The green tax revolution Europe needs

European policy-makers need to bolster short-term demand while simultaneously accelerating the shift toward carbon neutrality. The solution lies in a bold green tax reform, combined with generous compensation via the tax and benefits system and cheap funding to help firms and households adjust.

LONDON – On July 17-18, European Union leaders will meet in Brussels to try to reach an agreement on the bloc’s proposed €750 billion ($852 billion) recovery fund. Member states currently disagree on several issues, including the shares of grants and loans in the package and which conditions, if any, should be attached to the disbursements. But once leaders clinch a deal, the most important question will be how member states should spend the money. The answer is far from obvious.

Governments have two potentially conflicting objectives. First, European economies need a demand boost to compensate for the restrictions on “social” forms of consumption (restaurants, bars, concert halls, and the like) and to support spending by people whose incomes have fallen. In a recent working paper, researchers at the ifo Institute in Munich used surveys of German firms to show that COVID-19 is currently having a deflationary impact. This suggests that constraints on demand are greater than those on supply.

Second, European countries need to embrace digital opportunities more fully and make swifter progress toward carbon neutrality over the coming decade. The European Commission has therefore proposed that member states spend a sizeable chunk of the recovery-fund money on investments and reforms that promote long-term growth while fostering green and digital transitions.

But public investment – on items like new high-speed rail links, electric-vehicle charging stations, or fiber-optic networks – will do little to boost spending in the next few years. Such infrastructure projects need time to get through planning committees, and take many years to build. Consumption vouchers or cash-for-clunkers programs, on the other hand, would increase demand quickly, but would do little to hasten the transition to a sustainable digital economy, even if they were given a green tinge.

Yet, there is a way for policymakers to bolster short-term demand while simultaneously accelerating the shift toward carbon neutrality: a bold green tax reform, combined with generous compensation via the tax and benefits system and cheap funding to help firms and households adjust.

The economic rationale for such a plan is simple and widely accepted. By making harmful greenhouse-gas emissions more costly, green taxes push consumers and firms out of polluting activities and make energy conservation profitable. Furthermore, green taxes with a predetermined upward trajectory establish a credible path for the future cost of polluting. This gives businesses and households the clarity they need to invest in energy-saving innovation and equipment.

Europe’s existing carbon-emissions trading system has failed to provide this price signal. The carbon price was too low for too long to induce changes in consumption, and too volatile to give firms credible guidance regarding future pollution costs.

Recent fixes have brought the system closer to a carbon tax, but the price of CO₂ emissions is still only about €20 per ton. According to the World Bank, this would need to rise to about €50 per ton today, and €70 per ton by 2030, to be consistent with the emissions-reduction targets in the Paris climate agreement.

Moreover, the emissions-trading scheme does not cover three of Europe’s most polluting sectors: construction, transport, and agriculture. These three sectors, together with waste processing and some other activities, account for 55% of the EU’s greenhouse-gas emissions. Thus, bold national green-tax reforms are still needed.

In addition, EU member states should permanently reduce taxes on labor and increase social benefits, starting now. This would give the economy an immediate demand boost and strengthen incentives to work.

Policymakers should ensure that the tax cuts and additional spending more than compensate for the introduction of green taxes, which in turn would increase steeply over the coming decade. In the meantime, EU funding could partly offset the inevitable temporary increase in budget deficits resulting from such a policy mix.

True, green taxes can be politically problematic, because they create losers, including workers in polluting industries and people who cannot afford to insulate their homes or buy a fuel-efficient car. But the new EU funds can help to mitigate these effects.

At a regional level, the EU’s newly beefed-up Just Transition Fund can support local economies where polluting sectors are major employers. Governments should supplement this assistance with national investment programs to make green taxes more politically acceptable in these regions.

But giving households and firms clear price signals to reduce their emissions is not enough. They also need the means to adjust. The EU should therefore use some of its new funds to provide generous grants and cheap funding for green investments. Recipients should include municipalities, which often are responsible for public transport projects. Such investments would not only help to buy political acceptance for green reforms, but would also boost the efficiency of the new price signals by helping firms and households to react to them.

The COVID-19 crisis is distracting the world from the continuing threat of climate change. But it need not, because the EU’s recovery fund gives governments a unique opportunity to shift the tax burden from work to pollution. They should take it.

Christian Odendahl is chief economist at the Centre for European Reform.