Ecological tax reform:
a policy analysis of
the Costanza, Daly, Hawken and Woodwell package.

Philip Sutton
Director, Policy and Strategy
Green Innovations Inc.
Tel & fax: +61 3 9486 4799
Philip.Sutton@green-innovations.asn.au

Paper marked up in HTML format
by Callie Jordan
Diagrams prepared by Chris Mardon

Contents

• 1. Abstract
  
• 1. Introduction
  
• 2. Taking the pressure off the economy
  
• 3. Treating symptoms pragmatically
  
• 4. The Costanza et al. reform proposal
  
• 5. Transformed market conforming planning
  
• 6. Historical changes in the factor price structure
  
• 7. Reasons for the changing factor price structure
  
• 8. Non-renewable resource depletion
  
• 9. Aiming for a closed-cycle economy
  
• 10. Principles for the use of economic instruments
  
• 11. Changes needed in the Costanza et al. reform package
  
• 12. A revised ecological tax/expenditure package
  
• Acknowledgments
  
• Notes
  
• References
  

1. Introduction

Costanza et al. (1995) have advocated that governments adopt an ecological tax reform package. Their package consists of taxes on pollution, the depletion of natural resources and other environmental ‘bads’ with the funds raised being used to reduce taxes on income, labour, capital and other social ‘goods’.

The purpose of this paper is to consider whether the Costanza et al. package is an appropriate basis for policy and to recommend an approach that overcomes any deficiencies.

2. Taking the pressure of the economy off the environment

Over the last 30-40 years a vast literature has built up showing that species are being imperilled at an enormous rate, life support systems are being disrupted, high-grade non-renewable resources are being seriously depleted and reliance on renewed resources is falling, for example Meadows et al. (1992).

To solve these problems will, in many cases, require major technological changes. For example to halt enhanced greenhouse warming will probably require at least a 60% reduction in world CO2 emissions from the 1988 base, not the 20% targeted by governments (Intergovernmental Panel on Climate Change, 1990).

If human welfare is to be maintained or, in the case of the less well off, improved, and if timely changes are to be politically feasible it will be necessary to decouple the expansion of economic value from the creation of negative impacts on nature and life support systems and from the depletion of high grade physical resources.

3. Treating the symptoms pragmatically

Economists have argued for a long time that conflict between environmental/social and economic objectives can be reduced using economic instruments to regulate the economy. So it was inevitable that proposals would eventually be put forward to reduce resource depletion or pollution by taxing them (Hannon et al., 1981) or to reduce unemployment by subsidising labour (Layard and Nickell, 1980). Later modelling work has shown that proposals that combine these measures have an even better economic effect. Indeed net increases in GDP have been reported in many cases for Europe and the US (Brinner et al., 1991; DRI et al., 1994; Jacobs, 1994) and for Australia (Common and Hamilton 1994).

Costanza et al. are now arguing that it is time to implement such a package.

4. The Costanza et al. reform proposal

Their recommended package has the following elements: A suite of "natural capital depletion" taxes which would be applied to:

• fossil fuel energy

• minerals

• non-sustainable uses of ecosystems

• damage to natural capital caused by pollution

• emissions of pollution (eg. releases of sulphur and nitrous oxides, toxic chemicals
  and carcinogens)

• the consumption of natural capital - to the extent that material was not recycled.

A pool of revenues generated by the taxes, which would be used to:

• replace much of the current income tax and reduce taxes on labour and capital
  (with the reductions favouring middle and low income earners)

• fossil fuel energyprovide credits for investment in renewable alternatives.

An aim of the package is to create a low or zero pollution, closed-loop industrial system. The package would be implemented gradually, over a number of years, to allow businesses and consumers to anticipate and adjust to the new rules and incentives. The package would be fiscally neutral, with new or increased taxes being fully off-set by reductions in other taxes.

Should the Costanza reform package be implemented as proposed? The package must be tested first using an appropriate analytical framework.

5. Transformed market conforming planning

To date the countries with the best environmental records are the ones actively applying regulations and planning. So, to find policies to achieve win-win results, it seems reasonable to look for countries that have combined regulations, planning and good economic performance.

A number of countries have achieved this eg. Japan and the other Asian tigers. Their economic policies are focused more on industry policy than macroeconomic stabilisation. They use a form of economic planning called ‘market-conforming planning’, where, planning and regulations are directed at assisting the market to more effectively achieve its potential. Active steps are taken to ensure that social and regulatory policy does not lead the planning system and the market to negate the efforts of the other. Goals such as economic growth and income growth are shared, making cooperative action easier.

Market-conforming planning involves conscious:

• changes in the balance of economic activity between sectors

• upgrading of the sophistication of economic activity within and across sectors

• promotion of new areas of economic activity within sectors

• winding down of uncompetitive areas that do not have the capacity to be upgraded
  and restored to competitiveness.

(Komiya et al., 1988; Johnson et al., 1989)

Policies foster innovation, synergy and stability, with the market and the planning system both contributing.

But while the success of market-conforming planning, now recognised by the World Bank (1993), challenges old assumptions about the compatibility of markets and government planning, it doesn’t seem to offer the solution to environmental problems that is being sought. In addition to prodigious growth rates, Japan and the East Asian tiger economies have generated environmental damage and resource depletion on an equally impressive scale.

Clearly if the market is already going in an environmentally undesirable direction, accelerating its progress through market-conforming planning is not going to help environmentally. Is there a better approach?

For 50 years, during the middle of this century, Sweden practiced a highly successful economic system that seemed to have many of the features of market-conforming planning and yet it went further by doing things that seemed beyond the normal potential of the market. In the Swedish case, it simultaneously achieved full employment, an egalitarian income distribution, strong wage-rate growth, low inflation and strong economic growth.

In the 1930s the Swedes decided they wanted a productive economy and no unemployment. Conventional economic theory held that full employment would lead to high inflation which would undermine the economy. So to avoid this trade-off the Swedes made a number of deep changes to their institutional structures (Milner, 1989).

They (a) centralised the wage bargaining system, (b) adopted a structure of wage increases that reduced the gap between high and low incomes (c) introduced active labour market programs to match the labour supply and demand without having to rely on high wage differentials (d) introduced a high company tax system that reduced the employers ability to grant wage increases outside the negotiated agreement but recycled the tax money back into industry as investment funds. Once this was done the economy tended ‘naturally’ to grow strongly with low unemployment and low inflation. The detailed operations of the market sector were left relatively untouched as was the case with East Asian market-conforming planning.

This approach could be called market-conforming planning for the transformed market, or transformed market conforming planning (Sutton, 1995a). It involves first diagnosing the features of the economy that are causing major problems, then determining the institutional structures that give rise to these features. Then an integrating vision needs to be adopted to guide the choice of corrective policy actions. Actions can then be devised to:

• first transform the economy at the deep institutional level to set new directions (Principle 5.1)

• then enhance the dynamics of the economy so that it can move in the new directions more effectively (market-conforming planning) (Principle 5.2)

• and finally, if necessary, target specific negative features of the economy with very modest levels of regulation. (Principle 5.3)

The rest of this paper is devoted to finding a win-win solution to the problems outlined in section 2 using the approach just described. The problem-solving methods developed by Goldratt (1994 and Anon. 1994) for use within firms can be adapted for designing solutions on a national scale (Sutton, 1995b).

6. Historical changes in the factor price structure

For more than 100 years primary materials prices have fallen (Barnett and Morse, 1963; Nordhaus, 1974; Proudley, 1987; Trengove, 1986; Baumol et al., 1988) relative to labour and labour intensive goods (Hannon, 1977; Grilli & Yang, 1988). Grilli and Yang have concluded that the decline of primary commodities relative to manufactured products was about 0.5% per year from 1870-1980.

This long run trend in factor prices, that is, the prices of labour, materials, equipment and so on, has made the emergence of a high physical-throughput economy almost unavoidable, and has driven the economy further and further from a closed-cycle structure.

Figures 1-6 show how relative factor prices have changed.

7. The reasons for the changing factor price structure

This section explains why the extraordinarily consistent fall in resource prices relative to labour-intensive factors of production over at least the last 100 years, is not coincidental but is the result of one mechanism operating over the entire period (1).

The cost of production of physical resources has historically been driven downwards by technological innovations and growing economies of scale that have caused labour-shedding at a faster rate than in the rest of the economy. Competition has, for most of this period, been sufficiently strong to force the market price of resources down with the cost of production. Although this pattern was dramatically disrupted by the massive OPEC oil price rises in the ten years from 1973 (see Figs. 2 & 4) it has since been reinstated.

Labour prices on the other hand have behaved quite differently. Up until the mid 1970s, labour prices have tended to track the rising marginal revenue product of labour.

During booms, with labour in relatively short supply compared to other factors of production, employers have bid against each other for labour, thus driving up its price. During the downturns, institutional factors, eg. unions, the arbitration system and employer custom, have held wage rates high causing the reduced demand for labour to manifest itself as the unemployment of a proportion of the work force. In addition governments have usually stepped in to stimulate the economy to try to restart growth, thus returning the economy in due course to boom conditions once again.

Since 1973 the internationalisation of national economies has intensified forcing lower skilled workers in rich countries into more direct competition with employees in low wage countries. This has lessened the upward wage pressure in the booms and weakened the structures that hold wages up in the downturns. The consequence has been that, on average, the wage rate for employees in Australia and some other traditionally high wage countries has not risen appreciably over 20 years (See Fig. 3) (2). Despite this, since the collapse of the OPEC oil cartel, resource prices have fallen even faster than usual. This has been due to (a) increased technological innovation, (b) increased exports of often subsidised resources as poorer countries implement IMF structural adjustment programs and ex-soviet bloc countries struggle to generate foreign exchange and (c) greater willingness of transnational resource companies to operate in and export from many third world countries previously influenced by Marxist and self-reliance doctrines. So the relative fall of resource prices compared to labour prices has resumed despite the slow-down in wage rate growth in many of the high-wage countries.

The reduction of virgin materials prices relative to the prices of the labour-intensive factors of production has been caused by the conjunction of five conditions:

• the occurrence of economic growth,

• the existence of a relatively stable share of national income going to labour,

• the fact that most people gain their income almost totally from wages,

• the fact that resource royalties or severance charges have not been indexed to the
   growth of the economy, and

• the greater ease of decreasing costs of production in the resource sector compared
   to the other sectors of the economy.

If one or more of these conditions were changed then the pattern of factor prices would change (3). Prices are a system property arising from the interplay between the economy’s particular enduring institutional frameworks and the decisions of the current period, so ‘natural’ prices (Pasinetti, 1981) are contingent on the institutional framework.

Hence the shift from a relatively conserving economy in the pre-industrial and early industrial period to a fully fledged throw-away economy since the second world war can be explained, if the argument above is accepted, as an institutional externality. That is, the throw-away economy developed as an unintended and long-delayed side effect of establishing the institutional arrangements of capitalism in the transition from feudalism, especially (a) the establishment of wages as the principle means by which most people gain access to purchasing power and (b) the failure to establish a tradition of increasing the royalties and severance payments for non-renewable resources in line with the growth of the economy.

8. Non-renewable resource depletion

Neo-classical economic theorists generally hold that the price of resources should, as a result of the workings of the competitive market, go up as scarcity increases. As we have seen in Section 6 this is not the historic reality. In fact, prices reflect scarcity in the market not in the ground, so until scarcity-in-the-ground is perceived as having practical implications within the operating time-frame of the key economic actors, there will be no price escalation due to a scarcity premium.

Competition will ensure that prices track the cost of production. But even if economies of scale and new technology cannot compensate economically for the depletion of high grade resources, the relative rise in the prices of labour intensive products and rising incomes usually combine to ensure that there is continuing pressure to use more resources - despite the accelerating scarcity-in-the-ground. So, economic scarcity and market prices can fall for a very long time, for centuries in fact, while scarcity-in-the-ground rises. This dynamic is summarised in Fig. 7.

In the light of the actual dynamics of resource depletion and market prices it should have been expected that Paul Ehrlich would lose his bet with Julian Simon that the prices of chrome, copper, nickel, tin and tungsten would rise during the 1980s due to increasing physical scarcity (Myers and Simon, 1994).

9. Aiming for a closed-cycle economy

Having diagnosed the features of the economy that are causing major environmental problems, and determined the institutional structures that give rise to these features, it is time to turn to the integrating vision that will guide the choice of policy actions.

The most integrated vision is the notion of a closed-cycle economy designed to:

• conserve natural biodiversity

• conserve life support systems (eg. the climate system and natural eco-cycles including
  the soil and the water cycle)

• conserve physical resources

• rely on naturally or industrially renewed resources.

To illustrate how these issues might be woven together Fig. 8 gives the ecological/economic ‘signatures’ of an unsustainable economy and an economy on the way to becoming closed-cycle. Fig. 9 shows how the quality of materials changes as it flows through a true closed-cycle economy.

The key principles underlying the design of an economically viable and ecologically sound closed-cycle economy are:

• virtually all materials are recycled (Principle 9.1)

• any production of primary raw materials beyond that required to replace the tiny
  trickle of non-recyclable materials, is used to build up long-lasting physical stocks in
  the economy  (Principle 9.2)

• materials are managed to retain their physical quality for as long as possible
  (Principle 9.3)

• as the quality of materials declines they are reused for purposes that can accommodate
  the lower quality (Principle 9.4)

• to create a true closed-cycle economy the lowest grade materials must eventually be
  restored in quality, either through natural systems or through industrial regenerative
  systems (Principle 9.5)

• the entire system is highly efficient in its use of energy, consuming considerably less
  than the current throughput system despite the increased recycling (Principle 9.6)

• there is a transition from using non-renewable to renewable energy sources
  (Principle 9.7)

• the entire system is compatible with the conservation of biodiversity and life-support
  systems (Principle 9.8).

10. Principles for the use of economic instruments

Before moving on to look at recommendations for modifying the Costanza et al. package it is necessary to identify some general principle to govern the levying of eco-taxes and the use of the resulting funds.

For the purposes of this paper government charges can be divided into three general classes: (a) general revenue taxes, (b) special fund-raising levies and user fees and (c) regulatory taxes.

General revenue taxes are raised to cover the various expenditure requirements that governments have that are not self-funding. General revenue taxes should therefore not be hypothecated (Principle 10.1), that is the revenues should not be automatically reserved for expenditure in the area in which they were raised. The capacity of general revenue taxes to modify the behaviour of the market must be taken into account and, if necessary, compensated for when designing these taxes.

Special fund-raising levies and user fees are charged to fund particular activities and to pay for the cost of services. Special fund-raising levies and user fees should therefore be fully hypothecated (Principle 10.2).

Regulatory taxes are imposed to deliberately change behaviour. Revenues from regulatory taxes should either be spent on measures that will facilitate the change the tax is targeting or be rebated back to people’s income in ways that reduce other business input costs (4) (eg. via wage subsidies) or rebated through pensions for unwaged people (Principle 10.3).

A sharp distinction needs to be drawn between revenue and regulatory taxes. Their purposes are completely different and their magnitudes and dynamics are therefore likely to be quite different. Regulatory taxes should not be used for general revenue (Principle 10.4), otherwise there will be a temptation to maintain the behaviour that was to be changed.

A regulatory tax/expenditure package should to have a mechanism (5) built in to compensate for the erosion of the regulatory power of the package caused by either rising incomes or by the increased scale of the economy (Principle 10.5).

The players, at the points in the system that confer the greatest freedom to act or exert influence, should be targeted (Principle 10.6) when setting up regulatory taxes and their accompanying expenditure programs.

The idea of taxing ‘bads’ (ie. pollution and resource depletion) rather than ‘goods’ (income, labour and capital), which underpins the Costanza et al. proposal, and is advocated by bodies such as the World Resources Institute (Repetto, 1992), is a powerful and useful rhetorical device. But the concept of taxing ‘bads’ rather than ‘goods’ is not a proper technical basis for tax policy (Principle 10.7) since it is not a reliable guide for action (6). Indeed, some ‘bads’ should be taxed for regulatory reasons and some ‘goods’ such as employment should not be discouraged by taxes. But it is, however, appropriate to tax personal income (a ‘good’) so that it can be divided into moneys to be spent individually and socially. If, after weighing up their situation, people decide to opt for more unpaid time to use at their own discretion rather than pursuing personal and social income, this need not be a problem if there are no poverty traps.

11. Changes needed in the Costanza et al. reform package.

In the light of the analysis to this point, it is argued that a number of changes should be made to the Costanza et al. package:

• instead of a tax on mineral extraction, a set of taxes and bans should be introduced to close
  off the ‘escape routes’ by which materials can leave the economy. (See Principles 9.1 and
  9.2). It is the environmental impact of the extraction and processing of minerals plus their
  dissipative disposal that matters, not their transfer from the ground to the economy.

• instead of a fossil fuel tax what is needed is a general depletable energy tax that covers
  nuclear energy as well. (See Principle 9.7).

• the primary macro-measure for transforming the economy to conserve biodiversity
  should be a tax that reflects the extent to which land or waters have been alienated
  from their natural state rather than taxes on damage to ecosystems. The latter taxes can be
  used for fine tuning but they are unlikely to drive the whole system back to a better balance
  with nature.

• the revenues from eco-taxes should not be used to reduce personal income tax or company
  taxes (7). Instead payroll taxes should be eliminated and eventually replaced by a wage
  subsidy. (See Principles 10.3 and 4.)

• more emphasis needs to be placed on measures to increase the responsiveness of the
  community and business to the changed factor price structure. (See Principle 5.2.) The
  package should involve more than a tax shift and investment credits for renewable alternatives.
  Regulatory taxes can be effective at lower rates and their negative economic impacts lower if
  elasticities are higher.

• while the reform package needs to be phased in as suggested it will never reach a final
  position. For as long as economic growth continues, the macro-ecotaxes will need to
  increase so that rising purchasing power does not undermine their regulatory
  effectiveness. (See Principle 10.5.)

12. A revised ecological tax/expenditure reform package

A revised reform package suitable for implementation is summarised in Figures 10 and 11 and elaborated in Sutton (1995b).

Figure 10:
Ecotax and Expenditure Package for an Ecologically Sustainable Economy
Measures required to create an economically viable and ecologically sound closed-cycle economy.

Tax on the way in: Depletable energy Tax to equalise costs on the way in: Virgin material prices (cf. regeneratively recycled materials)

Tax to stop side effects: Alienation from the natural state Degradation of nature

Tax to block escape routes from the economy: Tailings etc. Waste to industrial or municipal tip Waste to incinerator Waste to sewer/sea Waste to export (to prevent physical dumping) Pollution Lost/dissipated material inputs User fees: Waste storage rentals

Invest in or subsidise solutions:
R&D for regenerative recycling and material quality retention
General R&D, infrastructure, structural adjustment and education in relation to waste elimination, renewed resource use and environment protection)

Revenue recycling:
Via negative payroll taxes, and pensions

Supporting mechanisms:
An economy wide life-cycle assessment system.

Notes:

• All taxes and the waste storage rentals would be indexed to the growth of the economy (except the cascade resource equaliser).
• Input virgin resource prices increased to just exceed regeneratively recycled resources.
• All disposal charges would reflect the extent to which disposal lowers the quality and accessibility of the waste for eventual reprocessing.
• Disposal charges would be split between waste disposers and manufacturers/importers to affect product design and disposal behaviour.

V 2.a 9/1/98

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Fig. 11. The uses of the growing revenues from the ecological taxes.

Special features of the package that may not be fully apparent from Figures 11 and 12 are:

• it would drive the economy to a structure that involves virtually zero pollution, waste and
  biodiversity loss as well as significantly lower energy use.

• rather than blocking the input of resources to the economy, which would prevent stocks from
  building up, it is the dissipative movement out of the economy as a result of use, disposal or
  accident that would be effectively blocked by ecotaxes and law-based regulations.
  Non-renewable energy would be taxed on the way into the economy because it cannot be
  built up into stocks in the same way that minerals can. (The active use of energy automatically
  accelerates its loss of quality and dissipation).

• in the early stages of the introduction of the reform package the depletable-energy tax and the
  carbon component of the pollution taxes would be rebated when energy intensive products
  were exported to allow for more gradual structural adjustment by export industries. This
  modification is particularly important for Australia because energy intensive products make up
  such a large percentage of its exports. It is probable that the depletable energy tax and the
  carbon component of the pollution taxes would not be fully applied to energy intensive exports
  until an international agreement was operating.

• in time there would be no more permanent waste disposal, all waste storages being designed
  instead for waste retrieval. Waste storage rentals would be high enough to encourage all stored
  wastes to be reprocessed eventually.

• disposal taxes would be split in half, with one half of the charge being fed to direct disposers
  by a user-pays system and the other half being charged to product manufacturers and
  importers on the basis of the estimated or actual levels of dumping of their products. This
  would encourage manufacturers and importers to modify their products to favour waste
  elimination.

• action would be taken to stop wastes being exported to be physically dumped. Outright export
  bans may not be GATT compatible but an export tax is probably acceptable (M. Churche,
  personal communication, 1995). Where recycled-materials markets do not currently exist for
  wastes and the costs of local disposal exceed the costs of disposal in another country, there
  would almost certainly be attempts to export the waste. This would undermine the creation of
  a true closed-cycle economy within the country.

• the alienation-from-nature tax would ensure that land-intensive or biomass-based renewable
  energy is not substituted for non-renewable energy at the expense of nature, and that the
  natural environment is not used as a dumping ground for materials to be ‘recycled by nature’.

• the revenue from ecological taxes would be largely recycled by using it to reduce labour costs.

• payroll tax reductions and wage subsidisation would be linked to active labour market
  programs to improve the matching of labour demand and supply with special benefit accruing
  to workers currently most prone to unemployment.

• although it is not a specific objective, this package would be expected to increase the long
  run growth of the economy because of the way that it favours productivity enhancing dynamics
  (Sutton, 1994).

Fig. 12. Changes in relative factor prices after the introduction of the recommended ecological tax and revenue package.