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The Political Economy of Environmental Tax Design[*]
Matthieu Glachant, CERNA, Ecole des Mines de Paris
This version: October 2001
Correspondence to: Matthieu Glachant, CERNA, Ecole des Mines de Paris, 60, boulevard St Michel, 75006 Paris, France, tel: +33 1 40 51 9229. E-mail:
Abstract
If regulation remains by far the dominant approach in actual environmental policy, environmental taxes are no longer a theoretical curiosity. However, existing taxes' design differ significantly with the theoretical solution envisaged in the textbooks. In particular, earmarking prevails and actual taxes are usually combined with regulation. Furthermore tax rates are generally too low to significantly influence polluters' behavior.
The paper develops a political economy model to explain these design issues. It focuses on three parameters: tax rate, earmarking pattern and whether the tax is combined with a regulation. These parameters are jointly selected through a voting procedure influenced by a green lobby and an industrial lobby making campaign contributions. One key assumption is the existence of a status quo policy entailing an emission standard.
Results suggest that an earmarked tax which rate is lower than the regulatory shadow price emerges in political equilibrium when the status quo regulation is imperfectly enforced and if the green lobby is sufficiently weak. This is so because earmarking finance abatement subsidies which reduces regulatory compliance cost. In this configuration, a tax is thus introduced to promote regulatory compliance. By contrast, a non-earmarked tax with rate above the regulation shadow price only emerges when the green lobby is very powerful.
Key-words: Environmental tax; political economy, earmarking, tax design
JEL classification: D72; D78; H23; Q28
1. Introduction
For years, economists advocate for a widespread use of environmental taxes for meeting environmental policy targets. The main arguments are that they help to save pollution abatement costs and provide higher incentives to innovate in abatement technology than the traditional Command and Control approach based on direct regulation. If regulation remains by far the dominant approach in actual environmental policy, environmental taxes are no longer a theoretical curiosity. In 1995, more than 300 environmental taxes were in place in OECD countries (OECD, 1995) and covered the quasi-complete range of environmental concerns: water or air pollution, noise, waste, land use etc.
However, existing taxes and charges differ significantly with the theoretical solution envisaged in the textbooks. In practice, pollution charges are not Pigovian taxes set at a level where the marginal environmental damage is equal to the marginal abatement cost. Paraphrasing the title of a famous paper by Hahn (1991), the patients do not exactly follow the doctor's orders.
Several studies suggest how “real” taxes work (Hahn, 1989, OECD, 1995, EEA, 1997). Three main features are worth mentioning. First of all, tax revenues are generally earmarked to finance pollution abatement projects through grants and subsidized loans in the domain they were collected.[1] Hence environmental tax revenues are "recycled" in pollution abatement subsidies.
Secondly actual taxes usually coexist with regulations. There is a simple historical explanation for that: when taxes are introduced, they do not substitute but are combined with the pre-existing regulatory system. Thirdly, tax rates are said to be too low. This means that rates are below the level of the Pigovian tax (at which marginal damage is equal to marginal abatement cost). But they are usually even too low to have a significant incentive effect on polluters' behavior as well. Their main role is thus one of fund raising.[2] This latter feature is probably the most welfare damaging feature of real tax schemes. If a tax is not capable of influencing the polluters’ behavior, it is a precondition for the instrument to bring social benefits in terms of abatement cost savings or innovation incentives that is not being met.
This policy context justifies the relevancy of a political economy analysis explaining the actual characteristics of environmental taxes. This is what the paper is attempting to do. It aims to analyze in a political economy framework environmental tax design issues: why is earmarking prevalent? Why are charge rates low and how the combination of the taxes with regulatory constraints affect the different charge parameters? The analysis deals with the three different design parameters: tax rate, earmarking pattern and whether the tax is combined with a regulation. We propose a model where these parameters are jointly selected through a voting procedure influenced by a green lobby and an industrial lobby making campaign contributions. The political part of the model is directly derived from a simple formulation combining probabilistic voting and lobbying recently suggested by Persson and Tabellini (2000, p 58) which were adapting a previous formulation by Baron (1994).
As to the "non-political" part of the model, two assumptions are central. Firstly, we assume the possibility that the status quo is not the absence of any environmental policy. Instead we assume that a regulation has been set through the same voting procedure in the past and is still in force. This captures the fact that a regulation frequently pre-exists when an emission charge is introduced: the setting up of a new environmental tax is then a matter of policy change. This strongly affects the political equilibrium since any policy change proposal is assessed by the agents against the status quo. The second central assumption of the model is that the regulation is imperfectly enforced. Again this is in line with what happens in reality: due to limited administrative resources, full compliance with regulation is unlikely to be observed. As we will see, this assumption crucially influences tax design in our model: imperfect enforcement confers a role of regulatory enforcement incentive to the tax only when revenues are earmarked. This is the key factor that leads political equilibrium to include an earmarking provision in our analysis.
The paper is organized as follows. A second section reviews the literature which has already quite extensively worked on some aspects of tax design and discusses the relevancy of our own contribution in this context. A third section introduces the model. In section 4., we characterize the status quo policy. Section 5. enters into the core of the analysis. It focuses on a situation of perfect enforcement of the regulation, so that the pollution abatement level in status quo corresponds to the level prescribed by the emission standard. Our analysis predicts that policy changes only occur under very restrictive conditions in this configuration. More specifically, the green lobby needs to be much more influential than the industrial lobby to be able to foster its best policy option: a non earmarked tax. The preference of the greens for non earmarking being basically determined by the fact that they receive a share of the tax revenue. In that configuration the tax rate is high (more specifically higher than the regulation shadow price).
In section 6., we consider that the case where regulation is imperfectly enforced. This changes the status quo position since now there is no pollution abatement initially. It widens the room for policy change: a tax is systematically introduced in this case but its design differs according to the relative strength of the green and industrial lobbies. In particular, when the green lobby is less powerful in relative terms, the political equilibrium involves the introduction of non-earmarked tax which complements the imperfectly enforced regulation. Tax rate is predicted to be low, that is under the regulation shadow cost. The basic reason is that earmarking permit to subsidize regulatory compliance and thus rises abatement level even at a low rate. When regulatory enforcement is not perfect, the political equilibrium is thus in line with the prevalent tax design encountered in reality. Section 7. concludes.
2. The literature on the political economy of environmental tax design
The formal political economy literature on environmental taxes is now developing quickly. Most contributions focus on the question of the instrument choice: they investigate why regulation remains much more widespread than environmental charges or other economic instruments of pollution control (see Djikstraa, 1999 for a recent survey). In comparison, the literature on design aspects is more limited. Most papers focus on earmarking.
By far the most popular line of argument put the emphasis on the influence on interest groups. Buchanan together with Gordon Tullock provide the basis of these arguments in a very influential contribution published in 1975. The paper is concerned with instrument choice (pollution tax versus direct regulation) but it directly applies to earmarking. It can be summarized as follows. In comparison with a non-earmarked tax, the distributional pattern of earmarking is reversed: the winners are the polluters (since they get back through subsidies tax payments) and the losers are the consumers (which would have benefited from tax revenue otherwise). This distributional pattern combined with the classical Olson's argument suggesting that the polluters' lobby gathering a lower number of members with higher unit stakes will be more influential than the consumer lobby leads to predict earmarking in political equilibrium. This is a positive argument explaining the prevalence of earmarking but it immediately leads to an efficiency argument developed for instance in a paper by Hansen (1999). In an incomplete contract setting, Hansen develops a model where earmarking is seen as a way to limit the political distortions introduced by polluters' lobbying against non-earmarked taxation.
A second line of arguments about earmarking moves the emphasis on voting concerns and elections. It is convenient to begin its presentation by reminding the standard "normative" argument of the theory of public finance against earmarking. Earmarking is essentially a constraint on the regulator's choice over tax revenue allocation. Ex ante, this constraint can perfectly be justified from an efficiency point of view. But ex post, this might not be true because the economic environment evolves over time: earmarking then prevents welfare improving adjustments. A political economy argument against this view was made again by Buchanan (1963) and subsequently extended by Goetz (1965). Their point is that the standard argument no longer holds when one adopts a more realistic view of the regulator. In particular, earmarking can be efficient if budgetary decisions are made through a voting process as it is the case in actual Parliaments. The rationale is that earmarking modifies the contents of the budgetary decision. Instead of voting twice and separately over public expenses and revenues, the constrained budgetary decision consists in selecting the bundle of public goods to be provided. Put differently, earmarking oblige to jointly decide over the level of provision of a particular public good (like pollution abatement) and its cost. It transforms the budgetary decision into a uni-dimensional policy choice. Consequently, earmarking drives away the efficiency problem associated with strategic voting over multidimensional policy under majority rule: the median voter theorem holds and there exists a single voting equilibrium. In a recent contribution, Brett and Keen (2000) suggest another argument. They develop a voting model where earmarking is shown as possibly efficient by limiting the negative impacts of electoral cycles and of political uncertainty associated with.
These contributions focussing on voting properties by Buchanan, Goetz or Brett & Keen actually do not bring positive but efficiency arguments. More precisely, they do not explain why earmarking prevails. Rather they arguments claim that earmarking is efficient in a politically constrained context. If we come back to more positive analysis of earmarking, Bös has recently offered a very rich analysis by entering more deeply into the government "black box" (2000). He develops of post-election politics model where the tax is selected by a Parliament controlling two ministers. One is the finance minister in charge of collecting tax, the other being the tax spender. A principal-agent setting is used to model the relationship between the Parliament and the ministers. Considering the internal structure of the government leads Bös to stress the importance of uncertainty over the future states of the world. If the Parliament or the ministers face high uncertainties, the scope for earmarking is reduced. The reason is that they will prefer to benefit from the non affected tax revenue to face a possible worsening of the economic situation. In other words, earmarking is a "safety net" against future negative shocks on the economy (and thus on public spending) in Bös' framework.
In the end, many arguments are available to explain the prevalence of earmarking. This is not true as regards other design aspects (tax rate, combination with regulation). To our knowledge, there is only one paper written by Fredriksson (1997) which explores the relationship between tax rate, abatement subsidy rate, lobby membership, and product price. There is no earmarking in his model since the abatement subsidy is exogenous. The political part of the model is the popular common agency model introduced by Bernhein and Whinston (1986) and subsequently applied to political economy issues by Grossman and Helpmann (1994). Fredriksson's analysis yields classical results about the influence of lobby membership on the tax parameters (for instance, the more members in the industrial lobby, the lower the tax rate) or other exogenous variables (e.g. the product price). One interesting result is that total pollution may be increasing in the abatement subsidy rate because of political distortions. This is so because inter alia the abatement subsidy reduces the industry's marginal cost and hence output increases. This may stimulate lobbying activity of industry because a higher level of output makes a low pollution tax rate more important.
In this context, a general analysis of tax design seems relevant. Our approach will be fairly classical in that we will concentrate on the distributional patterns of different design and their subsequent impacts on lobbies and voters' behavior in line with Fredriksson's model for instance, or the historical Buchanan and Tullock's paper. One difference with Fredriksson's paper is that, to model the political process, we will not apply the common agency approach popularized by Grossmann and Helpman. Instead, we will use a model of electoral competition with probabilistic voting and lobbies making campaign contributions. This is a model of pre-election politics since politicians commit to electoral platforms involving an environmental tax which is implemented if he wins the election. By contrast, the Grossmann and Helpman's approach is a post election model with political decisions being made by elected politicians already in charge who search for re-election. This methodological difference is not crucial however since both models bring similar results.