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Study: Tax compensations can be used to influence the economic effects of climate policy – consequences for different types of households vary

Government analysis, assessment and research activitiesMinistry of FinanceMinistry of the EnvironmentValtioneuvoston kanslia 20.11.2020 9.22
Press release 728/2020

The economic costs of climate policy measures such as emission tax and their effects on income distribution can be regulated by redistributing emission tax revenue back to households. This is the outcome of a study conducted by the Pellervo Economic Research Institute PTT, Merit Economics, and Statistics and Research Åland ÅSUB. The means to do this include earned income tax and/or corporation tax concessions and direct support to households.

The study used a dynamic general equilibrium model to examine the effects of different kinds of climate policy measures on the development of the national economy and on income distribution of households. The model was supplemented with a household microsimulation module. Besides the baseline scenario of the economy, the study comprised six alternative scenarios where different kinds of emission reduction measures were taken. The baseline scenario means economic development with climate measures decided by the end of 2019.

Based on the results, it seems that the costs of emission reductions to society could be lowered by using e.g. earned income tax concessions to compensate for these. The compensations have effects on the consumers’ purchasing power, supply of labour and investments. Besides these, they affect the distribution of the economic costs of the measures among households.

The study is highly topical in view of Finland’s climate policy objectives. One of the key issues for achieving these is how the costs of carbon taxes and other climate measures can be compensated for in such a way that adverse economic effects are minimised without compromising the effect on guiding the operations. The effects on income distribution are also important when political approval is sought for climate measures.

Six scenarios to describe impacts of different climate measures

The study compared the baseline scenario for the future development of the Finnish economy with six alternative scenarios where different kinds of climate policy measures are taken. The scenarios are

  1. transport fuel tax scenario,
  2. transport fuel and car tax scenario
  3. peat tax scenario,
  4. electricity and heating tax scenario,
  5. combined effect of scenarios 1–4, and
  6. carbon dioxide tax on consumption.

The scenarios assessed the effects of the measures when the additional revenue to the State was redistributed back to households through compensations. The compensations were implemented by reducing the earned income tax margins or corporation tax, or through income transfers as flat-rate redistribution of the revenue. To some extent households also received compensation for the effects of climate policy measures through the indexation of income transfers they receive.

The transport fuel tax scenario assesses the increases to the taxes on transport fuel introduced on 1 August 2020 and, besides these, the transport fuel and car tax scenario takes into account e.g. the abolition of the exception concerning the tax on diesel fuels and tax concessions for low-emission vehicles. In the peat tax scenario the taxation of peat is gradually raised to the same level with other fuels.

In the electricity and heating tax scenario these taxes are altered in various ways, including the abolition of the energy tax rebate system for energy-intensive industries. As the name indicates, the scenario for combined effects assesses the combined effects of the four scenarios described above. In the scenario with a carbon dioxide tax on consumption a tax based on carbon dioxide intensity is imposed on consumption and imports.

All the scenarios assessed led to a reduction in greenhouse gas emissions. Income inequality increased even in the baseline scenario, primarily because of the ageing population.

Compensations reduce the negative effects of measures

In all scenarios the compensations reduce the negative effects of the measures on growth and wellbeing. At the same time, however, the distribution of the costs of the climate measures depends on how the compensations are implemented.

In relative terms, reductions in earned income taxation benefited middle-income households the most, while compensation through corporation tax benefited the highest income earners. Over a longer term, in most cases households with the lowest income also benefited from these. The flat-rate redistribution of additional tax revenue to all households benefited those with the lowest income, but the overall effect on wellbeing remained lower than when compensation was implemented through earned income tax. On the other hand, in the case of flat-rate redistribution emissions decrease a little more than in the other compensation options.

Climate policy planning should take into account the fact that the effectiveness and income distribution effects of the policy may take different directions depending the measures taken. When considering climate measures and ways to implement the compensations, the effects on several different things should be taken into account: emissions, income distribution, effectiveness and overall economic wellbeing.

Based on the study, it seems that part of the increased tax revenue should be redistributed by lowering earned income taxes, but this favours middle income households in particular. This is why combinations of different ways to implement the compensations should be considered, such as combining a reduction in earned income tax with direct support that is more clearly targeted to lower income households.

The study report ‘Income distribution effects of climate policy’ was produced as part of the implementation of the 2020 Government plan for analysis, assessment and research.

Inquiries:

Olli-Pekka Ruuskanen, Research Director, Pellervo Economic Research PTT, tel. +358 40 641 5732, [email protected]
Juha Honkatukia, Merit Economics, tel. +358 40 304 5561, [email protected]
Jouko Kinnunen, Statistics and Research Åland ÅSUB, tel. + 358 18 25 494, [email protected]

The Government’s joint analysis, assessment and research activities produce data used to support decision-making, everyday operations and knowledge-based management. They are guided by the Government’s annual plan for analysis, assessment and research. The content of the reports published in the publication series of the Government’s analysis research and research activities is the responsibility of the producers of the data in question and does not necessarily represent the view of the Government.