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Annex 4
A Framework for Evaluation of Environmental Tax Proposals

Introduction

The Government of Canada strives to develop and implement policies that enhance productivity, competitiveness, growth and jobs while ensuring the sustainability of our resource base and the quality of our natural heritage. Strong, sustainable growth provides the resources to meet Canada’s social needs, to foster innovation, and to enhance standards of living and quality of life for this and future generations. The pursuit of sustainable growth requires that economic and environmental considerations be integrated into all aspects of decision making. In the best of cases, this will ensure that economic and environmental goals are advanced together. In others, it will entail trade-offs among these goals, but with informed decision making and choices that reflect careful deliberation.

The integration of economic and environmental considerations is how Canada will best achieve reductions in greenhouse gas emissions in order to combat climate change. It is also how Canada will assure clean air and clean water, protect species at risk, and manage the Great Lakes.

A strategy for a productive, growing economy and a sustainable environment requires that the Government deploy the full range of available policy instruments to maximize its leverage. In the pursuit of environmental goals, this will include regulatory instruments whereby government sets the rules, and markets—producers and consumers—are asked to adapt accordingly. It will encompass voluntary agreements and public expenditure, such as investment in innovation. Importantly, it will also include "economic instruments"—such as targeted grants and subsidies, and tax measures—that are intended to leverage market forces and to induce efficient, environment-friendly market outcomes (see box below).

In Canada, and internationally, organizations have underscored the potential contribution of economic instruments for achieving environmental goals in an efficient manner. At home, the National Round Table on the Environment and the Economy (NRTEE) and the Green Budget Coalition, among others, have proposed wide-ranging policy changes under such themes as "green budgeting" or "ecological fiscal reform." Internationally, the Organisation for Economic Co-operation and Development (OECD) has commented that Canada could usefully enhance its reliance on economic instruments to achieve its environmental policy goals while maintaining sustained economic growth.

Economic instruments, in turn, comprise a set of tools, one of which is the tax system. The basic role of the tax system is to generate revenue to fund public goods and services. Tax policy aims to ensure that this is achieved in a manner that is economically efficient, fair, and as simple as possible for compliance and administration. In some circumstances, the tax system may also be used to pursue other government policy objectives. Because of its breadth and reach, the tax system may impact a wide range of economic decisions. Accordingly, it has the potential to make an important contribution to the Government’s sustainable growth agenda.

The use of the tax system to advance environmental goals—or any other objective of public policy—must be judicious. For any particular goal, use of the tax system must be assessed relative to other instruments of policy, including other economic instruments such as subsidies or emissions trading systems. Principles of sound public policy require that the Government identify the set of instruments, including taxation, that will make the best contribution to its environmental goals, at the lowest cost (or with the greatest net benefit) for government and the economy, and in the fairest and simplest manner. Initiatives must also be pursued within the context of a commitment to balanced budgets and sound fiscal management.

The Government of Canada has put in place a range of economic instruments, including tax measures, that play an important role in advancing sustainable growth. This budget proposes several such measures, including a Clean Fund, expansion of the Wind Power Production Incentive and EnerGuide for Houses Retrofit Incentive programs, as well as the acceleration of capital cost allowances for a broadened range of efficient and renewable energy generation equipment. The Government intends to go further, and will do so in successive budgets.

This annex sets out the context and criteria that may guide the analytical evaluation of options to use the tax system to pursue environmental goals. As a framework, it is intended to contribute to the public policy debate and to facilitate dialogue with other levels of government, organizations and individuals who are concerned with the integration of economic and environmental factors in policy making and the pursuit of sustainable growth.

Market Forces, Market Failures, and the Case for Government Intervention

Under perfect conditions, market forces ensure that producers and consumers of goods and services integrate all costs and benefits of production and consumption into their decision making. Market prices are then established at levels that reflect all of these costs and benefits, and no government intervention is required to achieve an efficient allocation of resources in the economy.

In practice, perfect market conditions do not always hold. In some cases, the supplier does not bear all of the costs of production: other costs, called "negative externalities," are borne by other parts of society. Market prices then understate actual costs, and production and consumption levels are too high from the perspective of society. In other cases, producers or consumers may not capture all of the benefits of certain goods or services and "positive externalities" may accrue to other producers or consumers, or to future generations. Market prices are then above socially optimal levels, and production or consumption levels correspondingly are too low.

The presence of externalities, or other "market failures" such as lack of information in the hands of decision makers, generally underpins the case for government intervention. Under certain conditions, government may be able to correct for such market failures by implementing financial incentives or disincentives that establish improved price signals. Supply and demand may then respond in a manner that satisfies both private and broader public interests. If well designed, the intervention leverages the capacity of the marketplace to adjust, to innovate, and to minimize the cost of achieving defined public policy goals (see box below).

Economic instruments encompass a range of tools that have been used in specific circumstances, both in Canada and internationally, to advance environmental goals. Some of these tools are broad-based, affecting transactions across a range of products, technologies, or sectors of the economy. Others are more targeted. In addition to the tax system, the tools include tradable permits, grants and subsidies, and government procurement policy (see box below).

Against this background, the use of the tax system covers two key types of interventions:

• The imposition of specific taxes to ensure that environmental costs—the negative externalities—are factored into the price of goods produced and consumed, consistent with the "polluter-pays principle" (see box below). This may be advocated, for example to discourage the production and use of toxic substances that need not be banned altogether.

• The implementation of tax incentives to "price-in" positive externalities and to encourage the adoption by producers or consumers of more environment-friendly technology, goods or services.

There are limits to the judicious use of the tax system to advance economic growth and a sustainable environment. It is not sufficient that a market failure be identified. In some cases, there may not be a specific measure that could be implemented effectively to correct for the market failure. Further, government intervention has its costs. It may give rise to unintended and/or undesirable consequences. It may generate other economic distortions, or be unfair to certain producers or consumers.

It is important that all such considerations be factored into the analysis of environmental tax proposals. Where a clear goal is established, proposed tax measures must be assessed against a set of criteria that must also guide the evaluation of alternative forms of intervention—including regulation, spending, and other economic instruments.

Evaluating Environmental Tax Proposals

The basic role of the tax system is to raise revenue to fund government expenditures and to do so in a manner that is economically efficient, fair, and as simple as possible for compliance by taxpayers and administration by the government. The management of the tax system entails not only establishing the overall level of taxation in the economy, but also the structure of the tax system. This includes, for example, addressing how tax bases are defined, and how the tax burden will be shared among taxpayers.

Proposals for new environmental taxes may be assessed on a case-by-case basis, taking into account the following criteria.

Environmental effectiveness: whether, and to what extent, the proposal will contribute to achieving the environmental goal.

Fiscal impact: how the proposal will affect government expenditures or revenues.

Economic efficiency: how the proposal will affect the allocation of resources in the economy and Canada’s global competitiveness.

Fairness: how the impacts of the proposal are distributed across sectors of the economy, regions or groups within the population.

Simplicity: how governments will administer the proposal and how affected individuals or parties will comply—and at what cost.

Of course, there may be trade-offs among these different criteria that will require a decision, by government, on the relative weight to be applied to each criterion in making choices and establishing priorities.

Environmental Effectiveness

As a general proposition, an environmental tax measure will be effective if it induces a change in producer or consumer behaviour that achieves the environmental goal. This presupposes that two key conditions can be met.

• The environmental tax measure can be targeted effectively.

• It is likely to alter consumer or producer behaviour and generate an improved environmental outcome.

Effective targeting means that the measure can be designed to affect the transactions in the marketplace—and then, to the extent possible, only those transactions—that are germane to the pursuit of the environmental goal. For a tax measure, this requires that clear and objective parameters can be established in law to ensure that the tax incentive or disincentive will apply where it is most likely to make a difference.

In this regard, the tax system has some limitations. First, key parts of the tax system impact various segments of the marketplace differently. Specifically, income tax measures such as deductions or credits will generally affect only individuals or corporations that are, or may become, taxable. They will not affect entities like governments, Crown corporations, or non-profit organizations that do not pay income taxes. Similarly, corporations that do not have taxable income will tend to discount deductions or credits that have no immediate impact on their tax liability. Correspondingly, income tax measures may have a different value for different firms. This is in contrast to grants or subsidies that may be paid equally to all recipients. For example, whereas the Wind Production Power Incentive may be paid in the same amount to all producers, the value of accelerated capital cost allowance for the related capital investment will depend on whether the producer is in a taxable position today, or likely to be in the future. In contrast to income tax measures, excise tax measures (e.g. fuel excise tax relief for renewable fuels) may apply more evenly across market segments.

Second, the tax system is a relatively blunt instrument. The conditions of application of a tax measure are set in law, taxpayers are required to comply, and the Canada Revenue Agency administers the measure on that basis. As a general proposition, tax measures are not easily targeted to a very narrow segment of the market, or made to adapt to diverse circumstances or conditions. An expenditure program may be designed and administered in a manner that allows more discretionary application and narrow targeting to achieve a specific goal.

The effectiveness of an environmental tax measure depends on the sensitivity of demand and supply to changes in prices (see box for an illustration of this concept).

If a tax incentive is applied to a product for which demand is relatively insensitive to price changes, it will create "windfall" effects: the environmental benefit will be small and most of the fiscal cost will represent a transfer from taxpayers to purchasers of the subsidized product. In other words, a proposed tax measure that does not alter measurably the behaviour of producers or consumers will not be effective. An effective measure is one that will not simply reward good behaviour—although that may be considered appropriate in its own right—but one that will also induce a positive change in consumer or producer behaviour.

Fiscal Impact

Environmental tax measures will generally have an impact on tax revenues and the Government’s overall fiscal framework. For this reason, they must be assessed in the broader context of a commitment to balanced budgets, sound fiscal management and an efficient tax system.

A tax incentive represents foregone government revenue. In other words, it imposes a cost that, in a balanced budget context, must be offset by higher taxes, or reduced spending, elsewhere. The cost of a tax incentive may be difficult to estimate precisely because it depends on the degree of taxpayer take-up. This is in contrast to an expenditure program to which a defined amount of money may be allocated.

In comparing and ranking alternative proposals, it may be useful to evaluate the projected fiscal cost against the expected environmental benefits. For example, measures may be ranked by how many tonnes of greenhouse gas emissions reductions they produce per dollar of foregone tax revenue. Such comparisons may be carried out across tax and non-tax measures to help identify the most cost-effective environmental policy measures.

A tax disincentive may, alternatively, raise additional government revenue. This revenue will generally be deposited in the Government’s Consolidated Revenue Fund and be used to reduce other taxes, or to fund public spending.

Tax measures can be revenue neutral if they are structured in such a manner as to raise the level of tax paid by some taxpayers, while at the same time lowering the level of tax paid by others. Such an approach could be developed in respect of a set of measures that collectively would contribute to advancing environmental objectives while being neutral from a fiscal standpoint. While the result in terms of the total level of taxation could be neutral, it could be positive in terms of both environmental and economic efficiency outcomes (see "Economic Efficiency" below).

In some instances, there may be a case for directing some of the revenues of an environmental tax to a specific use—a concept generally referred to as "revenue earmarking." The rationale often cited by proponents of this approach is that the willingness of taxpayers to pay will be higher if there is a direct and transparent link between the incidence of the tax and the subsequent use of its proceeds (e.g. a tire tax to fund tire disposal costs).

From the Government’s perspective, however, in some circumstances earmarking may reduce fiscal flexibility and result in some programs being over-funded, and other priorities being under-funded.

Some proposed environmental tax measures—i.e. measures that affect the income tax base or the goods and services tax (GST) base—could have financial implications for provinces that share the same tax bases under agreements with the federal government.

In all cases, because of their fiscal dimension, proposals for federal environmental tax measures will generally be assessed in the broader context of developing fiscal priorities for the annual budget.

Economic Efficiency

Aside from the fiscal cost or revenue, economic costs or benefits of a tax measure must also be assessed and related to environmental benefits. There are three key considerations: internal efficiency, competitiveness, and adjustment costs.

A key thrust of a policy to integrate environmental and economic factors into decision making is to identify environmental solutions that also contribute to improved economic performance. Where market failures can be identified, a well-targeted tax measure may provide improved price signals, contribute to a more productive use of resources, stimulate technological innovation, and hence improve the efficiency of the economy. Careful analysis is required to assess the market failure and to determine whether a tax measure can properly deliver the intended adjustment to prices. This will inform how the tax measure may affect the allocation of resources in the economy and productivity. The benefits of correcting an environmental market failure, however, may not always be captured in economic performance, as conventionally measured. In these instances, the loss in measured economic output must be compared to the benefits of a better environment, evaluated more subjectively.

An important, related consideration is how environmental tax measures may affect the structure of the tax system. Within a revenue-neutral framework, tax incentives would be offset by higher taxes elsewhere. Conversely, environmental taxes that generate revenue would allow reductions in other taxes. Analysis shows that different taxes impose different costs on the economy.^[1] For example, taxes on consumption tend to impose lower economic costs than taxes on investment or saving. Correspondingly, environmental tax measures may generate added benefits or costs depending on whether their effect is to improve, or to lessen, the overall efficiency of the tax system.

Consideration must also be given to the impact—positive or negative—of a proposed measure on international competitiveness. This will include assessing the effect on both the overall level of taxation and the incidence of taxes on those sectors of the economy engaged in competition, at home or abroad.

By changing the behaviour of economic agents, tax measures will cause adjustments in the marketplace that may entail some costs. For example, tax measures that would reduce demand for a particular good will affect the producers of that good. The producers may respond by investing in new technology, or alternatively, by lowering production or shutting down their facilities. It is important that such scenarios be reviewed and that corresponding economic or social costs be identified.

Fairness

The fairness of a proposed tax measure relates to the distribution of the burden of the tax, or of the benefit of the tax incentive.

Generally speaking, it is considered fair that polluters pay a tax, and that firms and consumers willing to adopt environment-friendly behaviour benefit from a tax incentive. Nonetheless, the application of tax measures may, in some circumstances, be perceived to affect or benefit disproportionately particular individuals, regions, or sectors of the economy. The assessment of distributional impacts is an important part of the evaluation that poses particular difficulties as it may bring trade-offs into play.

Simplicity

Tax measures will work best if they are relatively simple and can be easily understood by affected taxpayers.

Compared with spending programs or regulation, tax measures will tend to work best where the intention is to leave more of the decision making and responsiveness in the hands of producers and consumers. Through the use of a tax measure, the Government affects a price or another economic parameter, and it lets economic agents respond accordingly. In the best of cases, this minimizes bureaucratic involvement and promotes flexible, cost-effective responses by taxpayers.

However, if the targeting of the measure or its adjustment over time requires a complex set of rules, this benefit may be lost and the tax system—its design, administration and compliance—may become unwieldy. Costs for the Government to administer and monitor, and taxpayers to comply with a measure, may become prohibitive.

Summary

The pursuit of a productive, growing and sustainable economy requires that both environmental and economic considerations be integrated into decision making.

In this context, the case for government intervention in pursuit of environmental goals is founded in large measure on the need and opportunity to correct market failures. Where market failures exist, well-designed government intervention can foster a more rational use of resources and enhance both environmental and economic outcomes.

The Government has a range of policy instruments at its disposal. Important among these are economic instruments—including tax measures—that aim to leverage the capacity of the marketplace to respond to price signals, to innovate, and to contribute to the achievement of policy goals at the lowest cost.

Environmental tax proposals may be evaluated against five criteria: environmental effectiveness, fiscal impact, economic efficiency, fairness, and simplicity. With the benefit of a detailed evaluation, a tax measure may be shown, in some circumstances, to be the most appropriate policy instrument for addressing an environmental problem. In others, it may not be the instrument of choice.

For any environmental goal, it is important that consideration be given to all of the available policy instruments and that solutions be identified that produce the best results for the environment, at the lowest cost for taxpayers and the economy, and in the fairest and simplest manner. Sound fiscal management and the pursuit of an efficient tax structure will require that consideration be given to both tax incentives and tax disincentives.

Opportunities to use the tax system to advance environmental goals will continue to be actively considered. For this purpose, it will be necessary to engage stakeholders, non-governmental organizations and interested Canadians on the best means to promote sustainable growth. The framework set out in this annex is intended to facilitate this dialogue and to foster a shared understanding of policy considerations that may be taken into account as proposals are developed, assessed and implemented.

¹ "Taxation and Economic Efficiency: Results From a General Equilibrium Model," Tax Expenditures and Evaluations, Department of Finance, 2004.[Return]

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