Making VAT fight climate change

This week is the first London Climate Action Week, promoting action on climate change at the local, national and international level. Whilst there is lots that local and regional actors can do it is inevitably limited to their areas of control. This can include congestion charging zones, local energy schemes and upgrades to social housing. However national governments will continue to have control of the biggest economic levers, namely taxation, subsidies and regulation.

National governments can influence climate change through the tax system, and an ideal mechanism could be re-purposing Value Added Tax (VAT) as a carbon consumption tax ("Carbon-VAT" or "C-VAT").

National governments are reluctant to use taxation as a driver of climate action, with limited examples including the EU's relatively benign Emissions Trading Scheme and the UK's Carbon Price Support tax. Some of this reticence can be put down to fears over public acceptability of carbon taxes as detailed in this 2017 report by the Grantham Research Institute (GRI) and the Centre for Climate Change Economics and Policy (CCCEP). But with public concern over climate change growing in both the UK and Europe I get the sense that governments are preparing to take action. This is immensely positive, but we must get it right.

One popular idea is for a system of "Carbon Fees and Dividends", as promoted by the Citizen's Climate Lobby (CCL). Broadly speaking this would see an economy-wide carbon tax imposed, with proceeds distributed equally amongst citizens.

The UK Labour Party has proposed a raft of policies including sanctioning firms that do not take sufficient action on climate change. They have also proposed a massive expansion of residential solar panels in the social housing sector.

The UK's Conservative-led Government continues to push offshore wind as key to decarbonising the electricity sector and some Conservative groups are now calling for the reversal of the ban on onshore wind receiving government support that has been in place since 2016.

I fear that the policies proposed by Labour and the Conservatives are either relatively unambitious (in the case of calls for more solar and wind) or vague and open to misapplication (in the case of John McDonnell's call for sanctions on climate-unfriendly firms). These policies all risk falling into the trap of picking winners rather than a laser-like focus on the issue that needs addressing, namely the emission of carbon dioxide and other greenhouse gases.

The CCL's call for a "carbon fee and dividend" is an interesting one, because it uses the technology-neutral principle of carbon taxes to harness market competition. CCL's proposal includes a "carbon dividend" to compensate for the regressive nature of carbon taxes and to gain public support. However, I am concerned that the idea of a "carbon dividend" would be difficult to administer as it is essentially a universal Benefit scheme. It would also be a massive change from the status quo and hence trigger some of the public concerns cited by GRI and CCCEP (same link as above). It is worth noting that the carbon tax proposal is in essence an extension of the UK's highly successful Carbon Price Support (CPS) tax in the electricity sector.

Is there a way to implement carbon taxation that is not regressive?

CCL's carbon tax proposals could be implemented without the complicated carbon dividend as long as we simultaneously make changes to other taxes such that the distributional tax burden doesn't change. Luckily such a tax does exist and it's a big one, VAT.

The distributional impact of VAT and an estimate for a carbon tax in the UK are shown in the chart below. This chart uses carbon tax data from a report by Policy Exchange (page 12) and VAT data from the ONS. Both taxes mean that those with higher incomes pay more (although a lower share of their income) and that those with the highest incomes pay approximately 4 times more than those on the lowest incomes.

VAT is in many ways a tax without a clear purpose other than raising revenue, making it an outlier among taxes which either redistribute income (income tax), discourage unhealthy behaviour (alcohol and tobacco duty) or discourage carbon emissions (fuel duty and Air Passenger Duty). By re-purposing VAT as a carbon consumption tax we can take climate action without significant distributive effects, and make a blunt and unloved tax work to fight climate change.

Implementation and pitfalls

The main benefit of re-purposing VAT as a carbon consumption tax is that a lot of the infrastructure already exists. The key change is that instead of charging VAT as a percentage (typically 20%), VAT would be charged as £ per tonne of CO2 equivalent (£/tonne). We can call the carbon consumption tax "Carbon-VAT" or C-VAT".

The changes can be gradual, with individual sectors moving from charging traditional VAT to charging C-VAT as a replacement. For example, in the electricity sector there is already a carbon tax on the main fossil fuels (coal, natural gas) that is paid by power stations (CPS and EU ETS) - this would be paid as C-VAT (£/tonne) and as such there would be no other VAT on electricity consumption (currently 5%). This becomes more complicated as we add more sectors and particularly as we implement Border Carbon Adjustments (BCAs) to reduce carbon leakage. That said, VAT and VAT rebates are already applied at customs borders.

If we want C-VAT to raise the same revenues as VAT currently does then we need to look at annual VAT revenues (c. 120 £billion - ONS) and compare this to annual UK carbon consumption (c. 800 Mt CO2_eq - Committee on Climate Change, p.32). This implies a carbon tax of c.150 £/tonne of CO2 equivalent, 5 times higher than the current level of carbon pricing in the electricity sector and undoubtedly sufficient to make a major dent in UK carbon consumption.

Conclusion

We are reaching a threshold in the climate change debate where governments will need to make major policy changes to have any chance of achieving global climate targets. It is key that we all advocate for implementable and technology-agnostic policy changes, whilst ensuring we avoid regressive distributional impacts.

I believe transitioning VAT into a carbon consumption tax (C-VAT) is a realistic climate policy that could drive major carbon reductions by pricing the externality of carbon emissions and other greenhouse gases.

And what happens if C-VAT is so successful that carbon emissions drop along with C-VAT tax receipts? One to watch, but certainly a nicer problem than the ones we currently have...