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Future of Tax

The future of tax is green

Author: ICAEW Insights

Published: 09 Mar 2022

Green tax main

Despite multiple challenges, governments are pushing forward with taxation policies to curb carbon emissions. More coordination will be needed if they are to use the tax system to help prevent the planet overheating.

The climate crisis is the most serious and urgent challenge facing us today. The past five years have seen the perceived risk of global heating move sharply from a distant, theoretical threat to one with immediate, significant and irrevocable effects.

A holistic and united response will be needed from governments, regulators, and businesses. Tax authorities, with the pressing concerns of low productivity and inequality, and the continued challenge of global tax avoidance, have so far fought shy of pushing for more radical action on carbon taxes. 

There is a growing consensus that the approach to tax needs to change, using it to more coherently influence the behaviour of businesses and individuals to deliver net zero carbon and a better environment. At the same time policymakers are looking for new sources of revenue to fund public services and investment, with carbon taxes seen as one way of plugging gaps in budgets as countries emerge from the coronavirus pandemic.

From a revenue-raising perspective there appears to be room to increase the tax take from environmentally-focused taxes, certainly in the UK. The Institute for Government (IfG) reports: “Even on the widest Office for National Statistics (ONS) definition, environmental tax revenues represented only a fairly small percentage – 6.9% – of total revenue from taxes and social contributions, and only 2.3% of GDP in 2019/20.”

No common view on how to tax carbon emissions

So, what can be done? “Fundamentally, there’s a consensus among economists – if not the wider world – that there remains a need to put a tax on greenhouse gas emissions in a consistent way,” says Stuart Adam, Senior Research Economist at the Institute for Fiscal Studies. “You can do that either through a carbon tax or through an emissions trading system, or a combination of the two.” 

However, Adam points out: “What we have at the moment is a mishmash of smaller policies that don’t fit together well and are horrendously inconsistent across things we could be doing to cut emissions to get to net zero.”

According to the IfG, the most explicit UK tax on greenhouse gas emissions is the UK Emissions Trading Scheme (ETS). The UK ETS works using a ‘cap and trade’ principle. The cap sets the total amount of carbon that can be emitted by a sector and as the cap is reduced over time, overall emissions from the sector must fall. “Emissions trading systems work in the same way as carbon pricing/taxes by placing a cost on emissions. But in an ETS, the price is not set solely by the government. Instead, participants monitor and report their emissions each year and then surrender the required number of emissions ‘allowances’.” 

The intention is that by gradually reducing the cap, market forces combined with further research and development will result in an overall move towards net zero. The question is whether these measures can move us quickly enough towards the goal.

Many businesses themselves are forging ahead with the net-zero agenda, preferring to reduce emissions themselves rather than wait for regulation to be written. Designing and applying regulation in this area is incredibly difficult, not least because it requires international coordination. Creating a tax system to fit with this is a big part of the challenge.

Unintended consequences

“Taxes can change the way people behave,” says Andy Lymer of Aston Business School. “Once you recognise that, tax as a lever can be used to change the direction of travel. So, an effective environmental tax policy to increase the amounts of tax paid on polluting things, like company cars and so on, can make a real difference … delivering an environmental impact.” 

However, as Lymer admits, the tax system can be a blunt instrument. “We can use the tax system to encourage more homeworking to lower emissions through transport, but what about the impact on home heating and the bills around that? Is that an appropriate use of the tax system to encourage behaviour change? Should we be allowing employers to move the cost of heating offices on to individuals at home?” 

“I think the tax system is not actually built to cope with not only a digital future but a carbon-neutral future,” says Ken Bowles, CFO of FTSE 100 packaging giant Smurfit Kappa.

Future action

In the future, regulators will continue to grapple with the issue of harmonisation. The EU is working through the implications of setting new carbon tax rules, while being mindful of the concern that these could penalise EU-based firms by allowing non-EU companies that do not have to comply with carbon tax rules to supply the EU market with cheaper products.

As Bowles argues: “If the EU was to bring in some kind of carbon taxing model for EU companies, that would clearly have a negative impact on competition from companies outside the EU, who might send imports/exports into the EU, which doesn’t have the same kind of carbon tax.”

As a possible pointer to the future, the European Commission (EC) recently adopted a proposal to prevent this problem using a new Carbon Border Adjustment Mechanism, which will put a carbon price on imports of a targeted selection of products. 

This, the EC says, will ensure that European emission reductions contribute to a global emissions decline, instead of pushing carbon-intensive production outside Europe. It also aims to encourage industry outside the EU to take steps in the same direction.

However, Bowles says: “As it’s set up today, I don’t think tax systems in the world are necessarily built to cope with, or indeed are looking to cope with, the concept of aligning a tax policy framework with the achievement of global climate objectives.”

Bowles – in line with his peers in business – accepts that the burden of investment will always fall on the bigger companies. “However, I don’t think we always have to think about the traditional model being the one that goes forward. I think there’s a world where governments – and let’s face it, that’s who sets tax policy – could have equally introduced a ‘carrot’ around incentivising companies to make sustainable investments and demonstrate carbon reduction.” 

The introduction of tax credits or capital allowances to encourage investment has also proved popular in some spheres. For instance, supporting the growth of the company car market for electric cars. 

“Accelerating those allowances to be able to show some kind of investment credit for work done to achieve particular sustainability goals could work well,” Bowles says.

International coordination will be key

Governments are increasingly willing to use tax to encourage more sustainable behaviour (witness the UK’s forthcoming plastic packaging tax), while at the same they are working together more closely through the OECD and more widely to cooperate on tax internationally. 

The level of international cooperation will need to increase significantly and much more rapidly than the decades-long process that has surrounded developments in international corporate taxation, for example. The climate emergency is global and much more urgent.

The risk with taxing carbon emissions in one country is that it may be tempting to move some activities to jurisdictions where they are more lightly taxed. And while taxes can be designed to address this risk, for example through a carbon border adjustment, a better approach would be for the other countries concerned to tax carbon emissions too.

Finance ministers and tax authority chiefs have a new mandate to green their tax systems. 

No one country can do that on their own – and so they will need to work with their foreign and environmental ministry colleagues to make sure rapid progress is made over the next five years. Do it right and their legacy will be to have helped save the planet.