Fiscal Policy for a Sustainable Environment

International Monetary Fund
Published Date:
August 2002
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In both developed and developing countries, fiscal policy has an important role to play in assuring sustainable use of natural resources and safeguarding the environment. This applies to both the tax and spending sides of the government’s budget. On the former,

  • Taxes can be used to ensure that prices reflect the full social costs of producing goods and services. This type of pricing is most conducive for growth over the long term. The prices charged for petroleum products, for instance, need to reflect not only the cost of buying or selling them on the world market but also the social costs of the airborne pollution their usage can create and—in the absence of better-targeted instruments, such as toll charges—the congestion associated with motor vehicle use.
  • A well-designed tax and royalty system is key to ensuring that countries receive a proper share of the rents earned by the exploitation of their natural resources and to ensuring that those resources are not overexploited. For many developing countries, rents from mineral deposits, forestry, or fisheries can be an important source of revenue and one that, with a well-designed tax regime, is compatible with socially appropriate patterns of resource usage. On the spending side.
  • Some public expenditures, such as assistance to rural energy efficiency and spending on forestry management agencies, directly support more efficient resource use. Subsidies for, or relatively low taxation of, kerosene may also be desirable, since in many developing countries it is used as a household fuel, providing an alternative to deforestation.
  • Other kinds of spending, however, may inadvertently increase environmental externalities by pursuing objectives that could be better achieved by less damaging means. Subsidies for particular kinds of energy use, for instance, are sometimes intended to serve primarily distributional goals but generate adverse environmental effects that could be avoided. The underlying equity objective could still be met by eliminating such subsidies and spending the resources saved on basic health care or education. (Box 1) gives more examples of these harmful subsidies.)

In many countries, there are significant opportunities for “win-win” fiscal reforms that enhance the sustainability of both resource use and the fiscal position. Prices of both intermediate inputs—such as energy or chemical fertilizers—and outputs—such as agricultural commodities—are still seriously distorted, even in many industrial countries, aggravating environmental degradation (Table 4). These cases of combined policy and market failures can be turned around to provide “win-win” opportunities for fiscal reform. For example, eliminating subsidies on fossil fuels can simultaneously strengthen macroeconomic balances, promote efficient resource allocation, and improve the quality of the environment.32 Beyond the elimination of policy distortions, there may also be cases in which environmental taxes—such as pollution or waste charges—are called for to properly account for the negative effects of pollution. These have the side benefit of increasing government revenue, enabling other and more harm- ful taxes to be reduced or beneficial public spending to be increased, although such revenues, especially in developing countries, may be modest.

Box 1.Environmentally Harmful Subsidies

Energy subsidies. Most countries provide explicit or implicit subsidies for coal, electricity, oil (mostly in oil-exporting countries), gas, and nuclear power. Yet energy use contributes to many of the world’s most serious environmental problems, notably (1) global warming owing to the greenhouse effect; (2) damage to property, forests, livestock, and aquatic life caused by acid rain, dust, soot, and ash; and (3) health problems, in particular respiratory problems.

Transport subsidies. In most countries, use of the road network is underpriced, stimulating road traffic and reducing the use of mass transport, which is less polluting.

Agricultural subsidies. Agricultural outputs and inputs have been a popular target of government subsidies. Such subsidies are damaging because they increase the demand for agricultural inputs, such as pesticides and fertilizers, which can cause health problems owing to the contamination of the food chain. They also provide incentives for land clearance, which can result in loss of wildlife, forests, and public amenities and lead to greater soil erosion.

Forestry and fishery subsidies. Direct or indirect subsidies provided by government to promote timber exports and/or local wood processing can result in deforestation, soil erosion, sedimentation in waterways, fire hazard owing to deadwood left behind, destruction of wildlife, destruction of tropical plants, and increased global warming (since forests act as carbon sinks). Similarly, subsidizing the fishing industry can jeopardize the sustainability of the fish stock.

Water subsidies. Subsidized water delivery for agricultural, industrial, and household purposes, coupled with demographic pressures, can lead to the unsustainable utilization of water resources (scarcity/stress, pollution, and runoff).

Industrial subsidies. When raw materials processing and energy use are subsidized, a negative impact on recycling and a strong negative impact on all kinds of emissions and waste can result.

Source: Gupta, Miranda, and Parry (1995).

Many of the fiscal reforms needed to enhance sustainable resource use and environmental protection would be good policy, even in the absence of such special considerations. This is because many of the most damaging provisions arise from distortions often introduced for nonenvironmental reasons, so that the same policy objective can be achieved by other means that do less damage. The desire to help farmers, for instance, has led some countries to zero-rate fertilizers and pesticides under the VAT. As an alternative, the VAT could be charged on these items at the standard rate; this would reduce the prospect of fraudulent refund claims and generate additional revenue, which could then help finance expenditures to benefit small farmers, such as those to improve rural transportation networks. In such cases, environmental considerations are usually only secondary in the policy debate, with revenue and standard efficiency issues being more to the fore; nonetheless, the potential environmental gains from such reforms can be significant.

Taking its lead from organizations with a particular expertise and mandate in the environmental area (especially the World Bank) and focusing particularly on problems with a macroeconomic dimension, the IMF has encouraged countries to implement fiscal reforms that are consistent with more sustainable resource use. In Uzbekistan, for example, the IMF has repeatedly argued that the degradation of irrigation water and agricultural land—owing to massive explicit and implicit subsidies—is unsustainable and has severe economic costs. To remedy this, the IMF recommended increased charges for irrigation and other communal services to cost-recovery levels. The IMF has also advocated reforms in the pricing of energy—in Azerbaijan, Belarus, Ecuador, Venezuela, and elsewhere—arguing that prices should reflect the opportunity costs to the country. To help counter the unsustainable depletion of water resources in Yemen, the IMF has encouraged reforms to progressively eliminate the substantial subsidies on diesel fuel and other petroleum products, since these encourage water overuse by unduly reducing the costs of operating water pumps. The IMF has typically not involved itself, however, in the design of pollution charges and other taxes explicitly designed to correct environmental externalities, leaving this to other organizations with the required expertise.

The forestry sector provides an example of how fiscal policy can be used to capture resource rents while, at the same time, providing a number of environmental benefits. Uncorrected market failures and governance problems are leading to the loss of large areas of forest in many countries. These problems have also attracted attention in some IMF-supported programs (Box 2). In many countries, the value of the rents captured from concessions for forest resources has been too low, leading governments in need of revenue to accept excessive exploitation.33 Reforming the pricing of forest resources would help governments to capture more resource rents and so strengthen fiscal balances. At the same time, these reforms would encourage more efficient and environmentally friendlier exploitation of forests.34

Box 2.The Forestry Sector in IMF-Supported Programs

Indonesia. In working with the authorities to prepare the IMF-supported program in 1997, there was mutual recognition that reform of the forestry sector’s fiscal regime could yield substantial benefits. The program incorporated reforms—such as the enforcement of selective-cutting guidelines, increased government capture of timber rents, and a moratorium on natural forest conversion—to encourage more sustainable use of forestry resources. Some progress in reform of the forest sector has since been achieved. The breakup of the forest product marketing monopolies improved efficiency and opened up the dialogue on forest policy reform, including with nongovernmental organizations (NGOs), bilateral donors, and other constituencies. The IMF and World Bank’s attention to governance issues in the reform process itself, particularly transparency and stakeholder consultation, has played a key role in empowering domestic constituencies supporting reform.

Cambodia. In the 1994 adjustment program, supported by the Enhanced Structural Adjustment Facility, reform of the forestry sector played a major role. Since then, the IMF has continued to emphasize that conditions for financial support would include government performance in monitoring log exports and ensuring a transparent flow of forest revenues to the national treasury. In addition, the IMF recommended establishment of a monitoring unit and other supportive measures to enhance transparency and good governance, such as requiring that all concession contracts be published and that all concessions in violation of their contracts be canceled. As the IMF program resumed in 1999 (after the domestic political situation had stabilized), the government committed itself to renewing forest sector reforms. Twelve forestry concessions were canceled; timber royalties were increased significantly (by almost 300 percent); and the monitoring of forest crimes was enhanced, including by establishing a Forest Crime Monitoring Unit with the participation of an international NGO as an independent monitor. Progress has since been made in restructuring the remaining forestry concessions, but effectively monitoring forest crimes remains a challenge. Efforts are, however, under way to further improve the monitoring of forest crimes. All logging activity by concessions is currently suspended until management plans are submitted and environmental impact assessments are approved by the government. Several additional concessions have been canceled, and the volume of forest land in protected areas has been increased.

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