Appendix A: Types Of Economic Instruments

The following typology describes example applications of some of the more common types of economic instruments, demonstrating the wide range of ways in which government can utilize market forces to promote a desired change. Figure A summarizes these categories and provides examples.

Figure A: Examples of Economic Instruments

Property Rights¹

Various types of property rights mechanisms are used to promote responsible resource management. The premise is that providing exclusive property or use rights will internalize the costs and benefits of resource depletion to the owner or user, whereas under open access regimes the costs of resource depletion are largely external to the user. By internalizing these consequences, owners will not deplete their resource unless the price of the resource commodity covers not only the extraction cost but also the depletion cost, which is the foregone future benefit as a result of present use.

Property rights are not suitable instruments for managing the environmental externalities associated with the use of a resource. Instead, they are primarily applicable to promoting the responsible management of land and soils (land rights), water resources (water rights), minerals (mining rights), and other natural resources that can be parceled out and enclosed or whose boundaries can be easily demarcated and defended. Property rights are less applicable to situations where the resource moves across boundaries (e.g., marine fisheries), when the quality of the resource is affected by the actions of others (as when a fishery is affected by upstream agricultural run-off).

Property rights are of three main types: ownership rights, such as land titles and water rights; use rights, such as licenses, concession bidding, usufruct certificates, and access rights (e.g., to roads, parks, etc.); and development rights. All three types can be restricted to account for environmental (and other) objectives by regulations or economic instruments such as differential land use taxes, development charges or impact fees. One form of attenuation of property rights involves separating development rights from ownership rights through transferable development rights (TDRs). Under TDRs, all or certain types of development are prohibited on designated sites, but property owners are allowed to transfer or sell their development rights to other sites, thereby recovering their full market value. Demand for such rights is ensured by allowing extra development (beyond building or zoning regulations) to the holders of transferred development rights. TDRs have been used extensively in the conservation of historical buildings, archeological sites, cultural heritage, wetlands and coastal areas, and to a more limited extent for the conservation of greenbelts, forests, and biodiversity.

Fees, Charges and Taxes

Fees, charges and taxes all require payments of specified amounts. They create an explicit cost associated with environmentally damaging activities and an easily quantifiable incentive for reducing the activity. A major disadvantage is that, on their own, these measures do not guarantee the amount by which a source or group of sources will reduce the undesirable activity. Another problem is that political considerations may preclude imposing fees that are high enough to have a significant impact.

There are numerous types of environmental tax instruments:

• Pollution, effluent and emission taxes involve payments directly related to emissions into air, water or soil. Although they are primarily suitable for stationary sources because of their high monitoring and administrative costs, pollution-related fees, charges and taxes are widely collected by all levels of government throughout the world for issues such as air pollution, water pollution, household solid waste and hazardous waste.
• Product charges, including sales and value added taxes, export charges, consumption taxes, import tariffs, input taxes and production taxes. These may be substituted for emission taxes when direct measurement of emissions is not possible. They can also be used to correct externalities other than emissions. They can be levied per unit of the harmful substance (as in a carbon tax) or per unit of the product, where the objective is to reduce use of the product generally. They can be applied to raw materials, intermediate products and final products.
• Insurance premium taxes are a form of environmental user charge and provide funding for environmentally related services. For example, the U.S. Superfund program imposes an excise tax on specified hazardous chemicals to help fund the clean-up of hazardous waste sites.
• User charges, including access fees, grazing fees, utility (water and electricity) charges, road tolls, and administrative charges, are payments related to services delivered by the government, or for access to a publicly-owned property or resource. These charges can be considered environmental tax instruments if the service they fund seeks to improve the quality of the environment or reduce the use of natural resources. Although fees can generate substantial revenues for governments, they tend to be set at rates too low to have a significant impact on pollution. Indeed, in cases such as CEPA, 1999, fees may be limited to administrative cost-recovery levels, rather than aiming at changing behaviour.
• Tax differentiation relates to variations in indirect taxes, such as excise duties, sales taxes or value-added taxes, for environmental ends. Goods and services whose production and consumption is associated with more environmental damage may be taxed at higher levels (e.g., European excise tax rates on petroleum versus diesel).
• Tax relief encourages specified behaviour, either by consumers of businesses. The most common forms of tax relief are accelerated depreciation and investment tax credits.

Deposit Refunds

These are forms of refundable charge systems that shift the responsibility for avoiding environmental damage to individual producers or consumers. Deposit-refund schemes require consumers to pay a surcharge when purchasing potentially polluting products. A partial or complete refund encourages consumers to return the end-of-life product for re-use or recycling or appropriate disposal.

Liability Rules and Bonds

Liability rules for natural resource damage, environmental damage, property damage or damage to human health or loss of life can provide strong incentives for businesses and other actors to consider the potential environmental implications of their decisions. Because liability regimes rely on the threat of litigation, they are associated with high transaction costs and therefore are used primarily only for acute hazards. Germany, Belgium, France, the Netherlands and the Nordic countries all enforce strict liability for various polluting activities (OECD, 1995, 1996, 1997a, 1997b, 1998). In the U.S., the Comprehensive Environmental Response, Compensation and Liability Act of 1980 established retroactive liability for companies found responsible for a site requiring clean up. Similarly, the Oil Pollution Act and the Clean Water Act make polluters responsible for cleanup costs, and other damages from spills. The Canadian Environmental Protection Act, 1999 contains similar provisions regarding liability for damages caused by environmental emergencies.

Bonds – including environmental performance bonds, land reclamation bonds, waste delivery bonds and environmental accident bonds – can be designed to ensure that resource extracting companies and potential polluters take adequate measures to prevent or minimize environmental damage and clean-up and restore residual damage.

Tradeable permits

There are two main types of tradeable permit systems. Cap-and-trade systems and (uncapped) credit systems, Cap-and-trade systems provide a mechanism for minimizing the overall costs associated with meeting a regulatory cap on emissions. Allowances for future emissions are sold or granted to existing sources. Uncapped tradeable credit systems do not impose a ceiling, and total emissions can increase as existing sources increase production and as new sources enter the market. In uncapped systems, credits are earned for controlling pollution beyond a baseline specified in one's permit.

Both types of tradeable permit systems are becoming increasingly popular in the U.S. At the federal level, they have been used for nation-wide issues such as the CFC trading, the lead gasoline phasedown, the Acid Rain Trading Program and CAFE standards for fuel efficiency. At the state level, examples include Southern California's RECLAIM program, Colorado's wood burning appliance program (under which existing appliances received a permit and new appliances must retire two existing permits) and Spokane County's program for trading the rights to burn dry grass. The tradeable permit approach has also been extended into resource management with programs related to tradeable catch quotas, tradeable water or resource shares and transferable development rights (see the discussion of TDRs in Property Rights, above).

According to a recent EPA review (NCEE, 2001), trading programs have certain features that have made them increasingly popular in the United States. In a trading program, capital moves between companies involved in trades, and innovative, entrepreneurial companies can profit from low-cost reductions in emissions. In addition, cap-and-trade programs can provide great certainty about the magnitude of environmental improvement that will be achieved. At the same time, trading programs may have several drawbacks, including the potential for high transaction costs (associated with the need to verify each reduction before authorizing a trade) and inactive markets, especially in credit or open-market systems.

Subsidies

All levels of government throughout the world utilize a wide range of subsidies to promote environmental protection. Examples include grants, low-interest loans, revolving funds, location/relocation incentives, favorable tax treatment, and preferential procurement policies for products believed to pose relatively low environmental risks. Subsidies are used to support the development of new technologies and techniques, pollution prevention and control activities, the cleanup of contaminated industrial sites, farming and land preservation, consumer product waste management and municipal wastewater treatment. Subsidies for environmental management can be criticized because the government providing the subsidy – and the taxpayer, ultimately – is helping to bear the costs that should be the responsibility of the polluter.

¹ Panoyotou (1994) provides an excellent description of property rights.

Appendix B: Experiences With Ecological Fiscal Reform

B.1     Background

During the 1990s, the debate over using economic instruments for environmental ends broadened into a discussion of ecological tax or fiscal reform (EFR), or tax shifting. EFR involves not just taxing "bads" but also reducing or eliminating environmentally-perverse subsidies. It also involves using the revenues from green taxes to reduce taxes on socially-desirable activities (e.g., labour, savings) or to encourage environmentally-desirable technologies (e.g., renewable energy).

Well over three quarters of environmental taxes in OECD countries target motor vehicles and energy use.²² EFR to date has thus largely been an attempt to encourage increased energy efficiency and reduce air emissions. This suggests both that most countries have not fully explored the potential for EFR and that the lessons available to Canada from international experience in non-energy related green taxes are limited.

Most of the extensive literature on green taxes and EFR reviews methodological issues such as design considerations, the mitigation of undesirable impacts and the analysis of effectiveness. This section, on the other hand, focuses on the process of EFR. At its core, the introduction of green taxes or EFR is a political process whose success will depend at least as much on leadership, timing and aggressive marketing as on design.

Over the last decade, several OECD countries (Belgium, Denmark, Finland, Iceland, Italy, Japan, the Netherlands, Norway and Sweden) have constituted "green tax commissions" to examine the opportunities for, and implications of, introducing environmentally-related taxes and charges. These commissions have varied in their mandate and composition (some have been multistakeholders (Norway) while others (e.g., Finland) have involved only government officials), and their success has been mixed. In addition, other countries (e.g., Italy²³ and Germany) have engaged in various aspects of EFR through direct executive and legislative action, without resorting to green tax commissions. Although the European and U.S. experience has been diverse, observers and participants have drawn several common lessons concerning the successful introduction of EFR, and this experience therefore offers interesting lessons for Canada.

B.2     Experience With EFR In Europe

In general, European countries have embraced a broad concept of EFR that includes some tax shifting while the United States has tended to focus on instrument choice to meet specific environmental problems. The process considerations around tax shifting and instrument design are different and Europe, not surprisingly, has had more experience with public consultation around EFR than the U.S. The capsules below illustrate how four European countries have introduced EFR.

Germany

German academics and NGOs were among the first in the world to introduce and popularise the concepts of tax shifting in the early and mid 1990s. The actual introduction of EFR was an explicitly political process that was negotiated as part of the Green Party's price for adhering to the ruling coalition agreement after the 1998 election.²⁴ The goals of German EFR are: i) to improve energy efficiency (and reduce GHG emissions) by making most forms of energy more expensive, and ii) to increase employment by reducing the social costs of labour.²⁵ More specifically, EFR is to accelerate structural changes in the economy, encourage investment in energy efficiency and support the introduction of environmentally-benign production processes.

In Germany, EFR has taken the form of gradually-increasing energy taxes, with exemptions to attenuate adverse competitiveness impacts on industry (including agriculture and forestry). Germany has combined increased energy taxes with tax incentives for the use of renewable energy, energy efficiency and public transit and has also used increased energy revenues to reduce social security contributions.

The German Parliament passed two laws on EFR in 1999. The second, the Law on Continuing Ecological Tax Reform stipulates energy tax increases and cuts in pension insurance premiums over a four-year period in order to provide a stable planning environment.²⁶ Between 1970 and 1997, labour taxes in Germany increased from 54% to 66% and environmental taxes declined from 7% of government revenues to 5%. The effect of EFR in Germany will be to reverse these trends: over five years, Germany anticipates shifting 2% of its tax revenue through EFR, a significant but not radical change.

The Netherlands

The Netherlands did not explicitly start out down the path of green tax reform. Nevertheless, over 30 years, the gradual introduction of several green taxes – along with corrective action to address problems that arose – have both legitimised the use of taxation policy to further environmental goals and established environmental taxes as an important source of government revenue²⁷ (Netherlands Green Tax Commission, 2001).

The first Green Tax Commission, established in 1995, recommended that the tax system combine a modest negative incentive with a significant positive incentive to change behaviour in environmentally-desirable ways. The idea that polluters should help pay the costs of environmental investments proved politically attractive and helped build public acceptance for these proposals. High unemployment in the mid-90s convinced successive governments to shift part of the tax burden to energy and away from labour, broadening the consideration of green taxes as an instrument of environmental policy to a social policy instrument. In 1997, the third report of the Green Tax Commission led to the publication of a government White Paper (Taxes in the 21^st Century) outlining options for major tax reform. The most important element of the package was increased energy taxes for households, combined with a cut in income tax, and incentives for energy-efficient investments. In addition, the Commission made a number of recommendations to differentiate the tax treatment of environmentally-harmful and benign behaviours.

In 2000, the Netherlands established a second Green Tax Commission to review the experience of EFR up to then and to identify remaining environmentally-harmful subsidies and possible new measures for EFR. As in the first Commission, the membership of the second Commission included both government officials and representatives from research institutions, NGOs and the private sector. The Commission reported to five ministers (Finance, Environment, Transport, Agriculture and Economic Affairs). Each member of the Commission was able to put forward proposals for discussion. These generally fell in one of the following four categories:

• Extending existing taxes to new groups;
• Increasing the positive environmental impact of existing taxes;
• Introducing new taxes;
• Providing financial inducements to change producer or consumer behaviour.

The Commission reached a largely consensual report on measures that deserved to be implemented, measures that should be rejected and measures for which insufficient information existed on which to reach a judgement. It was divided on whether to extend the Regulatory Energy Tax to major industrial users. The government asked the Commission to report in mid-2001 so that its findings could influence the preparation of the party platforms being prepared for the 2002 elections.

Denmark

Of all OECD countries, Denmark has most explicitly shifted its tax burden from income to green taxes. Even so, this shift has been marginal: between 1994 and 2000, income tax revenues fell by about 1 percent of GDP (to under 26%) while green tax revenues increased by slightly less than one percent (to 5% of GDP). Denmark has used the proceeds from higher energy taxes to reduce employers' contributions to social security and pensions and to subsidize investments in energy efficiency technology. While Danish green taxes cover a wide range of products, the revenues they generate derive overwhelmingly from energy products.

When the Danish Parliament adopted the "Energy package" in 1995, it did so with the proviso that the new legislation would be evaluated in 1998. This undertaking helped to increase the political acceptability of the measures (which increased CO₂ taxes and extended energy taxes to more sectors).

United Kingdom

In 1997, the U.K. government issued a "statement of intent" on environmental taxation. In 1998, the Chancellor of the Exchequer appointed a Task Force of four officials from concerned government departments, led by Lord Marshall, on how best to use economic instruments to improve energy use and reduce greenhouse gas emissions. Before issuing its final report in November 1998, the Task Force prepared a consultation document to which 143 organisations and individuals responded (Marshall, 1998). In 1999, the government announced that it would impose a climate change levy on energy use by businesses starting in 2001. The revenues raised will be recycled in part by reducing employers' National Insurance Contributions and by investing in renewable energy and energy efficiency technologies. In addition, the government has negotiated energy and emissions agreements with various industry sectors offering discounts on the levy to companies that meet negotiated reduction targets.

The U.K. government built acceptance for its proposed tax on industry and business use of energy by:

• Establishing clear environmental objectives to which the government is publicly committed;
• Iterative negotiation of the tax package;
• Introducing the tax as part of a mix of policy instruments;
• Including an element of hypothecation to help taxpayers reduce energy consumption and therefore liability to the new tax; and
• Further recycling revenues by cutting employers' social security contributions.

Like many public policy measures, the introduction of EFR in Europe has not been without controversy. In 2000, faced with fierce opposition from hauliers and a hike in fuel prices, the U.K. government abandoned its proposed "road fuel duty escalator" which would have raised the fuel excise duty by 6% annually. For its part, the Italian government has postponed ecological tax reforms, partly as a result of increasing world oil prices since 1999. A major restructuring of environmentally-related taxes and charges approved by the French Parliament in 1999 was subsequently ruled unconstitutional.²⁸ And in a referendum in September 2000, the Swiss electorate rejected two proposals for green tax reform.

B.3     U.S. Experience With EFR

Although the U.S. leads the world in its use of various types of trading regimes and uses a wide range of environmental taxes and fees, its experience with tax-shifting EFR is very limited. American environmental policy makes quite extensive use of pollution charges, fees and taxes at both the federal and state levels. A 1998 survey found that environmentally motivated tax provisions were virtually unknown in the US at the state level in 1970, but were widespread by the mid 1990s (Hoerner, 1998). The survey identified 462 provisions in place as of 1996, with only five states having fewer than five such provisions. A 2001 review by the U.S. EPA's National Center for Environmental Economics described numerous types of charges, fees and taxes, including: indirect discharge and user fees for water, direct discharge water fees, state effluent permitting fees, stormwater run-off fees, air emission permit fees, ozone non-attainment area fees, variable pricing for solid waste disposal, landfill taxes, hazardous waste taxes, and product charges levied at both the federal and state levels. Although some charges, especially product charges, have been imposed at the federal level, most have been introduced at the state or local level. In the case of air and water pollution, the federal government has provided policy guidance on charges, but the states have developed and implemented a wide variety of charges as they have seen fit.

Few of these are classified as "taxes". Under federal law, a tax is a purely revenue-raising instrument, whereas charges or fees are intended to offset costs to the government. Thus, tax receipts become part of general revenues. While many charges and fees that are collected must be placed in the Treasury General Fund, some are retained to supplement environmental agency budgets. The most common environmental taxes are product taxes, such as the federal gas-guzzler and CFC taxes and state taxes on fertilizers. Although lower than European levels, the U.S. also imposes gas taxes. Most U.S. environmental taxes are designed primarily to raise revenue. As a result, few are set at high enough levels to take into account the full costs of environmental damage or to change behaviour significantly (Pembina Institute, 2000; Hamond et al, 1997; National Center for Environmental Economics, 2001).

As in Canada, there has been considerable focus on eliminating economically inefficient subsidies from the federal budget over the past decade. Whereas in Canada there has been little attention paid to the environmental dimensions of the subsidy elimination agenda, the Green Scissors Coalition – a group of environmental, taxpayer and consumer groups – has focused some of the U.S. reforms on the elimination of programs that are both economically and environmentally inefficient. Since 1995, the Coalition has claimed credit for eliminating $28 billion in federal subsidies, and its 2003 program has identified a further $58 billion in subsidies that pollute natural resources and threaten human health.²⁹

Despite the widespread use of fees and taxes, and despite some academic and NGO support for more fundamental EFR, there has been very little attention paid in the U.S. either to the type of revenue-neutral feebates that are emerging in Europe or to the kind of tax shifting which some other countries are undertaking. A handful of such initiatives have been proposed at both the state and federal levels over the past ten years, but no significant measure has received political support. Former President Clinton's proposed BTU tax was intended to combine deficit reduction and energy efficiency objectives, but failed to receive the support of House or the Senate due to strong industry opposition and the general anti-tax political climate. His Climate Change Technology Initiative combined tax credits and direct spending to promote energy efficient and alternative technologies. Although implemented, the initiative was scaled down considerably due to concerns that it could be perceived as support for the Kyoto Accord and opposition to "greenpork" replacing other forms of subsidies.

The most ambitious attempts to introduce EFR in the US to date occurred in the mid to late 1990s in Minnesota where an NGO, Minnesotans for an Energy Efficiency Economy (ME3), worked closely with various state legislators to promote a series of revenue-neutral tax initiatives, combining new carbon taxes with reductions in property taxes. Despite backing by various politicians and fairly strong public support, none of the ME3 initiatives were passed. Proponents were unable to overcome doubts that the measure would be truly revenue neutral. More importantly, few industries that stood to benefit from the initiative (health services, retail, insurance, etc.) mobilized to support the initiative, whereas there was concerted opposition from those industries that could have been adversely affected (Noble, 1999).

In 1999 and 2000 the State Legislatures in Oregon and Vermont narrowly defeated proposals to establish commissions to review tax-shifting options. The Oregon Environmental Tax Study Commission (Bill HB 2473) proposed the creation of a commission to develop proposals for "implementing environmental taxes that shift the tax burden in the state toward undesirable activities while reducing taxes on activities contributing to the environmental health of the State of Oregon." The creation of the Commission was recommended by the 1999 report of the Governor-appointed Tax Review Policy Committee.³⁰ The Bill was defeated when the Ways and Means Committee refused to allocate the $200,000 budget for the Committee. A similar proposal in Vermont (Bill H.0477) would have established a committee "to study tax shifting options that support a strong economy while encouraging efficient use of natural resources."  The Bill also proposed a surcharge on gas-guzzlers and a tax rebate on fuel-efficient vehicles. Opposition to the fuel efficiency components of the Bill was strong, and the Legislative Council defeated a resolution proposing the study on tax shifting was defeated by one vote 1999.

A recent review of the U.S. experience suggests that the main lesson to be learned from U.S. experience is the need to proceed incrementally in order to develop a critical mass or credibility and trust in EFR (Pembina Institute, 2000). Despite the fairly extensive use of charges and taxes and the progress being made on tax shifting in Europe, considerable scepticism and anxiety continues to surround any proposed significant tax-based initiative. Collaborative efforts designed to demonstrate incremental progress towards allaying specific concerns such as distributional and competitiveness impacts appear to be required to ensure the support for most new EFR-type measures.

The prospects for significant EFR in the U.S. appear to be quite low in the short-term, particularly at the federal level. New taxation would run against the ideological grain of the current federal Administration, which has introduced two consecutive large tax cuts. In the medium term, however, it is conceivable that the need to address the growing deficit in the U.S. will create a political climate that is more conducive to new taxes in general, and to EFR in particular.

B.4     Canadian Experience With EFR

Although, unlike certain European countries, Canada has not had a green tax commission, it has created similar multi-stakeholder processes both at the federal and provincial levels:

• In 1994, the federal government created the Task Force on Incentives and Disincentives to Environmentally-Sound Practices. The Task Force brought together 32 members from industry, NGOs and universities, co-chaired by senior officials from Environment Canada and Finance Canada. Established in order to fulfill one of the promises in the Liberal Red Book, the Task Force was asked to identify one or more market-based instruments and barriers to sound environmental practice for consideration in the federal budget process.
• The National Round Table on the Environment and the Economy has provided regular advice to the federal government on green taxes and, more recently, on ecological fiscal reform (see, e.g., NRTEE, 2002).³¹
• Ontario created a Fair Tax Commission in the early 1990s that, in turn, set up a working group on environment and taxation. The working group included 14 participants drawn largely from environmental groups, labour unions and universities. The working group issued 2 reports in 1992 making a number of recommendations on the principles and criteria for applying green taxes as well as proposals aimed at the energy and transportation sectors, the protection of human health and the development of natural resources. The NDP government of the time implemented at least one of the measures recommended by the Commission – the Tax for Fuel Conservation.³²
• In British Columbia, the NDP government commissioned a discussion paper on environmental tax shifting in order to stimulate public discussion on how to make the tax system better reflect social, economic and environmental values without increasing the overall tax burden. The report was released shortly before the Liberal victory and does not appear to have influenced government policy.

²² Most other environmental taxes do not combine significant tax income with significant environmental effects.

²³ Over half of Italy's carbon tax revenues in 1999 were dedicated to reducing labour costs: Majocchi (2000).

²⁴ Belgium also introduced environmental taxes in 1993 at the instigation of the Green Party.

²⁵ In Sweden, a newly-elected conservative government looked to EFR to reduce very high marginal income tax rates by increasing taxes on energy and transport.

²⁶ Similarly, Italy's 1999 Financial Law sets out predictable increases in excise duties on oil use and cuts in compulsory contributions on labour over a period of several years.

²⁷ 13.7% of total tax revenue in 2002

²⁸ Note that the fall 2001 French Budget nonetheless includes many EFR measures.

²⁹ www.greenscissors.org

³⁰ Oregon Tax Review Policy Committee, Governor's Tax Review Phase II Policy Recommendations. January, 1999.

³¹ See for example, National Round Table on the Environment and the Economy (2002).

³² The TFC is a flat tax that applies to certain fuel-inefficient vehicles: see www.trd.fin.gov.on.ca/userfiles/HTML/nts_3_19281_1.html.