German Environmental Tax Reform, setting precedent

1.Introduction
Climate change, measured by

C O2

emissions, is a global environmental

problem; in economic terms embodies an externality: it harms other

members of the society and the responsible for it doesnt pay any of these
damages (Stern, 2007). A first step towards an international compromise
was taken in 1997, the Kyoto Protocol aims to control human-made
emissions. Though it entered into force in 2005, the German government
was one of the first in enacting it in 1999.
The Ecological Tax Reform is synonym for a series of tax increases on fossil
fuels in 5 stages between 1999 and 2003, sanctioned by the red-green
government after their election in 1998. Its main focus was to increase
taxation on a broad base without implementing new taxes, except for the
brand new electricity tax.
Energy

Before

source

ETR

After

Annual increase

ETR

1999

2000

2001

2002

2003

Petrol

50.1

+3.1

+3.1

+3.1

+3.1

+3.1

65.6

Diesel

31.7

+3.1

+3.1

+3.1

+3.1

+3.1

47.2

Heating Oil

4.1

+2.1

6.2

0.2

+0.2

0.6

+1.0

+0.3

+0.3

+0.3

+0.3

2.1

Natural
Gas
Electricity

Tab.1: Table of 5 stages of tax increases

Adapted from Deutsches Institut fr Wirtschaftsforschung (Kohlaas,
Gesamtwirtschaftliche Effekte der okologischen Steuerreform, 2005).

The revenue collected from these taxes was mainly used to lower non-wage
labor costs, the public pension system received in 2003 90% of the 18.1
billion euro collected. This huge transfer of resources to the public pension
scheme allowed a reduction in the Social Security Contribution (SSC) rate,
which went down from 20.3% in 1998 to 19.5% in 2005m these cuts

benefitted both employers and employees (Bach, 2005).

In the course of this essay we do both a theoretical and empirical analysis;
in the the latter we use data from the OECD, the Statistisches Bundesamt,
etc. Then, we mention a couple of alternatives that might solve some of the
problems the ETR fails to address. Finally, we conclude with some final
remarks on this issue.
2. Analysis
Theoretical
The ETR consisted of a series of pigouvian taxes intended to lower CO2
emissions (Pigou, 1954), the mechanism of action of the pigouvian taxes is
better explained by figure 1 (Wikipedia, 2016). One of the problems of a
pigouvian tax is its implementation, due to the complexity that measuring
emissions individually means; the German government took care of that
issue in a rather clever way, instead of taxing the output (CO2 emissions),
they taxed the input (Fossil fuel consumption). When doing this, they also
were aware of the substitution effect that might have taken place amongst
the variety of fossil fuels available in the market, to address this matter they
taxed the whole range of fossil fuels. Later on this essay we show that this
system was rather effective lowering both fossil fuel consumption and CO2
emissions.

Fig.

Recovered

from:

https://en.wikipedia.org/wiki/Pigovian_tax#/media/File:Social_cost_with_tax.svg

Another concern that rises when implementing this kind of taxes, its its
redistribution effects. A higher tax on an input means a rise in the
production costs, thus lowering overall production, which translates into a
decrease in the labour demand (Grlach, Knigge, & Lckge, 2005). The
response of the German government was to use the revenue of the ETR in
order to lower the Social Security Contributions (SSC) made by both
employers and employees, thus lowering non-wage costs; the intention was
to create jobs while reducing CO2 emissions.
Empirical Evidence
Fossil fuel prices, and in general energy prices, often fail to take into
account the true ecological costs their usage carries. This failure sends the
wrong signals to the market leading to an overconsumption, which creates
short and long term ecological problems, such as the climate change. Thus,
the aim of the ETR is to correct the wrong prices, making sure the right
signals are sent to the market, this is what is called the internalization of

the problem (Kohlaas, Auswirkungen der Okologischen Steuerreform auf

private Haushalte, 2005).
As aforementioned the ETR consisted of a series of both raises in the oil
products, and a cut of the Social Security Contributions (SSC). The
mechanism intended here is as follows, with a raise in the prices of oil
products, firms will lower their consumption; either making more oilefficient processes, turning to renewable sources of energy, or by simply
reducing their output; in any case, the CO2 emissions will decrease over
time without affecting the labour market in the long run. The effect of ETR
in increasing jobs is not defined, but PANTA RHEI calculated that the
reform made between 220 000 and 250 000 new jobs already in 2003. And
LEAN indicates an increase in employment of 176,000 in 2008 (Beuermann
& Santarius, 2006).

Fig. 2. Co2 Emissions per year (tons) and oil consumption (millions of tons).
Note:
Adapted
from:
https://www.quandl.com/api/v3/datasets/BP/OIL_CONSUM_DEU.xml (British Petroleum

, 2016) and http://dx.doi.org/10.1787/93d10cf7-en (OECD, 2014), (Accessed on 06

March 2016).

Figure 1 shows a sharp decrease in the consumption of oil after and during
the implementation of the ETR. The average consumption from 1990 to
1998 was approximately 134 million of tons, from 1999 to 2003 was
approximately

129

million

of

tons,

and

from

2004

to

2012

was

approximately 117 million of tons; thus proving extremely effective in

reducing oil consumption.
Furthermore, the graph also shows a severe reduction in C02 emissions,
which, as shown by the chart, is strongly correlated with the oil
consumption.

Fig. 3 Percentage of energy of fossil fuel origin and green energy.

Note: Adapted from doi: 10.1787/aac7c3f1-en (Accessed on 06 March 2016). (OECD,
2016)

Its also remarkable the slow, but steady, decline in the participation of
fossil fuel in the generation of energy. Moreover, one of the objectives of the

ETR was to promote the substitution of fossil fuel energy for green energy,
which as shown by figure 2 has recently been gaining importance as a
source of energy.
Tax Burden
The German Institute for Economic Research (DIW) prepared a series of
reports in which they analysed in deep the effects of the tax reform on every
sector. They found that the elasticity-price for the private demand f fossil
fuels decreases at a rate of 2% for every 10% in the increase of the price,
making it a very inelastic demand (Knigge & Grlach, Berlin). Hence, if the
demand is inelastic the burden is going to fall on the consumers, as we later
show this burden is compensated by the creation of new jobs and the
increase in GDP (Gayer & Rosen, 2014).
They found that the use of the revenues of the taxes to lower SSC shifted
the tax burden from the work factor onto energy consumption, worked. The
GDP increased in almost half a percent in comparison to simulations with
out the ETR; CO2 emissions also showed improvement when compared to
the simulations, managing a reduction of 20 millions of tons in only 2003c
(Knigge & Grlach, Berlin).
The studies attribute the positive effects to the investments made by the
firms in energy reduction technologies.
International Oil Prices and its possible effect
Fig. 4 Oil consumption per year and oil price (in 2014 US dollars).
Note: Adapted from https://www.quandl.com/data/EIA/PET_RWTC_D-Cushing-OK-WTISpot-Price-FOB-Daily?utm_medium=graph&utm_source=quandl (U.S. Energy
Information Administration Data , 2016)

However, it is also important to highlight the effect international oil prices

might have had in the decrease of the oil consumption. The last decade saw
the highest oil prices of all times, which may have helped this noble
enterprise, further research should be conducted on this topic.
Alternatives
Even though there is a decrease in emissions as a result of the ETR it is
hard to quantify how big the real impact is. Hence, it might be useful to
point out some alternative policies to reduce emissions.
First of all, it is worth mentioning an idea sketched out in the beginning of
the analysis. In a perfect world taxing the output its more effective in
reducing both the emissions and the costs associated with these reductions.
This would not only lead to lower consumption of fossil energy resources,
but would also give incentives to i.e. use better filters to lower the pollutant
agents released into the air. However, measuring the emissions of every
firm in reality carries huge administrative costs, which outweigh the
benefits of such a policy.

On the other hand, another approach is to fix the quantity of emissions the
society is willing to tolerate (i.e. via emission bonds), provided that the
conditions are right (Coase, 1960). A market for emission bonds would
provide the companies with the highest needs for emissions with the ability
to maintain their emissions, while firms who can reduce their contamination
levels at a lower cost would do so.

Fig. 5 Emissions trading

Note:
Recovered
from
https://en.wikipedia.org/wiki/Emissions_trading#/media/File:Emissions.Trading.jpeg
(Wikipedia, 2016).

This type of policy has been used since the Kyoto protocol proclamation in
1992 for emission-trade between countries; its been adopted in the EU
since 2005 for the same purposes between companies, a better explanation
of this mechanism is showed in figure 5.
Final Remarks
First of all, it is pretty clear that CO2 emissions have sharply decreased
since the implementation of the ETR in 1999; however, it is still unclear
whether this reduction is caused by the ETR, or the presence of high oil
prices in the past decade along with other economic facts, such as the

financial crisis. Nevertheless, the ETR is credited with having managed to

take some pressure off the pension system, by transferring roughly 90% of
the tax revenue towards the Social Security system (Bach, 2005).
It is also also important to mention that despite the problems the ETR has
faced over the years, such as recent public criticism (mainly due to general
misunderstanding of the reform) (Beuermann & Santarius, 2006); the
incentives that it generates to pollute at efficient levels; and, the distortion
it generates to the economy (Kohlaas, Gesamtwirtschaftliche Effekte der
okologischen Steuerreform, 2005); its still one of the best ecological tax
reforms out there. It sets an example for other developed nations, were still
on time to make things right.

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