Taxes on inputs and final products

Taxes on inputs and final products whose production or consumption are associated with pollution externalities, though indirect and hence less efficient, have the advantage of relying on the administrative procedure of the existing tax systems. No monitoring of the sources and levels of emissions or effluents is needed and product taxes can be easily collected from producers at the time of exchange (sale, export, import). Examples include taxes on fuels, on industrial chemicals, and on pesticides. The tax induces reduction in the use of these products and proportional reduction in the production of pollutants but provides no incentive for pollution abatement; its ability to act as an incentive for pollution reduction depends on its level being high enough and the demand for the product elastic enough to discourage the consumption and thus production of the product.
Environmental taxes on final products are particularly suited to the control of consumption-related pollution, because consumers are made aware, through higher prices, of the environmental
consequences of their choices.
An environmental tax on final products can be adjusted to ensure international competitiveness;
exports can be exempted, since the products are not domestically consumed and inputs can be made
subject to an equal environmental duty. In the case of raw materials and intermediate products, a uniform environmental tax may result in distortions and perverse incentives if some inputs or uses result in greater environmental damage than others. To remedy this problem a differential tax structure is often introduced—materials with higher levels of externality are charged higher tax rates, while environmentally friendly products have their regular tax rate reduced. The purpose is to induce a switching from polluting products to environmentally-friendly substitutes. If no such substitutes exist, differential taxation becomes a distortion. Since tax differentiation has by definition an incentive purpose, the differential tax is often calculated to be revenue neutral. An example is provided by the differential taxation of leaded and unleaded gasoline practiced in Thailand to induce switching to a cleaner fuel. Fiscal instruments include not only taxes but also subsidies. Instead of taxing the polluters to reduce
pollution to the optimal level, polluters can be subsidized to do exactly that. The optimal environmental subsidy is also equal to the marginal environmental damage at the level of the optimal tax. The outcome in terms of environmental improvement and static economic efficiency (resources expended for the improvement are minimized) is exactly the same except for differences in the transaction cost between collecting taxes and paying subsidies. There is, however, one dynamic difference which favors taxes. In the long-run subsidies tend to induce new entrants into the industry (or the expansion of existing producers) which results in both an increase in pollution and an increase in the cost of the subsidy. Distributionally, the burden of environmental taxes falls on the producer and consumer of the polluting products while that of the subsidies falls on the taxpayers. In this connection, subsidies violate the widely accepted polluter pays principle of distributing pollution control costs.
Governments wanting to abide by the above principle and, perhaps more importantly, facing growing budget deficits, do not usually favor environmental subsidies; yet most governments are rather generous with investment tax incentives. The most common such instruments are investment tax credits and accelerated depreciation for pollution control equipment and waste treatment facilities. While their impact on the budget is no different than that of subsidies, and while they equally violate the polluter pays principle, investment tax incentives are popular with governments because, (a) their costs are hidden from public scrutiny and hence are an expedient way to provide hidden subsidies, and (b) they give an appearance of promoting environmental protection without reducing competitiveness. Of course, the latter is not assured since the installment of the mandated (and subsidized) pollution abatement facilities does not guarantee their efficient functioning. Indeed, many mandated water treatment facilities are often found to be unserviceable to avoid operating and maintenance costs. Since there is no incentive to actually reduce pollution (only to install the equipment), the investment incentive subsidizes the overall investment and thereby induces an increase rather than a decrease in the level of pollution. Investment tax incentives are generally a source of distortion with hidden but large costs that should be avoided as much as direct subsidies. Tax incentives for environmental investments, in the form of both tax credits and accelerated depreciation are practiced in Canada, France, Korea and Taiwan, among others, while both Japan and Germany provide for depreciation and the Netherlands provides tax credits for environmental protection investments.