4 Overcoming The Barriers To Economic Instruments

Canada's limited use of economic instruments is the result of numerous factors. While some of these factors may be specific to Canada, many are common to all jurisdictions, and the experiences elsewhere may highlight opportunities for Canada to overcome these barriers.

Lack of Awareness

The relatively successful and widespread use of economic instruments in Europe has resulted in part from intensive consultation and awareness raising efforts focused on politicians, affected industries and, in some cases, the public. Many barriers to the use of economic instruments in Canada and elsewhere relate to lack of awareness and institutional inertia. Despite growing awareness among environmental policy experts, efforts to promote greater use of economic instruments must overcome the general lack of knowledge of these measures. More generally, stakeholders such as trade associations, NGOs, legislators and government agency officials may prefer to deal with policy instruments with which they are familiar.

European efforts to overcome these barriers have included ongoing initiatives by academics, environmental agencies and various NGOs to raise awareness about the overall importance of correcting the distortionary market signals that are associated with unpriced environmental impacts. In addition, the literature reviewing specific successful economic instruments consistently emphasizes the importance of focused awareness-raising efforts to ensure support for the particular instrument. To date, Canadian governments have not devoted similar efforts to promoting public awareness of the importance of market-based instruments. While it must be recognized that most European countries probably started from a context characterized by a lower ideological aversion to taxes than is the case in Canada, it is likely that awareness raising efforts could play a similarly valuable role in enhancing public and stakeholder support for economic instruments in Canada.

Resistance to "New Taxes"

One of the main barriers to the introduction of economic instruments in Canada has been opposition to any "new taxes." The European experience highlights various options for addressing this concern. It is particularly important, for example, to ensure that any new economic instrument has a clearly defined and well-understood environmental objective. Another approach has been to introduce environmental taxes in stages and to incorporate temporary relief packages. This can both help reduce the immediate effect of the tax and enhance corporate planning certainty. In a related vein, in implementing its energy tax package, the Danish government made a commitment to industry to undertake an ex post evaluation of the tax and to make adjustments if necessary.

European countries are also increasingly relying on revenue-neutral measures to allay concerns that an economic instrument represents a new tax. Although tax shifting (using revenue from environmental taxes to reduce taxation on investment or employment) represents one possible way to ensure revenue neutrality, in many cases an environmental tax may be too modest in scope to offset other taxes significantly. As a result, European countries are increasingly utilizing feebates to overcome anti-tax resistance and to overcome concerns about competitiveness impacts.¹⁴

One of the key barriers to the design of revenue-neutral economic instruments has been the tendency of departments of finance to oppose the earmarking of tax revenue on the grounds that it may not be the most efficient use of the money. Over the past decade, however, earmarking has been used more often in Europe, and the European experience suggests that earmarking can help overcome resistance to fee-based measures. Most consumers appear readier to pay a tax or a fee whose proceeds will fund an identified environmental program rather than general government operations. The growing experience with feebates also indicates that carefully structured measures to refund tax or fee revenues back to companies that undertake environmental improvements can actually enhance the overall impact of the program, as well as make the tax more politically tractable.

Competitiveness Concerns

One of the major concerns raised by the imposition of green taxes is their effect on the competitiveness of exporting industries. This concern is particularly significant for an open economy such as Canada's where several sectors are substantially integrated with the American economy. For some issues, these considerations tend to make Canada a policy-taker rather than a policy-maker. It is very important, however, to assess the potential competitiveness impacts of environmental taxes and other economic instruments in comparison to alternative policy instruments designed to achieve the same environmental objective. In many cases, economic instruments will offer the most efficient means of achieving a goal.¹⁵ In addition, recent work by Environment Canada and others suggests that there are probably opportunities for Canada to seek to "converge" with U.S. performance levels while using more efficient policy measures – such as economic instruments – that reduce Canadian compliance costs, thereby creating a comparative advantage.¹⁶

In general, European commentators emphasize the importance of pragmatic design in order to overcome concerns about competitiveness impacts or adverse distributional effects. Competitiveness concerns can be addressed in various ways, including by exempting exporters from green taxes, lowering the taxes for specific sectors, providing border tax adjustments, recycling tax revenues back to the payers through the use of feebates or by emphasizing consumer taxes over production taxes (see Text Box 3).¹⁷ Although economic theory suggests that exemptions and rebates will undermine the economic efficiency of a tax, such measures may be essential to overcome concerns about impacts on competitiveness or on local employment. Each of the many European countries that now has a CO₂ tax, for example, has had to compromise economic efficiency by protecting energy-intensive sectors. While exceptions for politically-influential sectors may increase a green tax's acceptability, they reduce its environmental benefits, particularly any needed structural changes. Nonetheless, such exemptions are probably "inevitable" (Schlegelmich, 2000). Two Swiss economists argue that "the trade-off between efficiency and political feasibility is fundamental and cannot be overcome" (Felder, Schleiniger, 2002).

The Need For Supportive Constituencies

The fact that economic instruments remain relatively little used despite the fact that the idea itself is over 75 years old,¹⁸ illustrates the particular importance of creating constituencies for their use. Despite a significant opening-up of policy making in Canada and elsewhere, the processes by which budget and fiscal policies are developed tend to reflect outcomes of brokerage politics in which long-term environmental sustainability interests are consistently under-represented. Overcoming this resistance can require the creation of constituencies that explicitly support the use of economic instruments. In many countries attitudes towards economic instruments have been influenced by explicitly political processes. Thus, for example, several European countries have introduced a commitment to ecological fiscal reform as a result of elections, either because a coalition government included a Green Party that made EFR a condition of its support (e.g., Germany, Belgium) or because a new government was looking for additional revenues to offset promised cuts in personal income taxes (e.g., Sweden) or in the case of the U.K., order to meet climate change emissions reduction targets to which the Prime Minister had made a strong public commitment.

To date, the absence of strong supporters of economic instruments in Canada, together with the over-riding "no new tax" sentiment, have militated against many possible measures. That situation may be changing with the emergence of various vocal proponents of economic instruments and EFR. Until recently, environmental NGOs have tended to oppose the use of economic instruments. Part of that opposition reflects concerns that the environmental impact of some economic instruments may be less certain than would be the case with a performance-based regulation. Some NGOs also worry that economic instruments symbolically represent a "license to pollute." This opposition appears to be diminishing, and many NGOs now appear willing to support economic instruments so long as they are designed appropriately. The International Institute for Sustainable Development and the Pembina Institute for Appropriate Development strongly support EFR. Older, more traditional NGOs such as Ducks Unlimited and the Canadian Nature Federation support specific initiatives, such as tax incentives for the preservation of endangered species habitat. Over the past three years, the Green Budget Coalition has evolved from a loose coalition of NGOs lobbying for a range of spending and fiscal policy reforms to a coherent umbrella organization representing most of Canada's major environmental NGOs in a campaign for ecological fiscal reform.

There is also growing support for the general principle that fiscal policy should shift the current emphasis away from the taxation of income and investment and towards consumption. While not addressing the issue from an environmental perspective, the Canadian Council of Chief Executives recently argued for just such a shift in taxation from income to consumption. In its October 2003, submission to the Standing Committee on Finance, Managing For Growth: Fiscal Prudence, Competitive Taxation and Smarter Spending, the Council argued that:

The general principle of smart taxation is that you should tax what you don't want, not what you do. While one goal of tax policy is to redistribute income fairly within the country, it is at least as important to shape tax policy in ways that stimulate the growth of employment and incomes. The economic evidence suggests that one way to do this without reducing net government revenues by a penny, is to shift the mix of taxes, putting relatively less of the burden on incomes and investment and relatively more on current consumption. (p.7)

Interestingly, the 2003 Report to Congress from the U.S. Council of Economic Advisors contains similar recommendations to move towards consumption taxes. The challenge for proponents of EFR will be to garner support for including environmental impacts within the basket of "consumption."

Lack of Experience

Both the European and the U.S. experience points to the value of overcoming opposition to economic instruments through the incremental accumulation of experience. In part, the increased use of economic instruments in the U.S. reflects an overall trend towards the use of market-based measures to address a wide range of social policies (deregulation of airlines, telecoms, trucking, etc.). American interest in economic instruments also may have increased as the compliance costs associated with command and control have risen with expanded regulatory coverage. In addition, however, Stavins (2003) and other commentators argue that much of the current support for economic instruments in the U.S. stems from the simple fact that some of the initial American economic instruments were successful. Importantly, some of the early American economic instruments – such as SO₂ trading, the CFC phaseout, and the leaded gasoline trading program – focused on previously unregulated issues. As a result: a) the proponents of economic instruments faced less inertia than might have been the case with an effort to improve the management of an issue that was already the subject of regulation; and b) the new measures succeeded in reducing emissions, not just in reallocating and reducing the costs of compliance. In short, early successes in a small number of issues paved the way for subsequent widespread application and innovation.

This lesson is particularly apt for Canada. Canada's circumspect approach to the use of economic instruments for environmental protection and conservation appears to be largely the result of a vicious circle, in which our lack of experience feeds an ongoing reluctance to depart from more traditional regulatory approaches. As a result, for example, individual risk managers do not routinely consider economic instruments as options for addressing specific issues. Overcoming this barrier will require political willingness to act, together with a considerable effort to enhance trust in this important set of instruments by publicizing the benefits and lessons learned from successes elsewhere and from Canadian experience as it evolves.

Canadian-Specific Barriers

Some of the barriers that are said to impede the use of economic instruments in Canada in reality may not represent greater challenges for economic instruments than for any other environmental protection measure. It has been argued, for example, that their use would require considerable federal-provincial negotiations. The need for this type of coordination is not unique to economic instruments, however. The shared federal-provincial jurisdiction over environmental management requires considerable coordination and agreement between levels of government for the management of most environmental issues (e.g., the management of hazardous waste; air emissions from electric power generators; or the conduct of environmental assessments).

It can also be observed that Canada's geographic, cultural and economic diversity makes it challenging to design "one size fits all" economic instruments. While these factors may be relevant on a case-by-case basis, they do not militate against the use of economic instruments in general. It is probably true that in some cases taxes on production will have different regional impacts, depending on such factors as the location of the sector being addressed or the type of energy (coal, oil, nuclear, hydro, etc.) utilized. In some cases, the Canadian market also may be too small to support trading programs that are not linked to American programs. Nonetheless, the effective use of economic instruments in countries with regionally diverse economies such as Germany or in economies much smaller than Canada's (Belgium, Sweden, etc.) suggest that there is considerable potential for the innovative and effective use of economic instruments in Canada.

¹⁴ Feebates combine a tax or fee on an environmentally undesirable activity such as emissions with a program to refund some of the fees to parties that undertake specified activities (such as investing in energy efficiency or pollution prevention planning) or to support capacity development related to the issue being addressed.

¹⁵ For an extended discussion of the potential competitiveness impacts of economic instruments compared to other instruments, see: OECD, 2003. Environmental Taxes and Competitiveness: an overview of issues policy options and research needs, http://www.olis.oecd.org/olis/2001doc.nsf/LinkTo/com-env-epoc-daffe-cfa(2001)90-final.

¹⁶ The prospects for economic gains through a strategy of convergence are explored more fully in Environment Canada, February 2003, Convergence Analytical Framework For Evaluating Canada/U.S. Environmental Performance.

¹⁷ The OECD has an ongoing program addressing options for overcoming potential competitiveness concerns related to environmental taxes. See, for example: OECD, 2001. Environmentally Related Taxes in OECD Countries, Issues and Strategies, and OECD, 2003. Environmental Taxes and Competitiveness: an overview of issues policy options and research needs, http://www.olis.oecd.org/olis/2001doc.nsf/LinkTo/com-env-epoc-daffe-cfa(2001)90-final.

¹⁸ Some of the original texts on economic instrument theory include:

• Pigou, A., 1920. The Economics of Welfare (on environmental taxes);
• Dales, J. H. (1968). Pollution, Property and Prices. U. of Toronto Press (on tradeable permits);
• Coase, R., 1960. "The Problem of Social Cost," Journal of Law and Economics, 3, October (on property rights).