Information about Asia and the Pacific Asia y el Pacífico
Journal Issue

Public Policy and the Environment

International Monetary Fund. External Relations Dept.
Published Date:
January 1991
  • ShareShare
Information about Asia and the Pacific Asia y el Pacífico
Show Summary Details

Governments must consider the possible impacts of their environmental policies on key

macroeconomic balances

Kenneth Miranda and Timothy R. Muzondo

Environmental degradation—ranging from soil erosion, desertification, and air pollution, to the shrinking of the ozone layer, pollution of the world’s oceans, global warming, and deforestation—is increasingly drawing interest from the international community. In large part, this has resulted from a growing awareness of the linkages between economic activities and the environment and the desire to ensure that the design of economic policies takes due account of environmental concerns. National governments, international organizations, and nongovernmental organizations are now actively trying to develop and adopt measures that would begin to address these rather serious problems.

In spite of the large volume of research on environmental issues undertaken over the last two decades, important gaps remain on the relationships between economic activities and the environment, the possible impact of economic policies—both macroeconomic and structural—on the environment, and the implications of structural environmental policies on macrobalances. This article raises some of those issues, highlighting that inevitably difficult trade-offs will arise, forcing governments to weigh the short run against the long run, as well as certain economic objectives against preservation of the environment.

Causes of degradation

Excessive environmental damage, whether national, transnational, or global in nature, is generally rooted in either market or policy failures. Broadly speaking, market failure exists when social costs differ from private costs (or benefits). Such failures may reflect the existence of spillover effects, unpriced resources, absent or thin markets, excessively high transaction costs that discourage otherwise beneficial exchanges, lack of information, technical uncertainty, the public good nature of many environmental resources, or a lack of property rights. Under such circumstances, overconsumption and excessive depreciation of environmental assets will occur, thereby creating a potentially serious threat to the sustainability of a local—or even global—ecosystem.

In the absence of measures to compensate for such failures, the harmful side-effects of many industrial activities may not be considered, thus leading to an excessive degradation of air or water quality, for example. On an international scale, when transaction costs are high or property rights are poorly defined, transnational spillovers (e. g., when acid rain affects the environmental quality in a bordering country) or international spillovers (e. g., when there is global warming or depletion of the ozone layer) may play a dominant role in the overconsumption or depreciation of mutually shared environmental assets.

Policy failures—particularly at the microeconomic level—may also create the same sort of threats. These might arise because governments leave a vacuum, that is, do not redress market failures through legal, regulatory, economic, or other means, when it is clearly feasible. Or governments might actually magnify existing market failures. For example, agricultural input subsidies in many developing countries and agricultural price supports in many developed countries may encourage chemical fertilizer- and pesticide-intensive forms of farming, with adverse impacts on water resources, nontargeted animal populations, human health, and the long-term productivity of soil resources. Or, the setting of forestry concession, stumpage, and improvement fees, which in combination are below true scarcity values, may lead to levels of logging above long-run sustainable yields.

Given the existence of these market and policy failures in most countries—and the fact that for some, these failures raise questions about the sustainability of growth and development over the long run—governments are increasingly finding that they cannot ignore these linkages. The challenge for them is twofold: to minimize the possible adverse effects of macroeconomic policies on the environment and to structure environmental policies so that they do not impair a country’s macroeconomic performance.

Macroeconomics and the environment

Efforts to achieve economic growth and full employment in the long run, and price stabilization and a viable balance of payments in the short run, hold the potential to enhance or degrade the environment and natural resource management in several ways. For example, the pursuit of high rates of economic growth may, depending on the economic characteristics of the economy, cause faster-than-sustainable rates of depletion of natural resources and increased waste emissions and energy use—a key factor underlying air pollution. On the other hand, rapid economic growth can generate the resources by which a government can finance environmental protection policies. In Ecuador, for example, revenues generated in the high growth eco-tourism sector, particularly fees charged to visitors to the Galapagos Islands, have been earmarked for nature park conservancy across the country.

It is often argued that the environmental impact of the choice and mix of macroeconomic instruments, such as monetary, fiscal, and exchange rate policies, should be taken into account. However, in many cases the environmental implications of these policies are ambiguous. For example, a devaluation of the exchange rate aimed at improving the competitiveness of a country’s exports can encourage overexploitation of the country’s natural resources—beyond the level that is sustainable in the long run. At the same time, such a devaluation may also increase domestic prices of imported petroleum products and may reduce air pollution as consumption of those products falls, as well as possibly reduce urban bias, and, hence, associated pollution and congestion problems.

The fact that the use of a macroeconomic instrument might result in some adverse environmental effects does not, however, mean that its use need be compromised. In the case discussed above, a devaluation is generally considered the most direct and efficient instrument for achieving balance of payments objectives. The problem of overexploitation of natural resources, if any, that could result as a by-product of the exchange rate change is best compensated through the application or adjustment of appropriate microeconomic instruments. For example, a government might increase rates of mineral taxation to offset the potential impact of an exchange rate devaluation on nonrenewable resource exploitation. Thus, by and large, it is more a question of the appropriate matching of policy instruments with policy objectives. Market and policy failures are essentially microeconomic in nature and are thus best addressed through the introduction of new—or a recalibration of existing—microeconomic instruments (see article by Gunnar S. Eskeland and Emmanuel Jimenez in the March 1991 issue).

Still another important link between macroeconomic activity and the environment is the national income accounting framework. In recent years, the use of conventional national accounts as an indicator of long-term sustainable economic growth has been increasingly criticized, because the accounts do not reflect diminished potential for future production caused by depletion of nonrenewable resources (see article by Ernst Lutz and Mohan Munasinghe in the March 1991 issue). As a result, measured growth can be illusory, and the prosperity it engenders transitory, if the apparent gain in income means a permanent reduction in the stock of environmental assets. In response to these concerns, a number of countries, including Norway and France, are now establishing resource accounts to supplement their economic accounts.

Environmental policies and macrobalances

Despite an extensive literature on the best way to design and implement various structural environmental policies, few attempts have been made to link environmental management policies to the broader area of macroeconomic management. Clearly, however, the policies adopted to address environmental concerns could have important macroeconomic implications for output, prices, and employment; the fiscal balance; the monetary accounts; and the balance of payments. These are briefly illustrated below. However, few firm patterns, and hence conclusions, emerge—partly because of the range of possible environmental policies, uncertainties as to their effects, and the widely diverse circumstances of countries in which they would be applied.

Output, prices, and employment. Overall, the level and structure of output, as well as employment and prices, are likely to be altered by the adoption of environmental taxes and subsidies, but the size and scope of these changes will depend upon a number of factors, including the structure of the economy and the mix of policies. For example, the introduction of environmental taxes may have short- and long-term effects on national output. Taxing an environmental spillover caused by a given market activity will reduce the output of such an activity. At the same time, the output of some other market activities, which previously suffered because of the environmental externality, could increase, thereby partly offsetting the reduction in measured economic output. However, if no other market activity were suffering previously (say, only natural beauty or air quality was affected), then there might not be an offset, and measured national income might actually decline, even while welfare was improving.

The introduction of environmental taxes could also lead to a once-and-for-all increase in the price level in the short run, as the “costs” contained in the taxes are passed through into the prices of final goods (assuming that monetary policy accommodates the price level pressures). However, fiscal revenues from environmental taxes could be used to finance offsetting reductions in other taxes. As far as employment is concerned, the taxed sector is likely to contract and, in so doing, release resources, including labor. In the short run, therefore, this may result in a temporary increase in the unemployment rate until other sectors of the economy absorb the labor and a new structure of production emerges.

Subsidy reform can also have certain output effects. A reduction of energy subsidies, for example, will reduce the bias toward energy intensity in the industrial sector and will have important output implications, as previously energy-intensive sectors of the economy attempt to adjust to new energy prices. A contraction of these sectors will also result in temporary labor dislocation and, to the extent that firms must raise prices, lead to once-and-for-all price-level effects. A number of Eastern European countries, including Poland and Hungary, are currently undergoing such a transition, in response to the realignment of petroleum prices to those prevailing in the world market.

Fiscal balance. As might be expected, the adoption of environmental policies can also have important budgetary implications, but here, again, a case-by-case approach must be taken. For example, the introduction of environmental taxes, and even pollution permits, will certainly raise additional revenues (the actual rate, however, should be based strictly on what is needed to address the environmental concern), whereas environmental subsidies or tax expenditures to compensate those who voluntarily reduce the amount of pollution they generate would adversely affect the fiscal balance—as, for example, with tax credits allowed to households and firms undertaking certain energy conservation practices under US tax law in the late 1970s and early 1980s. In cases where deforestation is a major problem, some forms of energy subsidy, which could be justified as a second-best solution, may need to be retained on a targeted but transitional basis. Finally, the changes in the levels and structure of output, employment, and prices, as noted earlier, might also affect the revenues generated by the existing structure of taxation.

Monetary accounts. In this economic sector, the adoption of environmental policies will most likely have, at best, some indirect effects and these could well be insignificant in most cases. Thus, for example, to the extent that the reform of subsidy policy, the introduction of environmental taxes, and the sale of pollution permits improve the overall fiscal position, the extension of credit to the government sector might be curtailed. On the other hand, the granting of environmental subsidies, effected via the budget, may worsen the fiscal position, necessitating an expansion in credit to the government sector. If a government decides to allocate a given amount of credit to agents undertaking certain prespecified forms of environment-improving activities at a preferential rate of interest, such environmental subsidies may have direct credit policy implication.

Balance of payments. For a country’s external accounts, the implications of environmental policies in the short run may be both direct and indirect, necessitating a detailed, country-specific examination. The introduction of environmental taxes, for example, might make exports and import competing goods less competitive, especially if other countries choose not to impose similar taxes. Two cases, however, need to be distinguished. Where an externality is national in nature (i.e., contained within the borders of a country), the deterioration of the balance of payments will be offset by an increase in the value of the country’s natural environment. In this instance, the loss of external competitiveness may be explicitly accepted as the price of improved environmental quality. But where an externality is transnational (e.g., .pollution into a river that passes through several countries)—or has global implications (e.g., the use of highly polluting forms of energy such as brown coal)—the incentive to implement environmental policies could be attenuated, because the country carrying out such a policy would suffer a loss in external competitiveness, but would be unable to appropriate the increase in the value of natural capital that accrues transnationally or globally—for example, cross-border pollution between Eastern and Western European countries.

This loss of competitiveness, however, can be reduced in certain situations. First, environmental taxes and pollution permits may not necessarily be implemented in the traded goods sector, and hence their external sector incidence may be reduced. Second, even if environmental policies directly affect a traded good, the loss in competitiveness in the market in which the tax is imposed may in part be offset by an improvement in the competitiveness of other traded goods that formerly suffered from the externality, thereby resulting in an altered structure of the balance of payments. Thus, in Madagascar, recent efforts to preserve natural habitats, such as rain forests, and simultaneously promote eco-tourism may result in lower foreign exchange receipts from, for example, logging activities, but greater receipts from tourism.

The reform of subsidies can have direct as well as indirect implications, as well. On the direct side, cutbacks in energy subsidies can lower import levels or, if the country is a producer, lead to higher exports. Similarly, reductions in pesticide and chemical fertilizer subsidies can lead to lower import levels of the products themselves, or of imported inputs for their production—although any short-run reduction in agricultural output resulting from a reduction of such subsidies may necessitate an increase in food imports. On the indirect side, any changes in the level and structure of production in the economy resulting from the adoption of environmental policies may also have significant implications for the level and composition of imports.


The introduction or strengthening of measures aimed at improving environmental management can have far-reaching implications for key macroeconomic balances. However, no generalization is possible. In some cases, the overall macroeconomic balance implications of such policies could be supportive of a country’s macroeconomic stabilization and adjustment efforts, while in other cases the net outcome may be unclear. In many other cases, however, important policy trade-offs, especially with regard to growth, price level, employment, fiscal balance, and balance of payments objectives, are likely to occur. When such is the case, it may, nonetheless, be possible to mitigate some of the adverse macroeconomic balance implications of environmental policies. For example, the negative balance of payments implications of resource sector taxes could be counteracted by the beneficial balance of payments effects of reforming subsidy and tax incentive policies in support of environmental objectives.

In the fiscal sector, the worsening of the fiscal balance, as a result of providing environmental subsidies or the implementation of environmental conservation projects, could be counteracted by the use of revenues from appropriately designed environmental and resource sector taxes as well as general tax reform. Finally, while the adoption of environmental policies would in general alter the path of measured national output through time, it may be possible to adopt some nonenvironmental structural policies concomitantly, so as to minimize this impact in the short run.

Other Resources Citing This Publication