually exclusive, can be thought of:
1. Revenues accrue to the National Treasury and are allocated to priority spending needs through the normal budgetary process, for example for pro-poor investments as well as investments related to health, education;
2. Revenues accrue to the Treasury and are used as part of a tax-shifting exercise to reduce the marginal tax rates of other distortionary taxes such as those imposed on labour;
3. Revenues are ‘earmarked’ or ‘hypothecated’ or ‘ring-fenced’ for spending on specific environmental programmes; and
4. Revenues accrue to the Treasury but there is some form of ‘agreement’ that spending on environmental programmes will be increased through ‘on-budget’ channels.
Although it can be envisaged that the second option could be of some interest for developing countries, it may be envisaged that option 3 is of greater relevance. In contrast to ‘tax-shifting’ policy referred to in option 2, earmarking revenues from environmental taxes for spending on specific environmental programmes (option 3) is promoted by some interest groups. However, earmarking (or hypothecating) tax revenues does not generally constitute sound fiscal management practice; an assertion heavily supported by international best practice. Despite these arguments, earmarking of tax revenues for environment purposes is practised in some countries, particularly in the transition countries of Central and Eastern Europe.
Probably, one of the biggest challenges is the removal of subsidies in the context of developing countries, in particular in the field of energy and fertilisers subsidy but as well in the tariff schemes for water supply and sanitation. For example, water policy is a national priority in many developing countries, such as in Sri Lanka. However, the achievement of this national goal is under threat as discussed by the Central Bank of Sri Lanka as it requires ‘economising on the usage, appropriate pricing to prevent wastage and over exploitation and attaining public consensus through awareness on the need for reaching sustainability. Two major factors threatening the long-term sustainability of water resources in Sri Lanka are improper pricing and deficiencies in regulation. Pipe borne drinking water is subject to a price, with a subsidy segment, but other forms of water supply are not subject to any pricing, leading to possible over exploitation and inefficient utilisation water (Central Bank of Sri Lanka, 2005, p.50)’. The situation in Sri Lanka is insofar no exception as in many other developing as well as developed countries water for irrigation is supplied free of charge or only levied with a lower tariff than water used by households and industries. The provision of free water does not encourage the efficient water use and an efficient allocation between competing users. These issues can be solved through an appropriate water pricing policy which also considers the prevailing country-specific conditions.
The approach of granting rather untargeted subsidies can regularly not be described as a success story in developing countries, while ‘the subsidy created serious macroeconomic implications through higher fiscal expenditure. Higher budget deficits emanating from huge oil subsidies in turn would either raise the government borrowings, compel it to reduce capital expenditure or increase the tax burden (Central Bank of Sri Lanka, 2007)’.
To show the real dimension of environmental subsidies in Sri Lanka, it is useful to make a comparison: during 2004 and 2005, the Sri Lankan Government provided large subsidies in the field of fuel and fertilisers amounting to around 22 billion Rs in 2004 and to almost 33 billion Rs in 2005. These figures should be compared to the total public spending on health, which amounted to around 45 billion Rs in 2005. It can therefore be stated that almost 75 per cent of the total budget for public health was used for energy and fertiliser subsidies. The Central Bank of Sri Lanka reported that the annual costs of subsidies could also have been used to construct about 1,300 schools or about 160 base hospitals per year.
Interesting in this context is an analysis of the effectiveness of subsidies as discussed in the two reports assessing the provision of fuel subsidies in developing countries – among them Sri Lanka - published by the International Monetary Fund (Lueth et al., 2006 and Coady et al., 2006). Both reports are very timely, as the authors are assessing the fiscal and distributional implications of fuel subsidies and it can be assumed that these findings are also applicable for many other developing countries.
conclusion of these reports seems to be a rather crushing verdict against subsidies, as it is summarised that ‘…subsidies are typically inefficient and regressive, as evidenced by the substantial leakage of existing subsidies to high-income households (Lueth et al., 2006)5’.
Conclusion
Over the last decade, the use of market based instruments, in particular of environmental taxes, has grown across the world as an increasing number of countries seek to reform their fiscal and environmental policies by making the two mutually reinforcing. Taxes, via their impact on market prices, send out signals that could have a significant impact on the behaviour of economic agents.
From the fiscal perspective, some environmental taxes are capable of generating significant amounts of revenue. This aspect of taxes, i.e. their revenue generating potential, is of great interest as a means to generate domestic funds for long term financially sustainable environmental investments.
The importance of generating domestic resources for environmental investments is highlighted in a recent UNEP report quoting the result of a study carried out by WaterAid (UK): ‘approximately 70 per cent of the current global spending on water and sanitation is provided by the domestic public sector, 20 per cent by ODA, and 10 per cent by private sector that comprises 7 per cent by international private flows while only 3 per cent comes from domestic private sector investments (UNEP, 2004)’6.
One of the key challenges for developing countries probably remains the reform of the existing subsidy schemes. However, a ‘single’ and straightforward way of reforming subsidies is not available and the given economic, social and geographical conditions of the individual countries and regions have to be kept in mind.
Reforming subsidies must also be seen as an important step towards freeing up revenues for financing other policy areas, such as achieving specific goals established under the Millennium Development Goals policy. What is even more significant is the fact that a large proportion of these subsidies have not even reached the poorer echelons of society. The rationale behind this policy approach of reforming subsidy is summarised by Lueth et al., 2006 as: ‘Subsidization of petroleum products can crowd out productive expenditures, increase public debt, and undermine the financial position of public enterprises’.
The evidence suggests so far that, with careful design, EFR can increase the efficiency of the economy. However, policy makers are facing a real challenge in combining aspects of economic efficiency and political and social acceptability versus environmental effectiveness; the need for a balanced approach remains the key. EFR can be a powerful
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It was calculated that about 52 per cent of fuel subsidies went to the top two income quintiles, compared to only 31 per cent to the bottom two income quintiles. Therefore, it is obvious that the fuel subsidy scheme maintained until the summer of 2006 was regressive, as well as being inefficient, as evidenced by the substantial leakage to high-income households (Lueth et al., 2006). Slightly different figures are reported by Coady et al., 2006, as these authors concluded that the share of the poorest 40 per cent of households (i.e. the bottom two income quintiles) in the total benefits from fuel subsidies amounted to 25.1 per cent in Sri Lanka.
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tool for mobilising revenues, while simultaneously promoting environmental objectives and supporting poverty eradication measures – but EFR is not a “panacea”.
Reference
Central Bank of Sri Lanka, 2005, Annual Report, Colombo, Sri Lanka.
Central Bank of Sri Lanka, 2007, Recent Economic Developments Highlights of 2006 and Prospects for 2007, Colombo, Sri Lanka.
Coady D., M. El-Said, R. Gillingham, K. Kpodar, P. Medas and D. Newhouse, 2006, The Magnitude and Distribution of Fuel Subsidies: Evidence from Bolivia, Ghana, Jordan, Mali, and Sri Lanka, International Monetary Fund (IMF) Fiscal Affairs Department, Working Paper WP/06/247, Washington, D.C.
European Environment Agency (EEA), 2005, Market based Instruments in Environmental Policy in Europe, EEA Technical Report, No8/2005, Copenhagen, Denmark.
Lueth E., M. Ruiz-Arranz, D. Coady and D. Newhouse, 2006, The Fiscal and Distributional Impacts of Fuel Subsidy Reform and Alternative Mitigating Measures, in International Monetary Fund (IMF) Country Report No. 06/447: Sri Lanka: Selected Issues, Washington, D.C.
Ministry of Environment and Natural Resources, forthcoming, Development of Market Based Instruments for Environmental Management in Sri Lanka, Colombo, Sri Lanka. Organisation for Economic Co-operation and Development (OECD), 2005, Environmental Fiscal Reform for Poverty Reduction, Paris, France.
Organisation for Economic Co-operation and Development (OECD), 2006, The Political Economy of Environmentally Related Taxes, Paris, France.
Speck S., 2007, Overview of Environmental Tax Reform in EU member states, working paper as part of the EU funded COMETR project (Competitiveness effects of environmental tax reform), National Environmental Research Institute (NERI), Ronde, Denmark, http://www2.dmu.dk/cometr/.
Speck S. and A. Datta, 2007, Environmental Fiscal Reform - differences and similarities between developed and eveloing countries based on a case study of the current situation in Sri Lanka, paper presented at the Eighth Global Conference on Environmental Taxation, Munich, Germany, October 18-20, 2007.
UNEP, 2004, Financing wastewater collection and treatment in relation to the Millennium Development Goals and World Summit on Sustainable Development targets on water and sanitation, Eighth special session of the Governing Council/ Global Ministerial Environment Forum, Jeju, Republic of Korea, 29-31 March 2004, UNEP/GCSS.VIII/INF/4
