Point of View

Richard Baron, taxation executive, Institute of Directors

The Government is considering the options for environmental taxes, or eco taxes. So what are the pros and cons of these taxes?

It all depends on the form of the taxes. Take the best-known environmentally biased tax we have, the excise duty difference between leaded and unleaded petrol. The difference is 5p a litre. More than twice as much unleaded petrol as leaded is now sold in the UK, suggesting the tax difference between the two has had the intended effect of changing behaviour. But engineers and car makers had to make this possible: at one time few cars could use unleaded. Was it worth the effort?

Pondering that question leads us into the main economic argument for eco taxes. The market works by putting prices on what we consume. There is not enough to satisfy everyone’s appetites, and prices are a way of sharing resources in a tolerably rational way. But some resources are not charged for unless there is a tax. Clean air is one of them. If you want to drive past my house and dirty my air, I cannot make you pay me, so you should pay a tax instead. If you want to burn leaded petrol outside my house, you should pay even more.

Now we see how to answer the question of whether the effort to provide cars which can use unleaded was worth it. It was if the cost was less than the value of getting lead out of the air. That value is the difference between the compensation people should be paid for having their air polluted with fumes from leaded, and what they should be paid for having their air polluted with fumes from unleaded.

That difference in compensation is the level at which the tax difference between leaded and unleaded should be set. The tax difference will make motorists pay the right extra amount for burning leaded. Some of them will then offer to pay a bit more for cars which can use unleaded. That will persuade manufacturers to provide such cars if it is worth their while. Whether it is will depend on how much they have to pay engineers to do the work. So the market balances everyone’s desires to produce the right result. Surely this is the perfect case for eco taxes?

Well, not quite. The market can only work if we start by setting the tax difference between leaded and unleaded at the right level.

That means knowing, in cash terms, how much we care about getting lead out of the air. But when the Government sets the tax difference it can only guess at the right figure.

Even if we can overcome this differently our problems are not over. Suppose a particular plastic generates 10 units of pollution per tonne made, and that the correct compensation rate for this pollution is £23 a unit. The pollution can be largely eliminated by putting filters on factory chimneys, but at a cost which will probably vary. The cost of getting rid of each unit of pollution might rise in £1 steps from £20 for the first unit to £29 for the tenth, as it becomes harder to get the remaining pollution out of relatively clean air. Impose a tax at £23 a unit and manufacturers will reduce pollution to about six units a tonne, the point where the cost equals the tax saving.

In economic terms this is the right result, but practicalities can prevent us from getting there. To apply a tax per unit of pollution, we must measure the pollution from each factory. That can be expensive. So it is tempting to apply a tax per tonne of output. But in that case, manufacturers will have no incentive to reduce pollution: they will pay the same tax whether they do or don’t, so they will continue to generate 10 units of pollution per tonne, and the tax should therefore be set at £230 a tonne to compensate for the 10 units of pollution. Output, and total pollution, will fall because the price of the plastic will rise to pay for the tax, but the overall result will not be the right one according to market principles: tax levels, pollution per tonne, output and prices will all be wrong.

Oddly, there can be a good reason to use taxes per unit of output. Suppose that the plastic is made in several countries and is traded internationally. A tax on pollution will only apply to UK manufacturers. They will lose business to foreign producers who do not pay the tax and can undercut them. The remedy is to tax the final product, applying the same levy to imports but exempting plastic exported from the UK. Then UK and foreign producers suffer the same tax in each national market. The wrong method of taxing pollution is needed to defend the UK economy.

So should we have eco taxes? Yes, if we can get them right. But do not expect that to be easy.