Economic Instruments in Environmental Protection in Denmark

3. Economic instruments in environmental protection

3. Economic instruments in environmental protection
3.1. Types of economic instruments
3.2. Categorisation
3.3. Taxes, charges, and user fees
3.4. Subsidies and other measures
3.4.1. Subsidies
3.4.2. Other measures
3.5. Use of the revenue and purpose of the instrument
3.6. Economic instruments in Denmark

3. Economic instruments in environmental protection

This chapter offers a general and more theoretical, albeit quite superficial, overview of the merits and types of economic instruments that are available. The chapter thus provides an overview of the overall theoretical context. The remaining chapters may be read independently of this chapter.

Economic instruments in environmental protection

Economic instruments in environmental regulation offer an alternative to the traditional ‘command-and-control’ instruments (direct regulation). The main accomplishments from applying economic instruments are illustrated in Table 3.1.

In Denmark, economic instruments have been known and used for years in environmental policy. In the 1970s, charges and earmarked levies were most commonly applied. The following decade introduced a shift towards more incentive-based instruments, and away from the earmarking of revenues. In the 1990s, yet another shift took place when the economic instruments became more integrated into the overall income tax system. Further, the principle of full cost recovery has been integrated in user fee legislation for many years.

Table 3.1.
The merits of economic instruments

3.1. Types of economic instruments

In this report, the term “economic instruments” will be used to identify all instruments which, by means of affecting price structures, impact positively upon the environment. The term “economic instruments” thus also includes subsidies, grants, and tax allowances that have a positive environmental impact.

This definition is in line with OECD’s definition:

OECD Definition

‘Those policy instruments which may influence environmental outcomes by changing the cost and benefits of alternative actions open to economic agents. They aim to do so by making the environmentally preferred action financially more attractive.’ (OECD, 1997, p. 20)

Rationale

The basic rationale behind economic instruments is to improve the state of the environment through a voluntary participation of rational, economic agents. Economic instruments take their effect through the impact that they have on price structures. An environmental levy on a specific item (such as an article or a service) increases the relative price of that item. Rational and economic agents (consumers and/or producers) will, as a consequence, reduce their demand of this item, as it has become relatively more expensive.

Furthermore, the argument is to internalise economic externalities, and in this sense, increase the overall economic efficiency. The levy would ideally reflect costs that are not internalised. This would, in particular, include the costs to society of the environmental and health effects in question. The price, including the levy, would thereby be a more correct reflection of the total costs of the production and/or use of the item in question.

3.2 Categorization ^[1]

Within the above-mentioned definition of economic instruments, a number of distinctions may be made.

First of all, a distinction is often made between taxes and charges^[2]:

In addition, there exists a number of other economic instruments used in environmental protection: deposit-refund systems, subsidies, and enforcement incentives together with market creating instruments. Table 3.2 provides an overview of the various categories of instruments and of the specific types within each category.

3.3. Taxes, charges, and user fees

In this report, a distinction is made between the following types according to the object for taxation:

A differentiation of the rates applied (typically phrased “tax differentiation”) presents a further variant method for applying a specific tax or charge.

Product taxes and charges

The purpose of product taxes and charges is to impose a levy on products that cause environmental damage through their extraction, production, use, or disposal. Typically, companies that trade or produce goods must keep accounts of their production, sales, and purchase, e.g. for VAT collection purposes. Thus, the collection and enforcement of product taxes may be directly related to such already existing registers and procedures. While this substantially eases the calculation and collection procedures, the environmental effects may be more difficult to foresee. This is, because product taxes and charges typically only have an indirect relation to the emissions, as opposed to effluent charges that are more directly related to the actual emissions. As a consequence, it may also be argued that emission charges, in many cases, provide a much stronger incentive to reduce emissions.

Tax Differentiation

Tax differentiation aims to stimulate the use of less harmful substitute products or inputs at the expense of more harmful products or inputs. Differentiated taxes on vehicle fuels thus are widely applied to stimulate, for example, the use of low-sulphur diesel, and the use of unleaded petrol and/or petrol with low contents of benzene.

Table 3.2.
Overview of economic instruments

Effluent charges/taxes

Effluent charges and taxes are based on the quantity and/or quality of discharged pollutants. Ideally, their level would reflect the costs to society of the discharge in question. For all practical purposes, the level is, however, established more pragmatically, because the costs to society are extremely difficult to assess. This difficulty includes, i.e. the uncertainties or lack of knowledge on current and/or future effects from the discharges; and the lack of complete knowledge on available technologies to reduce discharges. Consequently, effluent charges are mainly applied vis-à-vis sectors where the number of actors are limited, and where there is fairly good knowledge on the mentioned relations. This also illustrates that calculation and control are some of the major obstacles to a widening of the use of effluent charges and taxes, although the effluent charges, in most cases, provide the most direct relation between the environmental issue at hand, and the object for taxation.

User fees

User fees are payments for specific environmental services, such as waste disposal or sewage treatment. The intention is that payments for such services will reflect the costs of providing the service. This includes the costs of complying with the environmental requirements imposed on the plants. The size of the user fees should not exceed the full cost recovery. User fee levels are, among other things, determined by the environmental requirements imposed on the plants providing the service in question. User fees are typically calculated and collected by the units that own and operate the plants in question.

Administrative Taxes

Administrative taxes are payments for authority services that are associated with the administration of related environmental regulation. Administrative taxes can, in a sense, be considered as a user fee.

3.4. Subsidies and other measures

3.4.1. Subsidies

Subsidies provide the opportunity for financial assistance to motivate individuals or enterprises to act more environmental-friendly per se. Subsidies may also be used to reduce compliance costs in relation to specific environmental regulations. Subsidies may be in terms of grants, soft loans, or tax allowances. Subsidies may be financed through the general budget, or through earmarked revenues.

Earmarked revenues

Earmarked revenues may constitute the financing source for specific subsidy schemes. Thus, revenues collected from one specific or from several charges may be re-allocated for specific environmental purposes. This subsequent use may relate directly to the source of the revenue, or it may relate to any environmental purpose. While it is argued that the economic rationale for such schemes is weak, they may nevertheless play an important role in enhancing the acceptability of the taxes and charges in question, and in providing funds for the environmental expenditures.

The latter argument is particularly justified in cases where public financial resources are very scarce. In these cases, suitably designed environmental funds can be effective mechanisms for channelling earmarked revenues to help tackle serious environmental problems^[3]. By the standard of market economies though, the continued use of subsidies and the reliance on earmarked funds is a second-best solution. Earmarking sets aside economic resources outside the general process of financial and economic policy, thereby, reducing the economic resources available for other necessary expenditures. There is also a danger that over the longer term, resources may be channelled to problems that are no longer high priority. Further, the level of public services financed through earmarking may have to adjust to changes in revenue, rather than to changes in demand and needs.

Impacts from other subsidies

Subsidies that are applied for other reasons than environmental may also have an effect on the environment. For example, subsidies may aim to enhance the mobility of the work force, in terms of, e.g. tax allowances for cost of transportation to and from the workplace. Subsidies are also provided to agriculture through the EU, in order to support the competitiveness of European agriculture. Although such subsidies have been implemented for other reasons, their effect on environment may be negative. In other words, these subsidies may be counterproductive to the effects from using economic instruments in environmental protection, as for example, in terms of providing an incentive to intensive agriculture production. While this illustrates the importance of applying a highly integrated approach in assessing economic instruments in environmental protection, such instruments are nevertheless considered to be beyond the scope of the present report, and therefore will not be considered.

3.4.2. Other measures

Deposit-refund systems

Reusable items and Disposals

This measure adds a surcharge to the price of a product. The surcharge is refunded when the product, its residual, or packaging is returned to a collection system instead of conventional disposal. A distinction can be made between reusable items and items for disposal. The former has a value to the producer, whereas the latter has no value. The latter types thus call for public intervention to promote the establishment of a deposit-refund systems.

Market creation

The use of market creation is very limited in Europe, whereas it is a more commonly applied measure in the US. Emission trading systems establish property rights to a public good: the environment. Market creation renders it easier to control the overall levels of pollution, assuming, among other things, well-functioning financial markets.

Enforcement incentives

Enforcement incentives are actually at the border between administrative regulations and economic instruments. Enforcement incentives provide an economic incentive for compliance. They are particularly relevant in cases where non-compliance or postponement is an immediate alternative. Non-compliance fees are the most used instruments in this category.

3.5. Use of the revenue and purpose of the instrument

As can be seen from the above, the main differentiation between charges and taxes lies in the way the revenue is used. Considering all economic instruments (apart from subsidies), three main alternatives of spending the revenues can be mentioned:^[4]

1.    Allocation to the general budget;
2.    Reduction or removal of other distortionary taxes; and
3.    Earmarking the revenue.

Possible schemes for earmarking are manifold and include, for example:

Earmarking of revenues is not used in Denmark. However, in some cases, it has been decided to recycle all or part of the revenue to the affected industries. This has been motivated in competitive concerns. The recycling has been effectuated in two ways: 1) by means of reducing other industry-related taxes or levies, or 2) by the use of subsidy schemes that often aim to support environmental objectives.

The purpose of revenues

Another way of distinguishing economic instruments is by looking at the purpose of the revenues. One may distinguish between three distinct purposes, although it should be noted that instruments applied may not be categorised as fulfilling only one purpose, and that other purposes may apply other than those stated here. A differentiation may be made between:

If the purpose is merely to gain money for the national budget, the economic instrument can be categorised as a fiscal environmental tax. If the prime purpose is to create an incentive for behavioural changes, the economic instrument can be categorised as an incentive based instrument. Finally, if the purpose of the revenue is to cover the cost of using a specific natural resource or utilising an environmental service, we are then dealing with cost-recovery based instruments. The latter can be subdivided into either user charges or earmarked revenues.

3.6. Economic instruments in Denmark

The use of economic instruments in environmental protection has been substantially enhanced in Denmark during the last decade. A number of new instruments have been introduced, such as the taxes on pesticides, growth promoters, sewage, and tap water. Additionally, existing schemes have been modified and widened; this applies, in particular, for the energy tax system. Originally, this system was implemented mainly for fiscal purposes. During the last decade, the energy tax system has, however, been substantially modified to take into account environmental concerns to a much more significant extent. The modifications and additions include, for example: the implementation of the CO₂ and the SO_x taxes; and tax differentiation schemes in favour of less environmentally harmful vehicle fuels^[5]. On a general level, Denmark explicitly aims to generate large revenues from environmental taxes and charges, including vehicle fuel taxes, and in turn to decrease the income tax levels.

The Danish use of economic instruments in environmental protection typically distinguishes between:

User fees are directly related to specific environmental services. They specifically aim to obtain cost recovery for the environmental services in question.

Denmark applies a wide range of subsidy schemes which generally aim to prompt actions to reduce the strain on environment and resources.

Deposit-refund schemes are used to support recycling and re-use schemes.

The report also includes a description of the vehicle-related taxes. These are product taxes, and the mere fact that they are of a substantial size, motivates their inclusion in this report, as they can be expected to have a significant impact on the vehicle fleet in Denmark (although they are not only motivated in environmental concerns).

Tax differentiation will largely be dealt with as an integral part of the concerned product taxes.

Enforcement incentives are not used in Denmark, and neither is market intervention. In this regard it should be noted that the revision of the EU’s Agricultural support scheme includes a provision for applying “cross compliance schemes”. This would mean that support would only be granted to the individual farmer if certain environmental requirements are fulfilled. The scheme is, however, still under negotiation.

Denmark applies one administrative tax; the tax on environmental supervision. The tax is, however, not included in this report, as its environmental effect is limited. It imposes specific types of enterprises with a specific annual fee (which varies according to the type of enterprise). The annual fee is fixed, and it is to be paid no matter whether environmental supervision has been effectuated or not in the year covered.

Notes:

1. OECD, 1997, and COWIconsult, 1993.

2. OECD, 1997, p. 18

3. Understanding of the “St. Petersburg Guidelines” on Environmental Funds in the Transition to a Market Economy", published in “Environmental Funds in Economies in Transition”, OECD, 1995

4. DEPA, Hans S. Christensen, p. 12

5. The energy taxes and their role in the Danish energy policy is described in detail in chapter 12.