Public Accounts and Estimates Committee of the Victorian State Parliament (Australia)
Author: Philip Sutton
What role should economic instruments play in environmental policy
Economic instruments are another set of regulatory tools. As a class, they are not necessarily more or less effective than other regulatory tools such as law-based controls. The strengths and weaknesses of any particular regulatory mechanism (whether economic or law-based) must be judged in the context of specific regulatory needs.
Where an activity needs to be banned or changed in a very specific way, then law-based or prescriptive controls are probably the most effective. Where there are many ways to achieve the same outcome economic instruments can often deliver the best results.
Economic instruments are considered to be valuable because they generate price signals and Australian firms are renowned for their price sensitivity. Economic instruments are also considered to be valuable because they do not hinge on a sharp divide between what is legal and illegal, instead prices continue to provide an incentive to change the performance of the system well after a minimum or threshold standard has been attained. Economic instruments also create signals that flow into the economic system allowing for the possibility that least-cost responses to the price signal can occur somewhere else in the economy other than the point at which the instrument was applied.
However, even though Australian firms, which are dominated by commodity producers, seem to be more price-sensitive, on average, than the firms of regions noted for a high level of product innovation - environmentally-related price signals can often get lost among all the competing stimuli that are demanding management attention. The effectiveness of economic instruments therefore depends upon the responsiveness of the management system to the price signals generated (or as economists would put it the elasticity of the system).
Many economists argue for the use of economic instruments, and environmental levies in particular, simply because they generate price signals which are assumed to trigger desirable changes in the behaviour of firms. However if the responsiveness of the system (elasticity) is low then very large price signals might need to be used to produce a response. However very large price signals, especially when introduced very rapidly, may generate high costs in the economy, which can be damaging to its performance. This is the basis for the coal industry’s argument against a carbon tax. The industry assumes that no responsiveness-boosting measures will be taken and then argues that punitive ecotaxes would be needed to change the behaviour of the economy.
Other policy analysts argue that the most effective policies are those that concentrate on changing the responsiveness of the system. Amory Lovins, for example, argues that often responsiveness-inducing measures can often be so effective that even very small price signals (such as those that exist in the absence of economic instruments or environmental levies) can provide the necessary drivers.
An either/or debate about the creation of price signals or the deployment of responsiveness-inducing measures however can become very sterile - both approaches have value and they work best in combination.
For example, Amory Lovins is a strong advocate of ‘fee-bates”. These involve the application of a financial penalty for an undesirable activity and a financial reward for desirable activity (funded by revenues from the penalty side of the instrument). For example, a significant shift to energy efficient cars could be triggered by the imposition of a fee for the possession of energy inefficient cars and the provision of incentive to replace such cars with an energy efficient model.
Micro-control the character of the economy is probably best achieved through the use of law-based regulations, micro-level consensus-based visions and plans and highly situation-specific economic instruments. But the macro-directions are best steered by macro-level consensus-based visions and plans and the synergistic application of a suite of broad brush economic instruments (eg. environmental levies, tradeable permits, financial incentives/subsidies, etc.) together with strategically chosen responsiveness boosting programs.
The OECD recommendations make a great deal of sense and are supported. The recommendation that the cost-effectiveness of environmental policies and instruments should be assessed for cost effectiveness makes most sense where the cost-effectiveness of alternate means of achieving policies are compared. It does not make sense however to try to compare the cost-effectiveness of pursuing or not pursuing sustainability as sustainability is a fundamental goal. We argue that ecological sustainability and the provision of a decent minimum material standard for all are not goals to be traded off against each other. Policy development therefore needs to be directed to devising strategies that will produce a win-win outcome.
In terms of basic economic theory, levies and subsidies are equally valid instruments.
However tax departments usually try to discourage incentives or subsidies because there is the risk of regulatory capture where industry comes to demand subsidies that exceed the level required to achieve desired environmental outcomes. (Note the long campaign by many economists to wind back Australia’s tariff system.) Politicians and industry departments usually prefer incentives over ‘punishing’ instruments as the latter are politically unpopular and in the early stages when the responsiveness of the system is low they may not produce the positive changes in the behaviour of the economy that are expected.
As a general rule, subsidies can play a positive role early in a reform cycle and financial disincentives can play a key role later in the cycle and on an ongoing basis.
It is useful to divide taxes into two categories - revenue and regulatory. Traditionally taxes have been used principally to raise revenue. In this context an ideal tax is one where the economy is highly inelastic (highly unresponsive) as the idea is for people to pay the tax rather than avoid it. Environmental levies on the other hand are regulatory taxes. They are introduced quite specifically to change behaviour. It is to be hoped that environmental levies will not create a stable revenue base as it is to be hoped that undesirable activities will be, over time, reduced or abandoned.
If environmental levies are not applied in order to generate revenue then what should happen to that revenue? As a general rule revenue raised from regulatory taxes should not be included in ‘consolidated revenue’, otherwise governments may come to depend on the revenue and end up, perversely, wishing to continue the regulated activity at a higher than optimal level (eg. special taxes on the gaming and cigarette industries).
Instead revenues from regulatory taxes should be used:
to deal with the problem that led to the need for regulation in the first place (ie. by making it easy for people to change their undesired behaviours), or
to increase the economic wellbeing of the taxed community as a way of offsetting any loss of economic productivity due to the imposition of regulatory taxes, or
if the system is highly responsive and the tax system is causing no significant losses in economic productivity, the money should be returned to the taxed community in the least inflationary way possible. For example if environmental levies increase business cost in one area then the revenues might be used to reduce business costs in another area (eg. carbon taxes might be used to eliminate payroll taxes).
Tax departments generally have a tradition of opposing what they refer to as hypothecation, that is, raising money to be used for a special purpose in perpetuity. For example, at a particular point in time, it might be decided that society needs more roads so a roads tax is introduced. Once a sizeable revenue stream is generated a large road building industry could be built up that has an interest in the maintenance of the roads levy long after the point where society has enough roads. Tax departments usually argue that community needs should be met from consolidated revenue and that all possible calls on the public purse should have to compete transparently for funding. This is a powerful argument.
However, the logical of regulatory taxes is that the revenue should be either hypothecated (spent in the problem area) or rebated rather than being included in consolidated revenue. To overcome the risks of hypothecation identified by tax departments, special accountability mechanisms need to be put in place for the expenditure of revenues from regulatory taxes eg. the establishment of a set of transparent governing principles for each ecotax and a periodic public review by an independent authority such as the Auditor General or a body like the Productivity Commission.
What types of economic instruments will provide the greatest environmental benefits? There are a wide range of economic instruments that can be used. The discussion paper mentions many of them at the bottom of p. 94. A key economic instrument not mentioned is the deliberate use of competition. For example, support for innovators could be used to create a competitive pressure on laggard firms forcing them either to upgrade or lose market share.
Economic instruments can be applied at every level from the micro to the macro. The comments that follow relate to their use at the macro level or their additive effect at the macro level (many responsiveness boosting measures need to be applied at the micro level even though in many cases it is their aggregate (macro) effect that is the key concern. The instruments principally discussed are environmental levies or ecotaxes.
An ecologically sustainable economy would:
use dramatically less raw material and energy
not use fossil fuels / use renewable energy
have a closed cycle structure where material resources (apart from energy) were fully recycled (largely through the economy rather than nature) - waste dumps would only be used for temporary storage
be designed to eliminate the use of toxic substances
be spacially compact to leave ample room for nature
be premised on a stable population
be built around the sale of service flows rather than the sale of goods.
Economic instruments (taxes, user charges, tradeable permits, deposits, insurance premiums, etc.) and responsiveness promoting measures should be introduced as a suite (see package below) to drive the economy to a sustainable structure (in relation to all environmental issues) otherwise perverse incentives will be created and illogical environmental outcomes will be generated. For example, if strong incentives are introduced to foster recycling without also taking measures to encourage dematerialisation and a switch from fossil fuels then recycling could be pursued in ways that are wasteful of resources and that worsen the economy’s contribution to the greenhouse effect.
Often it is not the absolute price effect generated by economic instruments that counts (provided that there is a strategic application of responsiveness boosting measures) but rather it is the level of certainty and predicability and the financial trajectory that counts.
Participants in the economy need to know:
the government is totally committed to the application of economic instruments (ie. they will not be removed arbitrarily at some future time)
the pattern of introduction and change in the application of economic instruments and responsiveness-fostering measures so that forward planning can reliably factor in these measures (organisations usually appreciate the gradual introduction of major changes in predictable steps - each of which are bearable)
that, as the purchasing power of the economy increases, the economic instruments will be ramped up to maintain their regulatory power.
When economic growth is occurring environmental levies and other economic instruments intended to have macro effects should increase in perpetuity - indexed to the growth of the economy - unless the regulated activity is replaced at some point by better alternatives.
If these conditions are met then economic instruments and their accompanying responsiveness-boosting measures can register with decision makers as meaningful strategic drivers to factor into a wide variety of organisational management spheres (eg. corporate planning, investment policy, product development and marketing, R&D, production and distribution, education and training, recruitment, performance criteria, etc.).
So why use economic instruments, especially environmental levies? These instruments send signals that cost-reactors can understand; they demonstrate government commitment and intention and reduce the risk for business decision-makers for targeting sustainability; and they create a revenue stream to fund responsiveness-boosting projects.
At the micro level, which economic instrument or combination of instruments is best has to be decided in the context of the specific circumstances. General rules at this level are usually not terribly useful.
At the macro-level there is a strong case that environmental levies or ecotaxes combined in some cases with tradeable permits can play an important part in creating useful price and policy signals and can provide the revenue streams needed for responsiveness-boosting measures that ensure that the economy is sensitised and able to respond to the price signals.
Ecotax and Expenditure Package for an Ecologically Sustainable Economy
Measures required to create an economically viable and ecologically sound closed-cycle economy.
landcare levy (covering landcare and biodiversity)
Invest in or subsidise solutions:
(ie. responsiveness-boosting measures)
R&D for regenerative recycling (up-cycling) and material quality retention
General R&D, infrastructure, structural adjustment and education in relation to waste elimination, renewed resource use and environment protection)
Recycling of revenue from regulatory taxes not needed to fund the responsiveness boosting measures:
Via negative payroll taxes, and pensions
An economy wide life-cycle assessment system.
All taxes and the waste storage rentals would be indexed to the growth of the economy (except the virgin-resource tax - see next item).
Input virgin resource prices increased to just exceed regeneratively recycled resources.
The level of all disposal charges would reflect the extent to which disposal lowers the quality and accessibility of the waste for eventual reprocessing.
Disposal charges would be split between waste disposers and manufacturers/importers to affect product design and disposal behaviour.
V 2.b 2/7/00
Ecotaxation is discussed further on the following web pages:
Three environmental issues stand out at the macro-level as needing a great deal more attention:
the need to reduce the demand for fossil fuels and to switch to renewable sources as a way of preventing worsening greenhouse warming For further information see:
the need to reduce oil use due to the imminent peaking of world production of oil For further information see:
the need to prevent accelerated extinctions locally and globally.
For further information see: http://www.green-innovations.asn.au/mass-extinctions.htm The State Government could consider early action to introduce environmental levies for:
fossil fuels with a special loading for oil
land clearance (in addition to the current regulations).
The State Government could also support action by the Federal Government to introduce a 1% landcare levy to fund land protection and biodiversity protection programs. This measure is being advocated by The Australia Institute: http://www.tai.org/
Will there be significant social costs or benefits associated with such instruments? It is generally assumed that effective measures to protect the environment will constrain, not just specific economic activities, but the overall output of the economy. This assumption has been challenged in a number of quarters.
DRI et al. have run more realistic econometric models and found that well crafted environment management policies coupled with the effective use of economic instruments can produce a double dividendi: better environmental outcomes and superior economic performance. Michael Porter from Harvard University, an internationally renowned expert on business strategy has argued that high business performance in firms is positively and in part causatively correlated with high environmental performance - due to the multiple benefits of pursuing leading edge technology and management methods. Amory Lovins et al. in the books Factor Four and in Natural Capitalism has found empirical evidence that the pursuit of radical environmental solutions, if done using effective whole system design and if avoiding an ideological anti-business stance, can in a great many instances deliver cheaper and profitable solutions than more environmentally modest objectives - because the radical approach allows completely new solutions to be considered that have better potential for win-win outcomes.
The theoretical rationale for believing that environmental damage and resource depletion can be decoupled from economic growth, allowing an ecologically sustainable economy to achieve conventionally high rates of economic growth is set out in the paper “Is it possible for a green economy to have high economic performance?” http://www.green-innovations.asn.au/econ-mdl.htm
Other references for this section:
DRI et al. (1994). Potential benefits of integration of environmental and economic policies. Graham and Trotman and Office for Publications of the European Communities: Brussels.
Porter, M. & van der Linde, C. (1995). “Green and competitive: Ending the stalemate” in Harvard Business Review. Sept.-Oct.
von Weizsäcker, E. Lovins, and A., Lovins, H. (1997). Factor four. Allen & Unwin: St. Leonards, NSW.
Hawken, P., Lovins, A. & Lovins, H. (1999). Natural capitalism: the next industrial revolution. Earthscan Publications: London. http://www.natcap.org/sitepages/pid20.asp
If economic growth can continue at current (or even higher) rates then the business opportunities that emerge as the economy is restructured to enable the achievement of ecological sustainability are very considerable - as the graph below illustrates.
SCOPE OF BUSINESS OPPORTUNITIES
ARISING FROM THE RESPONSE TO
ENVIRONMENTAL ISSUES Green Innovations Inc. Ver. 1.a 24/04/97
i For a discussion of the double dividend concept see: