The Role of Environmental Tax Reform in Responding to the COVID-19 Crisis Dirk Heine and Christian Schoder 1. Introduction The COVID-19 pandemic has caused a deep global recession from which recovery is fast but uneven across countries. The health crisis following the outbreak of the Corona Virus Disease 2019 (COVID-19) has triggered a deep global economic crisis. In advanced economies, an average fiscal deficit of 3.3 percent of GDP in 2019 widened to 16.6 percent in 2020. During the same time, the average fiscal deficit increased from 4.9 percent to 10.6 percent in developing countries. However, a recent World Bank forecast expects the global economy to expand by 5.6 percent in 2021, which is the fastest recovery pace in 80 years (World Bank 2021a). Significant downside risk prevails amid a sharp resurgence of new COVID-19 cases. In emerging markets and developing economies, the recovery will be uneven as the pandemic’s lingering effects continue to weigh on consumption and investment. Despite increasing fiscal pressures, most countries still plan to provide protective fiscal stimulus to sustain their economies throughout 2021 while anticipating a gradual fiscal consolidation starting in 2022. Today’s caution about the timing of fiscal consolidation comes from challenges after the 2008-09 global financial crisis when consolidation was implemented early and contributed to a prolonged recession.1 Many countries have also delayed climate mitigation efforts, disrupting the path to sustainable growth. Representative of the predominant fiscal policy stance, the EU is advocating for the preparation of ‘credible medium-term fiscal strategies to anchor expectations’ and fiscal consolidation to start in 2022 or 2023, warning that ‘Member States should avoid a premature withdrawal of fiscal support to their economies.’ With a strong financial sector in place due to regulatory improvements made after the financial crisis, risks of an early withdrawal today are higher than the risks associated with keeping support measures in place for too long.2 Public finances will not recover quickly in most countries. As a reference, tax revenues as a share of GDP stayed below pre-crisis levels for an average of eight years after the global financial crisis in 2008-09. Gupta and Jalles (2021) argue that the pandemic is likely to compress public finances persistently in developing countries because of a significant fall in revenues. By contrast, revenues in advanced countries may recover faster - as they already have high tax rates, consolidation efforts may be focused on the spending side. As the economic recovery takes hold, many countries will introduce measures to consolidate public finances and stabilize the debt to GDP ratio. Fiscal consolidation is commonly defined as a policy to lower government deficits and debt accumulation by reducing the primary budget 1 See Blanchard and Leigh (2013). For a discussion on the optimal timing of fiscal consolidation in the COVID-19 recovery focusing on LAC countries, see IMF (2021). 2 See https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_885. deficit.3 In the short run, fiscal adjustment requires tightening the primary balance by increasing taxes and/or reducing spending, which are likely to hurt growth. The literature suggests that minimizing output losses depends on many factors, including: (i) the timing chosen for initiating fiscal consolidation; (ii) the speed of adjustment (gradual or sharp); (iii) the composition (expenditure- versus revenue-based consolidation) and the role played by accompanying policies (quantitative monetary easing, reforms of fiscal institutions and of goods, services, and labor markets to improve economic efficiency). This paper discusses the optimal timing of fiscal consolidation and the instruments to achieve it at the lowest economic cost. As argued below, these questions cannot be answered separately from each other. The economic costs of specific tax instruments depend crucially on the business cycle. A policy reform needs, therefore, to be timed optimally. Gupta and Jalles (2021) analyze tax reform data from 45 emerging and low-income countries over the 2000–2015 period. The results indicate that past pandemics created conditions for countries to implement tax reforms, particularly for corporate income, excise, and property taxation. The COVID-19 recovery offers opportunities to resolve weaknesses in tax systems and introduce taxes supporting green structural transformations. Understanding the impact of fiscal reforms on output, employment, and distribution is crucial for the political acceptance of these reforms. The preferred tax instruments are those that keep the negative impacts on the economy as small as possible while effectively reducing fiscal deficits. Past research has shown that, after recessions, fiscal policy output effects differ for the spending and revenue sides of the public budget: cuts to public investment tend to reduce output more than increases in taxes, suggesting that tax increases must be included in consolidation efforts. But which taxes? The paper will look at fiscal multipliers of different tax types. This paper aims to show that environmental tax reforms may be the best option to mobilize revenues during fiscal consolidation while reducing distortions and environmental externalities by shifting the tax burden from labor to carbon emissions. The paper discusses the role of environmental tax reform – including adjustments in environmental taxes, labor taxes, and public investment – in tackling the challenges arising in the post-COVID recovery. In addition to a thorough review of the relevant literature, this chapter will provide original research on the tax and spending multiplier effects on output and employment for a large sample of high- and low-income countries. In addition, the chapter will discuss the role of public investment – green investment in particular - in complementing and reinforcing the role of environmental taxation in moving the economy towards a low-carbon transition. The remainder of the paper proceeds as follows: Section 2 reviews the fiscal policy measures implemented during the early stages of the COVID-19 recession to provide economic stimulus and summarizes the debate on the usefulness of different policy measures. It assesses environmental taxes in the context of guidelines for optimal tax policy. Section 3 discusses the theory of optimal tax policy. Section 4 reviews the empirical evidence of environmental tax multipliers as well as labor tax multipliers. Section 5 discusses the literature on green investment multipliers. Section 6 derives policy implications. 3 See Tsibouris et al. (2006). 2. Tax policy to support crisis recovery and consolidation This section reviews the kinds of fiscal policy measures implemented to stabilize output and employment during the pandemic, as well as proposals to achieve fiscal consolidation while leading economies toward a path of sustainable and inclusive growth. It develops principles for successful fiscal policy during the COVID-19 recovery and discusses the role that environmental taxes may play given the low overall taxation of energy use, transport, pollution, and waste in both high- and low-income countries. Tax policy proposals and considerations The post-crisis recovery offers a unique opportunity for governments. Fiscal stimulus is not only a short-run stabilization tool; current economic distress also impacts long-term output potential. Public investment projects and private sector investment in the early recovery shape the capital stock of the future. Fiscal policy – both through direct spending and tax incentives – presents an opportunity to promote sustainable growth by facilitating the transformation of the economy to be more resilient against natural disasters, inclusive and equitable, as well as greener. Recovery packages that perpetuate the status quo will squander this opportunity, leaving climate change on a sub-optimal trajectory. By contrast, recovery policies that incentivize investment in the physical infrastructure, human capital, and natural resource management systems necessary to achieve international environmental commitments would dramatically improve the world’s chances of avoiding the most catastrophic climate scenarios. Various other aspects of sustainable fiscal consolidation need to be acknowledged in order to not undermine recovery. First, in terms of composition, policy makers can reduce unproductive and inefficient spending such as tax expenditures and tax deductions instead of increasing tax rates. Second, short-run tax increases should be aligned with medium-term policy effort to improve the fairness of the taxation system. Third, changes in tax and spending policies must be supported by credible fiscal institutional and structural reforms to sustain output and employment.4 Finally, developing countries with narrow fiscal and monetary policy space face more complex choices than advanced countries and will need international support.5 Which taxes have been recommended for fiscal consolidation? Apart from improving the effectiveness of existing tax systems, the crucial question for post-crisis resource mobilization is what tax instrument on which to rely. Revenue-raising policy options include: • A progressive wealth tax on high net-worth individuals; • Increasing property taxes;6 4 Gaspar, Hanif, Pazarbasioglu, Saint-Adams (2020): https://www.imf.org/en/News/Articles/2020/06/16/vc-facing-the-crisis- the-role-of-tax-in-dealing-with-covid-19. 5 International cooperation should promote fighting tax evasion and tax avoidance and more equitable taxation of economic activities at the global level. In this regard, the globally organized G20 Action Plan to deal with COVID-19 will benefit greatly from spillovers from the global economy's joint action. 6 Increasing taxes on residential and business properties has a higher potential for resource mobilization. Moreover, economic distortions are low as land responds inelastically to price changes. Property taxes could also contribute to the progressiveness of the tax system, see Barreix et al. (2020). However, maintaining accurate land cadasters may prove challenging for many developing countries. • New taxes on the digital economy;7 • Measures to broaden tax bases;8 • Reduction of tax expenditures and subsidies;9 and • Environmental taxation, designed to advance ecological and climate goals while minimizing adverse effects on economic activity.10 Principles for efficient revenue-based fiscal consolidation during the COVID-19 recovery Timing is crucial for the effectiveness of spending in supporting and stabilizing an economy after a crisis and of taxes in resource mobilization. Macroeconomic shocks like the COVID-19 pandemic arise swiftly and without warning. They require immediate fiscal policy responses as automatic stabilizers are not typically built for large shocks. Complex expenditure programs designed to stabilize economies in recessions often experience significant delays, which threaten to prolong the recession and undermine the impact of the fiscal expansion. Timing is equally essential for fiscal consolidation. Tax increases and spending cuts implemented too early in the recovery have been found to undermine expansion. For instance, front-load consolidation efforts contributed considerably to the double-dip recession in the Euro Area after the 2008 financial crisis.11 Not all short-run measures might be beneficial in the long run. As the post-crisis recovery takes hold, many policies that were beneficial in the short term may outlive their usefulness, and some could have undesirable long-term effects. Equally, some ‘green’ capital-intensive spending may not sufficiently raise employment in the short run and, therefore, may not be the best choice in a situation of high unemployment. For example, tax deferrals and tax cuts have helped businesses survive the initial contraction, but they risk becoming permanent, distorting incentives and undermining fiscal stability. Wage subsidies have helped shore up employment, but they too may become entrenched, which would slow the necessary reallocation of labor after the crisis. Principles for a successful recovery. In a context of limited resources, both high- and low- income countries must ‘walk a fine line’ identifying the most effective mix of revenue and expenditure policies. Tax revenues were significantly reduced due to the direct effects of the crisis but will start to increase as GDP recovers. In line with Barreix et al. (2020), we identify principles which tax policy reforms during the COVID-19 recovery should follow. Successful policy measures should: 1. Be efficient in term of resource mobilization, tax administration, and collection to strengthen public revenues and maintain fiscal solvency; 7 See Aslam and Shah (2020). 8 For example, value-added tax (VAT) rates on goods with strong externalities such as alcohol, sugary drinks, and tobacco could be increased, but the mobilization potential is low. The regressive nature of the VAT could be compensated by direct transfers to the poorest households, which, however, comes with considerable administrative effort. 9 For example, Barreix et al. (2020) and Bachas et al. (2020) propose raising the value-added tax (VAT) in countries with low rates and removing exemptions, for instance, for digital platforms. 10 See Landais, C., E. Saez and G. Zucman (2020). 11 See Rannenberg, Schoder, and Strasky (2015). 2. Not undermine the recovery; 3. Promote a fair distribution of the burden, considering regressive crisis effects; 4. Distinguish between temporary and permanent measures to manage private-sector expectations; and 5. Align with long-term objectives of sustainable and inclusive growth. Taxes should be able to generate revenues with minimum distortionary effects. Tax bases should be broad in order to minimize market distortions and tax evasion. Tax administration costs should be low, and collection efficiency should be high. In developing countries with large informal sectors, the ability of taxes to mobilize domestic resources is limited - especially as taxes on labor and capital income are easily evaded and effective tax administration is difficult. The economic costs of a tax policy are best measured as the output loss associated with the tax. To assess the economic cost of a tax increase in terms of output or employment loss, the standard measure used in the literature is the fiscal multiplier. Fiscal multipliers measure the impact of discretionary fiscal policy on macroeconomic quantities such as output. They are usually defined as the $-change in that quantity in response to a $1 increase in a fiscal policy instrument. An alternative way to define multipliers – which will be used here – is the percentage change in output after a policy change which amounts to 1% of GDP. The latter multipliers normalized by GDP are comparable across countries.12 An analysis of fiscal multipliers can provide a basis for evaluating the impact of policy alternatives on output. Multipliers provide an important measure of the economic impact of fiscal policy changes and allow for comparison across different spending and tax instruments. Yet, there are also qualifications to fiscal multipliers. Estimating the size of country-specific fiscal multipliers is challenging due to a lack of data. Typically, there are only a few discrete fiscal policy changes in a country, which limits the sample size and requires pooling various countries together. Moreover, estimated fiscal multipliers do not explain the underlying mechanisms on why multiplier may differ across instruments or countries. Multipliers are silent on the sectoral effects of fiscal policy, which may result in important frictions that are relevant to policy makers independent of the net macro effects. Fiscal policy aimed at stabilizing output, fiscal consolidation, and decarbonization may also have important implications for distribution across households and sectors which cannot be captured by fiscal multipliers and requires additional macro analysis.13 Finally, fiscal multipliers strongly depend on the economic context: For instance, during recessions, multipliers tend to be stronger than during recoveries. The role of environmental taxation in fiscal recovery and consolidation This section seeks to assess how environmental tax reform may successfully follow the principles mentioned above. Here, the focus is on the margin for tax increases and the implications for equity; the impact on output and employment will be reviewed below. For the 12 The advantage of the second definition is that it acknowledges the fact that countries differ in their economic size while the first definition does not: a $1 tax increase is a far stronger policy change in a low-income country than in a high-income country. 13 These important policy challenges arising in the COVID-19 recovery are discussed in detail in chapter 4. descriptive analysis, we use a sample of 75 high-, middle-, and low-income countries from 1994 to 2018.14 What are the tax instruments of interest? We focus on two tax instruments: environmental taxes (EVT), which comprise taxes and fees on energy, transportation, pollution, and natural resources, as well as personal income taxes (PIT). We consider environmental taxes because they are the broadest category of environmentally-related taxes and are the best for cross- country comparison. Personal income taxes are of interest because many proposals for environmental tax reform suggest lowering PIT and increasing different forms of EVT. Hence, assessing the net effect of such budget-neutral shifts in the tax burden requires estimating both EVT and PIT multipliers. What are the properties of EVT and PIT over time? Over time, country variation of environmental taxes relative to GDP is small. Ninety percent of the observations for energy taxes are between 0% and 5% of GDP. As is well known, most countries do not rely on environmental taxes as a significant source of domestic resource mobilization. Equally interesting is the fact that there is no increasing time trend in median tax revenues. Given the urgency of climate action and a history of international commitments to reducing carbon emissions, this result may be surprising. In contrast to EVT, PIT vary widely between countries, with median tax revenues at around 5% of GDP and ninety percent of cross-sectional observations between just above 0% and 13% of GDP. While there is some convergence across counties indicated by the narrowing intervals over time, it is interesting to note that there is no time trend in PIT. Cross-sectional observations for EVT and PIT. Figure 1 provides more details on the distribution of different country’s tax revenues across time. The plots indicate the scale of each country’s taxation of household income (red) and environmental taxation (blue) and also how these varied over time. The figures are ordered according to the median PIT tax revenues of individual countries across time and, for the sake of comparison, all y-axes have an equal range from 0% to 15%.15 Again, the plots indicate that PIT revenues vary strongly across countries. Most OECD countries accrue at least 5% of GDP from income taxes, whereas developing countries tend to have low effective PIT revenues. The latter is related to lower tax rates, weaker tax bases, lower collection efficiency, and a high share of informal employment. Environmental taxes hardly accrue more than 5% of GDP in the countries considered, with the median tax-GDP ratio much lower (around 2%). It is worth noting that EVT tax revenues as a share of GPD are only moderately higher in high-income countries than in low-income countries. Relative to the overall domestic resource mobilization, environmental taxes have a higher weight in developing countries than in advanced countries. 14 The data are obtained from the OECD Policy Instruments for the Environment (PINE) database as well as from UN-WIDER; for details, see Schoder (2021). 15 Note that Denmark’s PIT revenue-GDP ratio is around 25%, with little variation over time, and hence it is not in the plot. For Panama and Venezuela, no PIT data is available. To summarize, the data draws a clear picture: environmental taxes have not increased over time as a share of GDP, and their potential for tax revenue generation has largely not been realized. Environmental taxes account only for a minor part of domestic resource mobilization in most high- and low-income countries. Figure 1. Box plots for PIT (red) and EVT (blue) tax revenues as percentage shares of GDP (y-axis). The vertical line inside the box is the median (2nd quartile). The box indicates the 1st and 3rd quartiles. The whiskers show the minimum and maximum, respectively. Despite the still low taxation of carbon emissions, there has been considerable progress on this front in recent decades. Since 2005, the number of jurisdictions using either carbon taxes or trading systems to curb their emissions has tripled to 61.16 By contrast, in many countries that are not implementing such policies, the price incentives for the private sector to invest in low-carbon growth are worsening. This is because global fuel prices have recently fallen dramatically and are forecasted to stay depressed for much of the decade:17 that is, for the same period as the NDC climate change mitigation commitments. Falling fuel prices undermine incentives for the private sector to participate in the financing cost of achieving decarbonization objectives. This is a significant challenge for countries that have both ambitious mitigation targets and constraints on public finances. Without the right price incentives, a larger share of the total financing need for reaching decarbonization objectives will need to fall onto the public sector. The introduction of carbon taxation then yields a double gain for the public: first, it raises revenues, and second, it reduces the 16 See World Bank (2021c): Carbon Pricing Dashboard. 17 See World bank (2021b): Commodity Markets Outlook - January 2021. proportion of total financing needs for reaching mitigation commitments that will fall onto the public sector because it provides incentives that crowd in private-sector low-carbon investments. 3. Choosing the least contractionary tax instrument In a context of limited resources, developing countries must identify the most effective mix of revenue and expenditure policies. Policy makers have at their disposal various instruments of domestic resource mobilization. While optimal policy should raise revenues effectively for the sake of fiscal consolidation, it is essential that the post-COVID recovery is not undermined. Hence, this section discusses the criteria to critically evaluate the tax instruments available to policy makers. Measuring the economic costs of fiscal policy instruments The crucial criterion of tax policy evaluation explored in this chapter is fiscal multipliers. Fiscal multipliers measure the impact of discretionary fiscal policy on economic output and are defined as the percentage change in production, aggregate demand, or employment in response to a change in the fiscal deficit by 1% of GDP caused by an exogenous change in the policy instrument. The subsequent sections will address the multiplier effects of both taxes and spending in detail. Fiscal multipliers and the marginal cost of public funds. Another angle to look at fiscal multipliers relies on the marginal cost of public funds, which measures how much damage in terms of output is incurred when raising an additional unit of public funds. Fiscal multiplier studies typically focus on average effects, which may be transmitted through various channels such as income effects, substitution effects, and market distortions. The analysis of the marginal cost of public funds, however, usually assumes efficient markets and emphasizes output effects through market distortions associated with different revenue mobilization instruments. The marginal costs of public funds are derived from empirical or simulated Computable General Equilibrium (CGE) models. A seminal CGE study comparing the marginal costs of public funds of labor and green taxes was published by the European Commission.18 During the budget consolidation after the last global recession, the study found that in all its member states, the marginal cost of public funds was lower for additional environmental taxation than for additional labor taxation .19 While the relationship varies across countries, in any member state, the marginal cost of public funds of labor taxes is higher than that of green taxes; the same was found for advanced economies more broadly (OECD 2018). More recently, evaluations have become available for lower middle-income countries, too. Like other taxes, environmental taxation may lower economic growth in the short run; however, it is also a cost-effective means of reducing carbon emissions 18 See Barrios, Pycroft, and Saveyn (2013). 19 In particular, the study found that distortions created by labor tax increases are larger than those related to green taxes. and local pollution, generating health and climate co-benefits while minimizing economic distortions. Caveats of fiscal multipliers Data issues related to multiplier estimations. An analysis of fiscal multipliers or the marginal costs of public funds can provide a basis for evaluating the impact of policy alternatives. Multipliers provide one of the most important measures of the economic impact of fiscal policy changes in a very compact form. Yet, there are limitations: estimating the size of country- specific fiscal multipliers is challenging due to data limitations. Changes in tax or spending policies are infrequent events compared to the frequency domain of macroeconomic time series. For example, a time series of tax revenues covering 30 years may only include a few discretionary policy changes, with the remaining variation in the time series originating in endogenous fluctuations of the revenues with the business cycle. Hence, the pooling of countries under the assumption of parameter homogeneity is necessary to obtain robust empirical results. The identification of policy shocks has been the main challenge in empirical multiplier literature. Conceptual issues related to multiplier estimation. Moreover, the fiscal multiplier may not be constant over time and depends crucially on the state of the business cycle. In fact, the timing of fiscal consolidation during the recovery is of utmost importance. An important lesson from the 2008-09 crisis is that initiating fiscal consolidation when the recovery is still fragile can plunge the economy back into recession.20 Economic recovery itself is likely to increase tax revenues as business activity accelerates. However, countries that began with less fiscal space or were hit especially hard by the crisis may already face soaring fiscal deficits and rapidly increasing debt-to-GDP ratios. In these countries, policy makers must negotiate trade-offs between supporting short-term growth and initiating fiscal consolidation to restore market confidence and shore up public finances. The optimal timing of a post-crisis consolidation depends on numerous factors, including the structure and strength of the economy, the level and composition of the public debt stock, access to credit, and political-economy concerns. Some countries have already added revenue-raising initiatives to their stimulus measures.21 Fiscal multipliers give only a very aggregated idea of economic outcomes. Fiscal multipliers and the marginal cost of public funds only show part of the picture. Taxes that considerably contribute to correcting adverse externalities especially need to be assessed more broadly than simply assessing the respective multiplier. In other words, the marginal cost of public funds of environmental taxation needs to include its co-benefits. There is a consensus among economists that carbon charges are among the most environmentally effective and economically efficient instruments for reducing greenhouse gas emissions.22 By using the most efficient policy instrument, countries can minimize trade-offs between mitigation and other development priorities. Furthermore, these policies can have multiple benefits beyond climate - notably improvements in human health and welfare from reducing local air pollution and road 20 See Batini, Callegari and Melina (2012). 21 See Baker et al. (2020) and Landais, Saez and Zucman (2020). 22 Akerlof et al. (2019). accidents and congestion.23 Additionally, unlike regulatory measures or emissions trading systems with free allocation, carbon charges can raise revenues to help achieve other objectives. Lastly, if the charge were applied ‘upstream’ (at the point of extraction or import of the fossil fuels), it would be easy to administer and cover the entire economy, including much of the informal sector that most conventional taxes struggle to reach. Methods to estimate fiscal multipliers DSGE models for estimating multipliers. Various theoretical and empirical frameworks exist that allow for estimating quantitative output effects of tax and spending instruments. A vast literature estimates fiscal policy multipliers using Dynamic Stochastic General Equilibrium (DSGE) models. This model class focuses on a consistent micro-foundation and assumes economic agents to solve inter-temporal optimization problems under rational expectations. DSGE models are built around a general equilibrium which implies that resources are fully utilized in the absence of frictions. Introducing real and nominal rigidities assigns welfare- enhancing potential to fiscal and monetary policy. These models have been used extensively to estimate fiscal multipliers. Typically, fiscal multipliers in DSGE models are smaller than those obtained through other methods, see Box 1 for details. Macro-Structural models for estimating multipliers. Macro-Structural models are a popular alternative for empirical policy evaluation as not every behavioral economic relation has to be derived from optimal behavior necessarily. However, many Macro-Structural models are consistent with intertemporal optimization and rational behavior, especially in the long run. Because of a more data-driven evaluation of short-run macroeconomic adjustment compared to DSGE models, multiplier effects of fiscal expansion tend to be larger in Macro-Structural models than in conventional DSGE models. What is Bayesian estimation, and why are we not using it? Given that many elaborate economic models exist to simulate fiscal policy effects, one appealing approach for empirical multiplier analysis could be to apply Bayesian techniques to estimate the model parameters and empirical impulse-response functions (IRFs) to obtain the dynamic multiplier effects of interest. While this is a common strategy in the literature,24 it comes at the cost that the results are very sensitive to the underlying model structure. For this reason, we focus the review of environmental tax multipliers on regression-based analysis. The advantage of a regression- based analysis is its independence from the theoretical priors incorporated in an economic model; regression-based analysis allows the data to speak as freely as possible. Box 1: Dynamic Stochastic General Equilibrium (DSGE) and Macro-Structural models. At the core, DSGE models are models of general equilibrium: prices and quantities adjust so that, in the absence of frictions, all goods, labor, capital, and factor markets clear. All resources are optimally utilized. Only because of real and nominal frictions combined with market imperfections, such as monopolistic competition, is fiscal and monetary policy welfare-enhancing. The underlying micro- 23 See Heine and Black (2019). 24 See Gechert, Hallett, and Rannenberg (2015). foundation of economic behavior assumes economic agents solve inter-temporal optimization problems under rational expectations. Fiscal multipliers in DSGE models tend to be smaller than those obtained through other methods due to two core model features intrinsic to DSGE. First, intertemporal optimization smooths consumption and renders policy less effective unless a considerable share of hand-to-mouth consumers is assumed to spend all their disposable income. Second, the general equilibrium assumption imposes strong supply-side constraints on the economy. Hence, fiscal policy which seeks to stimulate aggregate demand needs to induce households to provide more labor and capital resources (which are always assumed to be optimally allocated). This requires considerable price signals. Yet, the central bank is assumed to respond aggressively to inflationary tendencies, even counteracting fiscal policy. Only when monetary policy hits the zero lower bound can fiscal policy be highly effective in stimulating demand and exhibits strong multipliers. Macro-Structural models (MSM) provide more flexibility compared to DSGE. The behavioral equations are not necessarily derived from intertemporal optimization, though they often are. Depending on the model closure, the long-run trajectory of the model economy may be driven by optimal market behavior or dominated by nominal and real rigidities. Krugman (2018) makes a case for variants of MSM as eclectic tools for policy prescription. While much of the debate DSGE vs. MSM has been related to the question of micro-foundations (Stiglitz 2018), there is another essential difference between DSGE models and MSM: while the former characterize a general equilibrium at any point in time, the latter are typically built around a short-term disequilibrium in the goods and labor markets. Hence, multiplier effects of fiscal expansion are considerably larger in MSM than in conventional DSGE models; in the former, a rise in output does not require households to supply more labor. Higher aggregate demand translates into higher demand for labor input which decreases unemployment. With more hours employed, consumption increases. Inflationary pressures from the goods market may or may not be counteracted by a rise in the interest rate. 4. Estimating tax multipliers Environmental taxes cover the sectors of energy, transportation, pollution, and natural resources. Taxes on fuels and carbon emissions – included in the ‘energy taxes’ - are at the core of environmental taxes. What are the empirical macro-economic implications of environmental taxes, and how do they compare to those of other tax instruments such as personal income taxes? This section will review these crucial questions. Macroeconomic effects of carbon taxes in recent literature Recent empirical literature has found that, overall, GDP and employment do not respond strongly to changes in carbon taxes. Employing the World Bank’s Carbon Pricing Dashboard, Metcalf and Stock (2020) estimate the dynamic output and employment effects of carbon taxes for a panel of 31 European countries. They find minor, statistically insignificant effects which tend to be positive rather than negative. There is no robust evidence in the European experience in support of carbon taxes reducing output or employment growth. Their results are robust to using different estimation methods, environmental tax measures, sub-samples, and control variables. These findings have been confirmed for other regions. A model-based empirical study for green development in China by Fan et al. (2019) estimates the paths of economic growth, pollution intensity, and resource intensity under different environmental tax parameters. They find that environmental taxes enhance green development and economic growth while reducing pollution intensity and resource intensity. In an earlier study, Bernard et al. (2018) estimate the output effects of the carbon tax introduced in the Canadian province of British Columbia. The sample covers the period 1990–2016. For this sample, no significant or negative output effects can be found. There are important caveats to the recent empirical literature trying to assess environmental taxes' output and employment impacts. First, a fundamental requirement in econometrics is to include all relevant variables in the estimation. In other words, an accurate estimation of the effect a variable (environmental tax) has on another variable (output) needs to control for all other relevant variables (personal income tax, budget deficit, public debt, etc.) to disentangle all the different effects correctly. Only then an estimated coefficient (environmental tax multiplier) can be interpreted as a causal effect. The estimated coefficients that seek to quantify the effect of environmental taxes on output may be biased and not accurately capture the tax multipliers of interest. For instance, environmental tax increases are often complemented by a reduction in other taxes (especially personal income taxes). Suppose the estimation of the output effect only includes the environmental tax but not the personal income tax. In this case, the estimation of the environmental tax effect will be distorted by the (incorrectly) ignored positive output effect that a reduction in personal income taxes has. Recent studies did not control for all relevant variables. Recent literature on environmental tax multipliers has not controlled for changes in other tax instruments accompanying environmental tax increases. Hence, their coefficients should be interpreted as the effects of overall tax reforms rather than an environmental tax multiplier. Relevant variables that should be included are government spending, public debt, or other tax instruments. Since the studies do not control for these variables in the specifications, the estimated coefficients conflate the isolated effects of all the policy changes associated with a carbon tax increase. Previous literature did not estimate multipliers but tax effects. Second, the previous literature has sought to estimate the effects of changes in tax rates rather than tax multipliers. Therefore, the literature provides answers to the question of the extent to which a tax rate increase affects output and employment. While this is of the highest relevance, policy makers interested in evaluating different policy instruments may desire a metric that is comparable across tax and spending categories. Fiscal multipliers – defined as the percentage change of a variable in response to an increase in the policy instrument by 1% of GDP - provide exactly that. They are comparable across policy instruments. The assessment of the net output and employment effects of an environmental tax reform potentially involving an increase in environmental taxes and a reduction in personal income taxes requires the estimation of multipliers. Fiscal multipliers in the literature Different tax instruments have different multipliers. While environmental tax effects on output and employment have been found to be small and insignificant, environmental tax multipliers have not been estimated despite an abundance of inquiries about the macroeconomic effects of tax policy changes. Most studies on tax multipliers do not differentiate tax instruments.25 Noteworthy exceptions are Riera-Crichton, Vegh, and Vuletin (2016) and Gunter et al. (2018), who estimate value-added tax multipliers. Dabla-Norris and Lima (2018) estimate personal income tax, corporate tax, and value-added tax multipliers and differentiate between tax rate and tax base changes; yet, multipliers are assumed to be homogeneous along the business cycle. Mertens and Ravn (2013) estimate, among others, PIT rate effects on output using quarterly post-WWII US data; translated into tax multipliers, they find values of 2 on impact and 2.5 at the peak. Multipliers are regime-dependent. Recent studies find evidence for the regime dependence of fiscal multipliers. Jordà and Taylor (2016) estimate the output loss of a 1% of GDP fiscal consolidation pooling expenditure cuts and tax increases and find a 5-year GDP loss of 4% during contractions and only 1% during expansions. Callegari, Melina, and Batini (2012) estimate fiscal multipliers for the US, Japan, and Europe and find them stronger during contractions. Baum, Ribeiro, and Weber (2012) obtain similar results comparing periods of positive and negative output gaps for the US, Germany, France, Japan, and Canada. As another form of non-linearity, Gunter et al. (2018) study how value-added tax multipliers depend on the initial level of taxation and find that lower taxes are associated with lower multipliers than higher taxes. Gechert and Rannenberg (2018) review 98 empirical studies and conclude that expenditure multipliers are stronger during downturns while tax multipliers are not. Multipliers differ across instruments. Acosta‐Ormaechea et al. (2019) find that increasing consumption and property taxes while reducing income taxes boosts long‐term growth. Income taxes, social security contributions, and personal income taxes tend to have a stronger negative effect on growth relative to corporate income taxes. Original estimation in this chapter. This chapter estimates the dynamic multiplier effects on output and employment of environmental taxes. To assess environmental tax reforms, environmental tax multipliers are compared to those of personal income taxes, comprising mainly labor taxes. The analysis is based on a large panel of 75 high- and low-income countries covering 1994 to 2019. Data on environmental taxes are obtained from the OECD Policy Instruments for the Environment (PINE) database, which gathers detailed information on environmentally related taxes. Data on personal income tax revenues are taken from the UNO WIDER database. The study focuses on how the corresponding multipliers depend on the business cycle, the state of the energy sector, and exposure to trade in order to gain further insights into the driving forces of tax multipliers. In particular, the study differentiates between regimes of 25 Blanchard and Giavazzi (2002); Guajardo, Leigh, and Pescatori (2014); Alesina, Favero, and Giavazzi (2015); and Alesina et al. (2017). For extensive literature reviews, see Gechert, Hallett, and Rannenberg (2015). negative and positive output gaps, economic contraction and expansion, low and high fuel prices, low and high tax levels, low and high carbon-intensive GDP, and low and high trade exposure. Empirical findings for environmental and personal income tax multipliers This section presents original econometric results on environmental tax multipliers in the context of the post-COVID recovery, along the lines of Schoder (2021).26 Estimation results for environmental tax (EVT) and personal income tax (PIT) multiplier effects on output and employment27 are discussed. For both PIT and EVT, the panels in Figure 2 show the respective effects on GDP, consumption, investment, trade balance, and employment from a tax increase of 1% of GDP. 26 To obtain dynamic multiplier estimates, the study applies the local projection method proposed by Jordà (2005). For details, see the annex and Schoder (2021). The latter is a technical contribution estimating energy tax multipliers and comparing them to personal income tax multipliers. It reports several robustness checks and the theoretical underpinnings. The current chapter focuses on the broader category of environmental taxes as they allow for a broader policy mix, including non-fuel- related tax instruments. The analysis here covers 75 countries from 1994 to 2019. 27 As a share of the population and pooled over all countries and years. (a) EVT effect on GDP (b) PIT effect on GDP (c) EVT effect on consumption (d) PIT effect on consumption (e) EVT effect on investment (f) PIT effect on investment (g) EVT effect on net exports (h) PIT effect on net exports (i) EVT effect on employment (j) PIT effect on employment Figure 2. Dynamic multiplier effects of a 1% of GDP increase in EVT and PIT, respectively, on selected macroeconomic measures. The dark (light) shaded areas are the 70% (90%) confidence bands. The core finding is that environmental tax multiplier effects on output are weaker than personal income tax multipliers. The estimated EVT multiplier effects on output range from 1.1 on impact to 1.8 at the peak after one year. Negative EVT multiplier effects are statistically significant only until two years after the policy reform. The estimates for PIT multipliers are higher than those for EVT: 1.4 on impact and 2.3 at the peak after three years. The PIT estimates are significant for all forecast horizons. These findings are consistent with previous literature. The seminal study by Metcalf and Stock (2020) does not find a statistically significant effect of carbon taxes on GDP for a panel of OECD countries. Their results slightly deviate from Schoder’s (2021) because they do not control for PIT changes in their regression model; though their estimates may well capture the effect of a full environmental tax reform rather than an isolated carbon tax increase. The findings are also consistent with Bernard et al. (2018). The PIT estimates are broadly in line with Mertens and Ravn (2013), who find PIT multipliers between 2 and 2.5, and slightly stronger than Dabla-Norris and Lima (2018), who estimate tax rate effects that translate into PIT rate multipliers of between 1.3 and 1.5. Why do EVT multipliers show a higher variance than PIT multipliers? Interestingly, the EVT multiplier estimators exhibit a higher standard deviation than the PIT multiplier estimators, indicated by wider confidence bands in the plots of Figure 2. This is because the multiplier heterogeneity across countries is higher for EVT than for PIT. What are the multipliers on the demand components? The multiplier effects on consumption, investment, and the trade balance provide further details. On average, EVT increases have no negative effect on consumption. In contrast, PIT increases have a permanent, negative effect on consumption with multipliers of around 0.8 on impact and 1.1 after four years. Regarding investment effects, the estimates are not statistically significant for either EVT or PIT; this is not surprising as investment dynamics are much more volatile than consumption dynamics. The investment response is very sensitive to input substitution elasticities along the value chain in production. The trade balance is found to deteriorate in response to increases in both EVT and PIT, though the contraction is slightly stronger for EVT than for PIT. The results show that environmental taxes do not seem to reduce employment. On average, the data seems to show a slight positive effect on employment; yet, the results are not statistically significant. This is very much in line with Metcalf and Stock (2020) and Bernard et al. (2018), who find no significant employment effects from carbon taxes. In contrast, an increase of PIT by 1% of GDP lowers the employment-population ratio by 0.2% on impact and by 0.7% after three years; the estimates are statistically significant. Theoretical explanations The evidence provided suggests that environmental taxes reduce output but to a lesser extent than personal income taxes. As shown in Figure 2, environmental taxes do not affect consumption or investment much but mainly net exports. This section seeks to provide the economic rationale for these empirical findings. Personal income taxes permanently reduce consumption and, to lesser extents, investment and net exports. Environmental taxes seem to boost employment slightly, while personal income taxes reduce employment permanently. How can these core empirical findings be explained? The transmission of PIT. Personal income taxes, which mainly consist of labor taxes, affect two crucial macroeconomic variables: the household sector’s disposable income and the cost of labor in production. Country-specific labor market conditions and institutional settings determine the tax incidence and, hence, which of these two variables is relatively more affected. To some extent, labor taxes cut directly into the disposable income of households which reduces consumption. This negative consumption effect is strong in countries/years with the following characteristics: • First, large pools of idle labor are available such that the nominal wage does not respond strongly to changes in labor taxes or labor market conditions, and the tax incidence is mainly born by households; • Second, a high share of hand-to-mouth consumers who spend their entire yearly income on consumption and cannot smooth consumption over time; • Third, facing higher labor costs, firms substitute labor for cheaper production inputs such as capital and energy. The easier it is for firms to reduce the labor input to production, the stronger the direct employment effect. Depending on whether labor and capital are substitutes or complements, the increase in labor cost will either increase or reduce capital investment;28 and • Finally, higher labor costs will be partly passed on to prices raising the domestic price level, eventually deteriorating the terms of trade and reducing net exports. The contraction of domestic demand, however, will dampen this negative effect on the trade balance. The transmission of EVT. While the labor tax directly affects aggregate demand, environmental taxes mainly affect relative prices (and hence production structures) and inflation. Environmental taxes may be levied at various places along the value chain. Upstream taxes on carbon emission or energy immediately trigger a relative input substitution of carbon- or energy-intensive inputs for more capital- or labor-intensive inputs. Additionally, countries vary considerably in their production technologies. Hence, the ability of countries to substitute between different inputs of production varies widely across the sample. Where substitution is difficult, higher input costs may translate into higher prices. Hence, the inflationary potential of environmental taxes can also be expected to vary widely across countries. The role of substitution. In response to rising environmental taxes, countries facing relatively rigid production structures will see their price levels increase more than countries that can more easily substitute out the more expensive production factor. Countries with low-carbon technology in place but not yet widely disseminated will find it easier to substitute out carbon- 28 Note that the negative direct effect of labor taxes on employment and consumption has dynamic repercussions as lower aggregate demand reduces sales and further dampens the economic outlook and the incentives for the private sector to invest. intensive factors of production than countries without access to green technology. Developing countries will be more severely affected. Without input substitution, tax hikes may increase prices in energy-intensive sectors, possibly translating to higher inflation. This may cause a deterioration of the trade balance and potentially a stronger reaction of monetary policy. The same holds for the consumption basket: if countries have trouble reducing the share of carbon- or energy-intensive goods in consumption, they will face increasing consumer prices and a deterioration of external competitiveness. Finally, countries with flexible production structures and consumption baskets are more likely to face employment expansion (due to crowding in of labor to production), investment expansion (due to crowding in of capital to production), and consumption expansion (due to crowding in of low energy-intensive commodities to the consumption basket). The response of investment to carbon prices. The expected response of private capital investment to an increase in energy-related taxes may be of particular interest to policy makers. Niu et al. (2018) predict an expansion of overall capital investment following a carbon tax increase. However, this expansion requires that capital be a substitute for carbon-intensive inputs to production, which may not necessarily be the case. Fiorito and van den Bergh (2016) find an elasticity of substitution between energy and capital of 0.9, indicating that they are weak complements. The model outlined in Schoder (2021) suggests that the response of investment to an increase in energy is very sensitive to the aggregate elasticity of substitution between energy and capital. Both investment expansions (if substitutes) and contractions (if complements) are possible and depend on country characteristics. For this reason, the EVT multiplier effects on investment exhibit the widest confidence bands of all plots in Figure 2. Theoretical employment effects. Apart from the implications on investment, policy makers are concerned about the employment implications of environmental taxes. While the negative employment effects of a PIT increase are rather straightforward, neither the sign nor the size of the employment response to an EVT increase is clear. On average, the data suggests there are no or slightly positive employment effects. Yet, economic theory may help disentangle different channels that are all averaged out in the empirical analysis. When energy prices increase, firms will increase energy efficiency overall and substitute energy for capital and, especially, labor, which can be hired more easily than capital can be expanded. This may cause an expansion of employment which depends on the respective elasticities of substitution between capital, labor, and energy. Hence, the labor demand effects of environmental taxes on production are rather straightforward: as a substitute for energy-intensive inputs, labor demand will increase. As a complement, it will decrease. The role of the supply side. The extent to which the labor demand expansion materializes during a production expansion crucially depends on the supply side. In countries with large idle labor resources either originating in persistently high structural rates of unemployment or large informal sectors, the response of nominal wages will be moderate. At the given wage, firms will be able to hire the labor they require. The EVT-induced employment boom will not be constrained from the supply side. However, in countries with strong labor markets and low unemployment, additional labor demand may not be accommodated. Instead, the nominal wage may respond considerably, creating inflationary pressures that in turn induce policy makers to use monetary policy to cool down the economy by increasing the interest rate. Hence, the employment effects may not be as strong or may even be negative. Regime-dependent multipliers Why regime-dependent multipliers? The previous section used the entire sample of 75 countries from 1994 to 2019 in order to obtain the baseline tax multipliers. The estimation results provide a good sense of which macroeconomic implications policy makers can expect environmental tax reforms to have on average. The underlying assumption that tax multipliers are identical across countries and time shall be partly relaxed in this section, as the period of post-COVID recovery may not be very average. For the next few years, the World Bank (2021a) projects solid growth of global real GDP even though many economies will operate below potential for a considerable time, with large pools of unemployed labor. Moreover, pre-tax prices of oil, natural gas, and coal have substantially decreased from their long-term average levels. Although the oil price rallied in 2021, large production capacities and a prolonged suppression in jet fuel consumption have caused oil price projections to remain low for much of this decade (World Bank 2021a,b). In light of predictions of positive growth and low fuel prices in the next few years, regime- dependent multipliers for EVT and PIT are estimated in order to predict the output effects of a post-COVID environmental tax reform that shifts the tax burden from labor to carbon emissions. Accordingly, regimes are defined along two dimensions. First, a contraction (expansion) regime is characterized by negative (positive) per-capita real GDP growth in the year of the policy change.29 Second, a low-price (high-price) regime includes country-years for which the pre-tax country-specific fuel price was below (above) the sample median. Accounting for different regimes. Formally, regimes are captured by dummy variables which take the value one for every country-year which meets the expansion regime and high-price regime criteria, respectively. The dummies are then added to the regression model interacting with the regressors. Growth-dependent multipliers. The growth-dependent multipliers are plotted in Figure 3. EVT multipliers depend crucially on at what stage of the business cycle the tax policy change is implemented. When increased in years of GDP expansion (including the early recovery when the economy still exhibits a negative output gap), EVT do not affect GDP on average. On the other hand, when implemented in years of GDP contractions, EVT multipliers are considerable, reaching values of around 7. However, it should be noted that the corresponding confidence bands are very wide, indicating quite some uncertainty regarding the true multiplier of the contraction regime. Nevertheless, these estimates and the differences in the expansion multipliers are statistically significant. 29 Note that this definition does not imply that, for instance, a negative growth regime requires negative growth throughout the period that is covered by the dynamic multiplier–only the sign of the growth rate during the year of implementation matters for the regime. Regimes are formed based only on country-year characteristics at the time of the policy impulse (year 0), while the dynamic multipliers capture future GDP values relative to the previous one (year -1). A regime change after the policy impulse is irrelevant for the regime-dependent multipliers. Growth-dependent multipliers for PIT. For PIT, the regression results do not provide evidence that the multiplier depends on GDP growth. For both regimes, the dynamic multipliers are similar even though the PIT multipliers seem to be slightly stronger in a contraction than in an expansion. The estimated PIT multipliers range from 1.2 to 2.1 when implemented during an expansion and from 1.7 to 3.0 during a contraction. These differences, however, are not statistically significant. This result is consistent with Gechert and Rannenberg (2018), who do not find overall tax multipliers to be state-dependent. (a) EVT effect on output (b) PIT effect on output Figure 3 Dynamic tax multipliers for output under the negative-growth regime (dashed line) and the positive-growth regime (dot-dashed line). The shaded areas are the 90% confidence bands. Theoretical explanation of regime-dependent multipliers. There are good reasons for tax multipliers to depend on the state of the business cycle. During an economic contraction or early recovery, credit constraints on households are more severe, and borrowing to maintain previous consumption levels becomes more difficult. In this scenario, the share of liquidity- constrained households increases. The same holds for credit constraints on firms that are less able to substitute lower internal finance by higher external borrowing. In this economic environment, current wages and profits become the main driver of consumption and investment spending. An increase in labor taxes cuts into both wages and profits, thereby directly reducing aggregate demand. The effects of a carbon tax are less clear-cut. Consumers may reduce the energy intensity of their consumption basket while firms may substitute energy for other production inputs. Historical examples. Apart from regression-based evidence, there are also good historical examples of EVT reform impacts. Sweden reacted to its greatest macro crisis since World War II in 1991 with a reduction in labor taxes financed through the introduction of a carbon tax. In 2001, Germany reacted to its macro crisis by slashing social security contributions financed by energy taxes. In 2008, British Colombia reacted to the Great Recession by cutting labor and corporate income taxes, financed through a new large carbon tax. These examples have been substantively evaluated in the literature, which found that these reforms created a small net increase in output. In response to the current crisis, Sweden and Canada are repeating these reforms, and Northern Macedonia is raising fuel taxes to finance a public investment stimulus. (a) EVT effect on GDP (b) PIT effect on GDP Figure 4 Dynamic tax multipliers for output under the low-fuel-price regime (dashed line) and the high-fuel-price regime (dot- dashed line). The shaded areas are the 90% confidence bands. Fuel price-dependence of multipliers. How do tax multipliers depend on fuel prices? The low- and high-price regimes are demarcated by the median pre-tax real diesel price of 0.53 USD per liter. The results for the tax multipliers in the two regimes are plotted in Figure 4. Statistically significant fuel price regime dependence is found for both EVT and PIT multipliers. When implementing the tax increase during a year of low real fuel prices, the subsequent dynamic multipliers tend to be weaker. Environmental tax multipliers become statistically insignificant with point estimates close to zero. When fuel prices are high during the tax change, the following EVT multipliers are between 1.8 and 3.8. While the differences are smaller for PIT, they also have lower standard errors. PIT estimates range from 1.1 on impact to 1.8 fuel prices are low and from 1.7 to 2.7 when fuel prices are high. Overall, results suggest that environmental taxes may be an appealing source of domestic resource mobilization during the post-COVID recovery when pre-tax fuel prices are projected to remain low for much of this decade (World Bank 2021b). Since most fossil fuel or carbon taxes are levied on the quantity of energy used rather than on its price, firms are indifferent between paying a higher pre-tax price for energy or a higher tax. Hence, energy tax multipliers should be expected to be weaker when fossil fuel prices are low. Note that PIT multipliers depend on fuel prices since higher energy costs reduce the firms’ cash flow. In such a high-cost environment, raising labor costs will induce strong labor substitution effects. Core insights from estimating environmental tax multipliers Summary of baseline results. Overall, environmental tax multipliers are estimated to be slightly weaker than personal income tax multipliers. This is driven by the strong negative consumption effects of income taxes which are absent from environmental taxes. The overall investment response to tax increases is highly uncertain, given that input substitution elasticities differ considerably across countries. Green investment will be stimulated, but the trade balance is found to deteriorate in response to tax increases. While environmental taxes do not seem to have statistically significant effects on employment, an increase in PIT reduces employment. The reviewed results are in line with the view that an environmental tax reform shifting the tax burden from labor to fossil energy may be expansionary. Summary of regime-dependence. In terms of how multipliers depend on the state of the business cycle, the literature does not find negative multipliers for environmental taxes when tax reforms are implemented during an economic expansion. Only when implemented during contractions do environmental multipliers seem to be strong. For PIT, however, the literature finds similar multipliers to that of the baseline and no statistically significant evidence for business cycle-dependent multipliers. These results reinforce the view that, from the revenue side, public finances are best consolidated by increases in energy taxes rather than personal income taxes. Summary of fuel price. Comparing low and high fuel price regimes reveals that environmental tax multipliers are only negative and significant when country-year-specific fuel prices are above the median value at the time of the policy change. When fuel prices are low, these multipliers are positive but not statistically significant. PIT multipliers, however, do not seem to depend strongly on fuel prices. These results support the idea of restructuring fuel taxation in times of economic recovery when/where fuel prices are low.30 Implications for the current recovery. These results have significant policy implications for the economic recovery from the current COVID-19 crisis. While fiscal consolidation will become a pressing issue for many countries soon, fuel prices are low, and output is expanding. In such a context, our results suggest that environmental taxes have no impact on output or employment while labor taxes are contractionary. Hence, an environmental tax reform, especially in countries with low environmental taxes, that shifts the tax burden from labor to carbon emissions can be expected to contribute to three central recovery objectives: (a) consolidate public finances, (b) reduce carbon emissions, and (c) stimulate output and employment growth. 5. Public consumption and investment multipliers The importance of climate-smart spending policy. Economic stimulus packages have mainly been targeted at alleviating the contraction in economic activity and employment; greening the economy was not a priority. As policymakers turn their attention from crisis management to recovery, they face important tradeoffs between short- and long-term objectives. International experience shows that while untargeted fiscal support can temporarily shore up employment, it also tends to bail out unproductive firms and business models and perpetuates embedded economic distortions. By contrast, environmentally responsible, pro-growth structural reforms can realign economic incentives to encourage sustainable production and consumption patterns. While reorienting the economy toward low-carbon growth is costly and challenging in the near term, over the long run, it is clearly preferable to propping up an unsustainable status quo. The role of public debt. An important dimension of the tradeoff between short- and long-term objectives is public debt. On the one hand, countries facing high debt levels need to stay liquid 30 Call for the restructuring of fossil fuel prices have grown; for example, World Bank Group President David Malpass has stated that “with oil prices lower, this is a good moment for countries to work toward reducing and reforming their fossil fuel subsidies.” https://www.worldbank.org/en/news/speech/2020/10/12/remarks-by-world-bank-group-president-david- malpass-at-thefourth-ministerial-of-the-coalition-of-finance-ministers-for-climate-action. in the short run and reduce debt to a sustainable level in the long run. This calls for a resumption of growth and fiscal consolidation. On the other, robust economic growth is the precondition for successful fiscal consolidation in both the short and long run. The optimal policy mix needs to be carefully calibrated in order not to jeopardize the path for recovery. To reduce public deficits, policy makers can either increase taxes or reduce spending. In the previous section, we made a case for using environmental taxes as part of a post-COVID fiscal consolidation effort. In this section, we review the economic implications of spending instruments and discuss them in the context of recovery, consolidation, and climate crisis. Estimating consumption and investment multipliers What are the multiplier effects of government consumption and government investment? Based on the sample of 75 high- and low-income countries from 1994 to 2019, the panels in Figure 5 illustrates for both spending categories the respective macroeconomic effects on GDP and employment. Both government consumption and government investment have early multiplier effects on output of around 1. Yet, while the consumption multiplier becomes insignificant two years after the policy change, investment multipliers are considerable and significant beyond four years. The results for employment confirm this difference. (a) Government consumption effect on GDP (b) Public investment effect on GDP (c) Government consumption effect on employment (d) Public investment effect on employment Figure 5. Dynamic multiplier effects of a 1% of GDP increase in government consumption and public investment, respectively, on selected macroeconomic measures. The dark (light) shaded areas are the 70% (90%) confidence bands. Theoretical explanation of multiplier effects on investment. This is not surprising. Among different types of investment programs, the multiplier is more persistent for interventions that not only stabilize short-term aggregate demand but also contribute to structural improvements of the economy that support long-term output potential. While current government spending stimulates aggregate demand in the short run, it does not create productive capacity in the future. Investment, however, not only stimulates short-term demand but increases capital and enhances productivity in the future. Hence, investment multipliers exhibit more persistence than consumption multipliers, particularly when investments have long lead times. Regime-dependence of spending multipliers. Spending multipliers are also regime-dependent. Aghion et al. (2012) has argued for directing countercyclical spending on areas where growth is enhanced, such as innovation and education. Spending multipliers vary with the level of government spending, the phase of the business cycle, and country characteristics (cf. Batini et al. 2014). In the very early recovery phase, investments should account for the bulk of stimulus measures. There is, however, a potential trade-off between the speed of intervention, readiness of projects, and ability to help long-term output potential. Therefore, governments will need to search for “shovel-ready” investments projects today, so that (unlike in past experiences) investments hit during the slump of the crisis and thus use the spending multipliers at their peak. Fiscal multipliers tend to be larger in countries with fixed exchange rate regimes, limited trade openness, and low debt levels.31 High short-term multipliers can turn negative in the medium to long term when price and quantity adjustments in the consumption and investment sectors unfold. 6. Policy implications The aim of this chapter is to inform the policy debate in the aftermath of the COVID-19 pandemic on what macroeconomic implications environmental tax reforms, shifting the tax burden from labor to carbon emission and launching public investment programs to facilitate the green transition, can be expected to have for output and employment. For that purpose, we estimate the output, consumption, investment, trade, and employment multipliers of environmental taxes (comparing them to personal income tax multipliers) as well as multipliers of public investment (comparing them to public consumption multipliers). First, the estimation of regime-dependent multipliers allows for the study of multipliers in the post-COVID recovery context. The econometric analysis suggests that environmental tax multipliers are slightly weaker than personal income tax multipliers. This result can be explained by the strong negative effects of income taxes on consumption, which are not found for environmental taxes. While environmental taxes do not seem to affect employment at all, 31 See Barrell et al (2012); Ilzetski, Mendoza and Vegh (2013); and Huidrom, Lim, Kose, and Ohnsorge (2019). an increase in PIT slightly reduces employment. Overall, the baseline results are in line with the view that an environmental tax reform shifting the tax burden from labor to fossil energy may be expansionary. Second, investigating how multipliers depend on the state of the business cycle sheds light on the optimal timing of environmental tax reform. The results of the regime-dependent multiplier estimation clearly suggest that environmental tax multipliers are around zero if the tax increase is implemented when output is expanding. Hence, especially in the recovery, environmental tax multipliers should be expected to be zero, on average. Only when implemented during contractions do environmental tax multipliers seem to be strong. For PIT, however, we find similar multipliers to those of the baseline and no evidence for business cycle-dependent multipliers. These results reinforce the view that, from the revenue side, public finances are best consolidated by increases in energy taxes rather than personal income taxes. Third, environmental tax multipliers may depend on the state of the energy sector. Comparing low and high fuel price regimes reveals that environmental tax multipliers are only negative and significant when country-year-specific fuel prices are above the median value at the time of the policy change. When fuel prices are low, these taxes do not seem to affect GDP adversely. PIT multipliers are not found to depend on fuel prices. Overall, these results support the idea of restructuring fuel taxation in times of economic recovery when/where fuel prices are low. The estimation results for public investment multipliers suggest that expanding public investment may accelerate the green transition not only by providing consumption and technology alternatives but also by persistently expanding GDP. The optimal environmental fiscal reform may include a combination of environmental taxes and a expansion of public green investment programs. Carbon charges could equally finance revenue-neutral tax shifts, which would enable countries to continue present fiscal stimuli without adding to pressure on public finances. A ‘green tax shift’ would build on the experience of several countries, including Sweden, Germany, and Canada. To enable such a policy of revenue-neutral net stimulus, a carbon charge should be combined with a reduction in the type of taxation that most holds back the restoration of growth, employment, and equity. In the international literature on environmental tax reforms, the best- performing tax shift is often to reduce wage taxes on low-income workers (Heine and Black 2019). A slightly less well-performing tax shift is to reduce general income taxes. Here, we reviewed the impact of the second type of reform, enabling comparisons to the same magnitude of revenue-raising from environmental taxes. These multipliers are statistically highly significant. We see that the reduction in output from raising additional revenues through income taxes is greater than for environmental taxes during expansions and low pre-tax fuel prices, especially in the short run. Following the economic shock from COVID-19, governments had to deal with a significant reduction in tax revenues and mounting calls to support households and businesses hit by containment measures. It is no surprise that policy makers’ attention shifted away from long- term objectives such as fighting climate change to the need to handle the economic crisis. This paper has shown that carbon taxation can actually be part of the solution for reigniting growth and restoring sound public finances because it can raise significant revenues at a lower cost to the economy than several more conventional revenue sources (Estevão 2020). Overall, the literature reviewed and original empirical evidence presented here suggest that there won’t be a one-size-fits-all environmental tax reform for the COVID-19 recovery. Country specifics matter. 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The dependent variables of interest are the log of real per- capita GPD and per-capita employment. To better understand the composition of the GDP effects, real consumption, real investment, and the trade balance are also considered as dependent variables. si,t is the other core input to the regression model above: the shock variable, which for the question of interest is the tax instrument considered under consideration or, in particular, the cyclically-adjusted tax revenue-GDP ratio. Then, bh has the interpretation of a cumulative multiplier indicating the percentage change (relative to the year before the policy change) of the dependent variable if the policy instrument permanently increases by 1% of GDP. The regression model provides a multiplier for every future time horizon h, assuming that a permanent policy change has been implemented in h=0. The vector of control variables Δxi,t includes real government spending to account for the fiscal space effect of taxes on public spending. An increase in tax revenue mobilizes resources for the government, which is then more likely to increase its spending. Not controlling for government spending may, therefore, bias the estimated tax multiplier, which may appear smaller than it really is. Fiscal policy measures hardly affect tax instruments in isolation. Tax reforms typically affect various instruments simultaneously. Hence, if the multiplier effect of changing a specific policy instrument is of interest, the regression model needs to control for at least one other tax instrument. Hence, the vector of control variables includes personal income tax in the regression for the environmental tax multipliers and vice versa. The specification assumes a lag structure of one.32 It includes country and time fixed effects, ai,h and dt,h, respectively. Country-fixed effects are introduced to account for country-specific intercepts and time-fixed effects to account for common trends across countries. Methodologically, including fixed effects is crucial as the countries pooled in the sample should be as similar as possible. Note that the underlying assumption is up to country-specific intercepts; the parameters are homogeneous across countries. This is also assumed for years: every year is assumed to be the same except for year-specific intercepts.33 uh,i,t+h is the error term. Because of serial correlation in the error terms, heteroscedasticity and auto-correlation robust variance-covariance estimators are used. The local projection method can easily be extended to account for regime dependence. This allows us to study how multipliers differs between contractions and expansions, regimes of low 32 Increasing the lag structure to 2 or 3 does affect the results considerably. 33 To account for heteroskedasticity and auto-correlation Schoder (2021) applies the method proposed by Driscoll and Kraay (1998) for estimating a robust co-variance matrix of parameters for a panel model. Because of serial correlation in the error terms, the study follows Jordà (2005) and uses heteroskedasticity and auto-correlation robust variance-covariance estimators. fuel prices and high fuel prices, as well as low taxes and high taxes. For each of the binary regimes considered, one can define a dummy variable zi,t and estimate the regime-dependent parameters of yi,t+h - yi,t-1 = ai,h + dt,h + (1 - zi,t) (Δsi,tbh(1) + Δxi,tgh (1)) + (1 - zi,t) (Δsi,tbh (2) + Δxi,tgh (2)) + uh,i,t+h How to identify policy-induced changes in tax revenues? Multipliers quantify the response of a dependent variable to a change in a policy instrument measured by the associated tax revenues. Yet, tax revenues are not driven by policy discretion alone. Tax revenues are highly cyclical because the tax bases co-move with GDP; both energy consumption and income – the respective tax bases of the EVT and PIT – are strongly correlated with GDP. Simply using tax revenues as the regressor in the specification above would render the estimates bias due to the feedback of output into tax revenues. This is known as a simultaneous equation bias, and empirical literature provides different strategies to identify the purely policy-induced changes in tax revenues. The narrative approach seeks to identify discretionary policy changes on a case-by-case basis by studying official policy records (Romer and Romer 2010). Only observations that can be explicitly traced back to a policy change make it into the sample. Unfortunately, the OECD PINE data set does not (as of now) include historical data on environmental tax policy changes. Hence, another approach is followed here, which is the most common in the empirical tax multiplier literature. The cyclical adjustment approach assumes a given country- and tax-specific constant output gap elasticity that can be used to remove the cyclical element from tax revenues.34 This approach seeks to quantify the feedback effect that GDP has on tax revenue. An elasticity of 0 means that GDP does not affect the tax base at all; an elasticity of 1 indicates that the tax revenues are proportional to GDP. If GDP increases by 1% relative to trend GDP, so will tax revenues. An elasticity of above 1 implies that the tax revenues fluctuate more strongly than GDP. Typically, PIT and corporate income tax revenues are found to be more volatile than GDP. Price, Dang, and Botev (2015) estimated output-gap elasticities for PIT and indirect taxes for OECD countries and Dudine and Jalles (2017) for a large sample of high- and low-income countries. For instance, the OECD average of the PIT output-gap elasticity is 1.77. In contrast, the average indirect tax output-gap elasticity is 1.08. The corresponding country-specific values are used to cyclically adjust the broad category of environmental taxes. Since there are no output gap elasticities available for the narrower category of energy taxes, Schoder (2021) estimates the respective output-gap elasticities, following Price, Dang, and Botev (2015) by using total energy consumption as a proxy for the tax base. The average of the EVT elasticities is 0.74. Hence, energy taxes are, on average, less cyclical than personal income taxes. 34 See Giavazzi and Pagano 1990; Alesina and Perotti 1997; and Perotti 2012.