An overriding challenge for many European governments and policy-makers is to reduce major fiscal deficits with the least collateral damage to their economy. This paper aims to clarify the role carbon-related fiscal measures can play in contributing to fiscal re-balancing in Europe. It builds on a broader report carried out by Vivid Economics for the European Climate Foundation and Green Budget Europe (Vivid Economics, 2012), which includes a detailed assessment and modelling of the issue. This paper provides an overview of the analysis in the report, and extracts key messages for policy-makers.

A review of current carbon-energy taxes across a sample of nine EU member states reveals a great discrepancy in the tax rates used within and across countries. Without a common set of signals, various economic problems can emerge, from inappropriate investments in fuels and technologies, to carbon and economic leakage1 between countries and, ultimately, overall loss of welfare.

Raising or adjusting national taxes on energy and carbon can help to correct these discrepancies, while generating useful revenues that can contribute to fiscal re-balancing. The analysis compares such carbon-related taxes with conventional direct and indirect taxes raising similar amounts of revenue. It reveals that carbon fiscal measures can indeed raise significant revenues while having less detrimental macro-economic impact than other tax options. Similar results are found for a tightening of the cap in the European Union Emissions Trading System (EU ETS). Such a tightening could raise considerable revenue at lower macroeconomic cost than equivalent increases in direct or indirect taxes, both at the level of the EU as a whole and for a significant majority of Member States. The analysis suggests that the smaller the proportion of allowances that are allocated for free, the more attractive EU ETS reform becomes as a mean of raising revenue.

Raising energy and carbon taxes and tightening the EU ETS, however, are not without adverse impacts. In particular, they can have a negative impact on income distribution, and lead to loss of competitiveness and to carbon leakage.

Nevertheless, although the modelling confirms that energy taxes are often regressive, it also shows that other forms of taxes can lead to significant decline in economic activity, which in turn can cause even greater losses to lower income and disadvantaged households. Further, the regressive impact of energy taxes can be alleviated. The appropriate approach is likely to vary by country – depending on factors such as data availability and variability in energy consumption across (low-income) households. Once such variables are factored in, the negative impacts on low-income groups may be offset using a relatively small proportion of the tax revenue (that would otherwise be) raised.

As for carbon leakage, the analysis suggests that, over the medium to long term, border carbon adjustments have the potential to deliver better protection against leakage than free allocations of ETS permits. Border adjustments could in fact contribute to fiscal consolidation more than a shift to full auctioning on its own, and are a more attractive way of raising revenue than an increase in direct taxes. However, considerable challenges relating to their feasibility, compatibility and political acceptability remain. If introduced, therefore, carbon tax adjustments will require careful and smart design.

Overall, carbon fiscal measures have the potential to play an important role in fiscal policy. In the past such measures have generally been considered only as instruments of environmental policy; their fiscal role has been largely overlooked. In the light of Europe’s current fiscal crisis, it is time to reconsider that view.

Michael Jacobs, John Ward, Robin Smale, Max Krahé and Samuela Bassi

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