Can taxes on energy work?

OECD Observer

Click to enlarge. Source: OECD

Can taxation help governments achieve environmental goals with respect to energy use and emissions? Yes, with conditions.

A recent OECD report, The Political Economy of Environmentally-Related Taxes, argues that taxation already provides a useful environment policy instrument, but that its use could be made more effective in disciplining demand. In fact, environmentally related tax revenues represent some 2-2.5% of GDP in the OECD area, though the rate varies widely from country to country. The largest number of environmentally related taxes is levied on energy products (150 taxes) and motor vehicles (125 taxes).  

The effectiveness of energy taxes could be further improved if exemptions were scaled back and the rates of taxation were brought into line with the amount of environmental damage being caused. More international co-ordination would help, too.  There are two main barriers to taxing energy more widely. The first is a worry that taxation of this type, if not applied in a wide spectre of countries, will lessen the international competitiveness of some energy-intensive sectors and may lead to losses of revenue and jobs. On the other hand, closing down subsidised loss-making polluters could be a low-cost way for governments to reach environmental goals, the report notes. 

The second policy concern is that additional energy taxes, for heating fuel for instance, could hit poor people and pensioners disproportionately. The effects of additional energy taxation on low-income households can be mitigated or compensated by measures such as targeted tax allowances and credits. For example, in 1996 the Netherlands introduced a regulatory energy tax (RET) on the use of natural gas and electricity. The RET rates were later raised progressively, while at the same time the tax rate in the first bracket of personal income tax (PIT) was reduced in step with the RET increases. 

In some instances though, concern over effects on income distribution deters governments from imposing energy taxes on households. For example, households have been excluded from the UK’s climate change levy because of the government’s commitment to tackle fuel poverty. 

So far as the competitiveness issue is concerned, there is in fact little evidence that environmentally related taxes have had much impact on particular sectors. However, this is in part due to the fact that energy intensive industries are characteristically exempted. Indeed, the comprehensive OECD/European Environment Agency database shows that the largest number of exemptions is linked to “manufacture of coke, refined petroleum products and nuclear fuel”, reflecting exemptions for fossil fuels produced by this sector. A high number of exemptions is also linked to “manufacture of motor vehicles, trailers and semi-trailers”. 

Imposition of additional taxes on energy-intense sectors is often politically sensitive. For instance, aviation fuel is exempted from taxation and any change in the current situation seems out of the question, particularly on international flights. Nonetheless, the European Commission is now considering ways to address this issue on flights within the EU. In addition, the International Air Transport Association is looking at the wider picture, partly because of environmental concerns. The challenge is how to persuade as many countries as possible to put similar policies in place.  

As The Political Economy of Environmentally-Related Taxes notes, under the Kyoto Protocol most OECD countries have legally binding and quantified obligations to limit emissions of greenhouse gases. This has already contributed to new policy initiatives in several countries. The evolving CO2 emissions trading scheme in the EU is an example which obliges the power sector and selected industries to hold emission allowances for the CO2 emissions they cause.

One approach to improve effectiveness is to recycle part of the tax revenues back to affected firms, even if case studies carried out by the OECD show that this partially undermines the primary objective of reducing emissions. Another possibility is to adjust border taxes, such as import and export levies, to even out price distortions caused by country differences in environment tax levels. However, the free trading rules under the World Trade Organization can make this approach problematical. 

Revenues raised from energy taxes do not have to be earmarked for environmental purposes in order to be effective. Their mere imposition should encourage businesses and other taxpayers to favour more environment-friendly alternatives. In practice, many taxes on motor fuels are channelled into road building. This may sometimes be good for the environment–for example by relieving congestion–but in other instances it may add to the problem. Alternatively, revenues of this type can be used for more general purposes, such as strengthening budget balances, increasing public investment, or reducing other taxes or social security contributions. 

Is there an “optimal” tax rate on motor fuel? This is not at all easy to define, the report warns, suggesting that ideally, the tax rate on motor fuels should–as for other tax-bases–reflect the size of the negative environmental effects, or externalities, each fuel causes. If any revenues raised are used to lower other, more distorting, taxes, then so much the better. 

Generally speaking, energy and other environmentally related taxes can work well in combination with other regulatory instruments, voluntary agreements and other procedures to help achieve their goals. The report explores several examples, including Denmark’s initiative to combine CO2 taxes with agreements on improved energy efficiency in industry, with tax revenues being recycled back to participating industries, such as via other tax cuts. 

Overall, as in all good policymaking, two features are vital for success: coherent policy goals that are clearly stated, and a good public understanding and acceptance of the need for action and of the measures that are being adopted. One example of incoherence cited in the report is the tax rate on diesel, which in most countries is much lower than the rate for petrol. This is regrettable from an environmental point of view, the report’s authors say, since diesel-driven vehicles cause more local air pollution and noise than petrol-driven vehicles. Keeping the tax low as an incentive to buy into the energy-efficiency qualities of diesel-driven vehicles is not an argument, the report says, since that benefit is already “internalised” in the lower running costs of the car. 

The message is that taxes can help in the fight against global warming and to alleviate other environmental problems, as long as they are properly and coherently applied. 􀂄 Rory J. Clarke 


OECD (2006) The Political Economy of Environmentally Related Taxes, Paris. ISBN 92-64-02552-9. Available at

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©OECD Observer No 258/259, December 2006

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