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 RESTRUCTURING MINNESOTA'S TAX SYSTEM: TAXING POLLUTION RATHER THAN WORK AND INVESTMENTDavid Morris, Vice President, Institute for Local Self-Reliance Testimony before Minnesota House of Representatives Committee on Taxes February 23, 1995 My name is David Morris. I am a resident of Saint Paul and co-founder and Vice President of the Institute for Local Self-Reliance, a 21 year old nonprofit research organization based in Washington, D.C. and Minneapolis. I come before you wearing another hat as well. I am a board member of Minnesotans for an Energy-Efficient Economy. I am the author of several books on energy policy and have written over two dozen technical reports. Those most relevant to this proceeding are: Making the Polluter Pay: The Case for a Minnesota Carbon Tax and Green Taxes. I congratulate this Committee for holding these hearings. In recent years there has been increasing interest in using pollution taxes to restructure national and state tax systems. Two factors are responsible for this interest. First, the recognition that current tax systems make economies less efficient. Second, the recognition that the prices we pay for goods and services do not reflect their full environmental costs and that these environmental costs are not trivial. Economists increasingly embrace the proposition that our tax system perversely raises the price of "good" economic activities like investment and employment that we would like more of, while we keep low the price of "bad" economic activities, like pollution, that we would like less of. In Europe, where there are strong environmental political parties and high unemployment, pollution taxes coupled to an overall restructuring of the tax system is receiving very serious attention and support. Several European countries have begun to introduce tax shifting measures. In mid 1993 European President Jacques Delors publically declared his support for taxing natural resources and reducing taxes on labor. And just a few weeks ago eight of the ten largest corporations in Sweden, in an audience with Prime Minister Ingvar Carlsson, requested that a dramatic shift in Sweden's tax structure toward environmental taxes. From what I understand, Prime Minister Carlsson asked these corporations whether they represent all of Swedish industry. They responded that they might not represent the energy and resource intensive and polluting industries of the past but they definitely represented the labor and knowledge intensive and non-polluting industries of the future. In the United States the conversation about tax shifting is more muted. But here too there is interest in the concept. The Ford Motor Company and the GAP clothing chain supported a carbon tax introduced a year ago in California that would have replaced a portion of the state's retail sales tax. The new Republican majority in the U.S. Congress is proposing that we restructure our tax system toward taxes on consumption. Pollution taxes are a type of consumption tax. Economists have long agreed that as presently structured our tax system penalizes work, savings and investment. As we raise taxes on labor and capital we tend to reduce productivity and overall economic activity. Studies disagree on the extent to which this is true but they agree on the overall direction of the impact. For example, several studies found that for every 10 percent rise in state and local taxes on labor there is about a 4 percent decline in employment .[1] Other studies found that if tax rates on investment income are raised 10 percent savings also falls by about 4 percent. Economists have a fancy phrase for this effect, "marginal excess burden of taxes". That is defined as the additional loss of private income due to reductions in work effort and investment. Most studies find that this loss is in the range of 30 cents on the increased tax dollar. While economists find that our present tax system raises the price of "goods" they also increasingly agree that our present pricing system underprices "bads" like pollution and resource inefficiency. When we buy a gallon of gasoline or a kilowatt-hour of electricity or purchase any product we are not paying the full environmental cost of extracting and processing that product and disposing of it. Internalizing these real environmental costs into the prices of these products can encourage businesses and households to become more efficient. For after all, pollution is a sign of inefficiency and wastefulness. As the late Buckminster Fuller once observed, "Pollution is nothing more than an unharvested resource". Increasing numbers of economists favor substituting pollution taxes for taxes on labor or income as a way not only to reduce pollution but to make the economy more efficient. An analysis by the World Resources Institute suggests substituting $100 billion of environmental taxes for a mix of current federal taxes yielding the same revenue might generate $40-60 billion yearly in additional real income.[2] A number of economic studies have examined the overall impact of tax shifting. These analysis have assessed the overall impact of environmentally based tax shifting on the U.S. economy, on the European economy and on several national economies within Europe. These studies' conclusions vary significantly depending on the kind of economic forecasting model used as well as the kind of tax shifting proposed.[3] Some models conclude that the greatest positive impact comes from offsetting pollution taxes with reductions in taxes on investment. Others believe that the greatest positive impact comes from reducing taxes on labor. Virtually all models conclude that a significant pollution tax would reduce future pollution and fossil fuel use. To give an example of the results from one of these models, the Danish government examined the impacts on their economy from increasing their existing carbon dioxide tax by about $25 per ton. This analysis might be relevant to Minnesota because Denmark has a gross domestic product about 20 percent larger than that of Minnesota and is heavily involved in international and intra-European trade. The Danes concluded that if the revenue generated by the carbon dioxide tax were returned through income tax reductions the result would be a loss in production and a rise in unemployment. But if the revenue generated were returned by reducing business' social security reductions employment would increase by some 4,000 jobs in the short run and production would modestly increase as well. Table 1 Effects of a $25.50 per ton increase in Denmark's CO2 tax on the Danish Economy Returned through income tax reductions
Returned through employer social security reductions
How High Should Pollution Taxes Be? To date environmental taxes in Minnesota have been used or proposed for the purposes of revenue generation, not tax restructuring. For example, the Minnesota Solid Waste Tax raises about $25 million a year. In April 1992 State Senator Steve Morse introduced a bill to impose a $6 per ton carbon tax and raise about $150 million a year.[4] The bill was re-introduced a year later with a modified tax of $2 per ton, which would have raised about $50 million a year. Tax shifting demands that we embrace a much higher environmental tax. It should be a tax high enough to conceivably change behavior in a way that reduces pollution while not being so high that the public sector becomes dependent on pollution for its revenue. Clearly if pollution taxes are effective, in later years the quantity of pollution will stabilize or decline. Most tax restructuring efforts in the U.S. and Europe propose environmental taxes that replace 5-15 percent of the existing total tax revenues. For Minnesota this percentages would translate into pollution taxes that generate about $1 billion in annual revenue. This revenue could displace about 5 percent of the current total state and local taxes[5]. Happily, we can justify this $1 billion environmental tax figure as being consistent not only with efforts elsewhere but conservative recent estimates of the true costs of pollution in Minnesota. In 1993 the Minnesota legislature required the Public Utilities Commission(PUC) to quantify the environmental costs associated with electric power production.[6] In February 1994 the PUC established interim figures. Currently a contested case proceeding is going on before an Administrative Law Judge. That hearing, which includes expert testimony and cross-examination of witnesses, will be concluded by May. The PUC is expected to approve final environmental cost figures by the fall. The PUC proceedings will provide a wealth of expert data on environmental cost accounting. By statute the PUC will apply its final pollution cost figures only to the electricity generation sector. But from an overall economic perspective, the environmental costs quantified by the PUC should be applied to all economic activities within the state. As Table 3 shows, if this were done we would discover that only about 25 percent of the total pollution cost falls on electricity producers. Almost half is borne by the transportation sector. Table 2. Pollutants Generated By Sector (Percent)[7]
Sector CO SOx VOC PM NOx CO2[8] Mercury[9]
Transportation 70.0 4.8 30.1 21.6 38.7 31.8 n/a[10] Table 3. Pollution Cost Generated By Sector In Minnesota (Percent)[12] Sector Percent
Transportation 44 The estimates of the cost of pollutants provided by the experts in the PUC proceeding vary dramatically. Assuming these costs are applied to pollutants generated statewide, the aggregate cost estimates vary from a few hundred million dollars a year to several billion dollars. For purposes of this discussion, I use the cost estimates proposed by the Minnesota Department of Public Service. The DPS estimates are on the low end of those proposed by other expert witnesses in the PUC proceeding and are conservative compared to the costs of pollution used by regulatory agencies in several other states. The DPS environmental externality estimates, if applied statewide to all pollution regardless of the generating source, would come to about $1.1 billion. Table 4. Statewide Cost Of Pollution Using Department Of Public Service Mid-Range Externality Values (millions of dollars) Pollutant[13] Total Cost
VOC $437 A pollution tax could be imposed on each pollutant generated. However, as Table 4 reveals, almost 50 percent of the pollution costs are generated from the burning of carbon. Thus it might be administratively simpler to impose an across-the-board carbon or carbon dioxide tax. A tax of $50 per ton of carbon or about $15 per ton of carbon dioxide emitted would raise $1.1 billion.[14] Table 5. Externality Cost By Pollutant In Minnesota (Percent)[15] Pollutant Percent of Total
CO 21 A Possible Tax Restructuring Plan The $1.1 billion in pollution taxes would replace about 5 percent of total state and local tax revenues. The revenue from the pollution taxes would be used to reduce other taxes. It is important to emphasize that this is a revenue neutral process. We are not proposed to increase overall taxes but rather to change the kinds of economic activities we tax. What kinds of tax reductions we propose to offset the increased pollution taxes depends on the relative weight we give to equity and efficiency concerns. For purposes of this hearing, the following is proposed. A reduction by 30 percent in workers' compensation payments by industry. A reduction of about 30 percent in commercial/industrial property taxes. A reduction of about 15 percent in residential property taxes. And an elimination in state income taxes for families earning less than $20,000 a year. Potential Tax Reductions From $1.1 Billion in Pollution Taxes
Proposed Action Cost This type of tax restructuring may not be entirely fair for low income Minnesotans. Pollution taxes tend to be regressive. They fall more heavily on low income households. Energy use is a good surrogate for pollution and poor households spend more than 15 percent of their income on energy while households earning over $50,000 a year spend less than 3 percent. A $50 per ton carbon tax would increase annual taxes by $359 on a low income household in Minnesota. Assuming 514,000 low income households in Minnesota, the amount generated by a $50 per ton carbon tax from low income households throughout Minnesota would be $185 million. The $200 million used to eliminate state income taxes for lower income households would not be useful for those households that pay no tax. Table 6. Impact of a $50 Per Ton Carbon Tax on Low Income Households
Thus we need to find a way to compensate the very poorest members of the community for the increase in their cost of living due to pollution taxes. One way to do this might be to invest much more heavily than we now do in energy conservation programs for this sector. As of 1991 low income energy efficiency programs in Minnesota were serving about 20,000 homes per year, although by far the largest amount of spending was used for the 10,000 homes served by the weatherization program. At current rates, the weatherization program would need 50 years to serve all low income households. To date low income energy efficiency programs have found it difficult to even keep up with the increased number of households in need. Assuming a $2,000 investment per home, $75 million from the pollution tax would serve an additional 37,500 homes per year. In addition to existing low income programs, this would allow the entire low income household population to be served within about 10 years. Each household would reduce heat, electricity and water expenditures by $100-200 per year or more. This exercise offers a glimpse into the opportunities for tax restructuring based on pollution taxes. The next step for the legislature and the executive branch is to evaluate the impact of various types of tax restructuring. State agencies have the computer modelling capacity to do this. They can determine which types of tax restructuring and what levels of pollution taxes can generate the largest increase in economic efficiency while holding harmless the low income sector of the state. Industrial Competitiveness Whenever pollution taxes are suggested an immediate and reasonable first question is, "How will they affect state industries?". There are two responses to this question. First, pollution taxes can be designed in such a way as to protect existing state industries that are engaged in export and could be adversely affected by such tax increases. Second, the rapidly growing industries of today are knowledge and labor intensive. They will be far less concerned about a pollution tax than they might be a high personal income tax or a high commercial property tax. Thus if pollution taxes are used to offset these other forms of taxes, the new tax structure of the state can generate the same amount of revenue as before while making the state more attractive to the types of companies that will be most competitive in the future economy. No matter how well-designed environmental taxes are they will have winners and losers. Nevertheless, pollution taxes can and have been designed so as to minimize their adverse impact on domestic industry. For example, to cope with competitiveness issues European nations either exempt heavy industry from carbon taxes or create a two tiered structure for business and households. In 1991 Sweden introduced a $37 per ton tax on carbon dioxide emissions. Energy intensive industries were exempted. Household and non-manufacturing industries paid rates four times higher on average than mining, manufacturing and agriculture industries.[20] In 1992 Denmark introduced a carbon dioxide tax. The charges are twice as high for households as for businesses: $14.23 per ton of CO2 vs. $7.11. To protect its industry, Denmark goes even further by offering refunds to energy intensive businesses. For firms engaged in export, refunds of the tax are possible depending on the ratio of the tax relative to the value added in production. For industries where the tax amounts to more than 3 percent of the value added, a total tax refund is possible. However, Denmark permits such refunds only if "reasonable" energy efficiency investments are undertaken. These investments must be specified in energy audits carried out by consultants certified by the Danish Energy Agency.[21] Finland and Denmark also have a cap on the amount of carbon taxes a firm that competes internationally must pay.[22] Table 7: Carbon Dioxide Taxes in Europe as of January 1, 1994
Country Tax per Ton of Effective Exceptions Comments Carbon Dioxide Date Denmark Households/Public May 5, 1992 CO2 taxes shown are part $14.23/ton of an integrated CO2 and energy tax system. The introduction of the CO2 tax Industry/Commercial January 1, For energy-intensive in 1992 was accompanied 1993 by $7.11/ton industry, refunds up a small reduction in to energy 100% if reasonable taxes. The industrial and conservation projects commercial sectors are have been carried exempted from ordinary through. energy taxes. Finland $4.00/ton January 1, * Products used as Tax rate for motor fuels 1990 revised raw materials in is larger than if it several times industrial production. were proportional to carbon content. * Fuels in overseas planes and ships. Netherlands $2.35/ton January 7, Non-energy uses and Previous general 1992 international sea/air environmental tax traffic. restructured to 50% CO2 and 50% energy-based. Norway Gasoline: January 1, * Fuels in all air Increases in the CO2 tax $44.68/ton 1991 and sea Mineral Oil: coal: 1/7/92 transport. rate on mineral oils in $20.04/ton Natural Gas: revised * Coal used as input January 1993 were offset $44.68/ton several to Coal: $17.23/ton times industrial processes. by an elimination of the basic tax rate for mineral oil. Sweden Residential January 1, Cap on total energy- There also is a CO2 tax 1991 on $36.68/ton revised intensive industrial fuel used in domestic several CO2 air times and energy taxes paid: traffic. * Electricity sector * International sea and Industry air traffic $9.42/ton * Biofuels * Ethanol Source: International Energy Agency,Climate Change Policy Initiatives - 1994 Update (Volume 1, OECD Countries) Conclusion Pollution taxes are an idea whose time has come. Nations are discovering that their existing tax systems undermine economic efficiency and encourage pollution. By raising the cost of resource inefficiency and lowering the cost of investment and employment, states and nations can encourage high productivity, higher employment and lower pollution. Minnesota has been in the forefront of creative thinking not only in the environmental sector but in the tax sector. Now it needs to put its collective thinking cap on and design a tax system that encourages economic efficiency and environmental protection. We can and should engage in a statewide discussion about the kinds of pollution taxes and the kinds of tax reductions we should favor. In some respects, we have the capacity to look before we leap. We can use our modelling and analytical capabilities to evaluate the impact of various types of environmentally based tax shifting proposals. We should use that capability to inform the statewide discussion and then, perhaps in the next legislative session, introduce legislation that reflects the outcome of this analysis and this discussion.
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