Env Fiscal Reform

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ENVIRONMENTALfiscal reform

What Should Be Done and How to Achieve It


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What Should Be Done and How to Achieve It

ENVIRONMENTALfiscal reform

May 2005


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Copyright 2005The International Bank for Reconstruction and Development/THE WORLD BANK1818 H Street, NWWashington, DC 20433, USA

All rights reservedManufactured in the United States of AmericaFirst printing May 2005

This publication is a joint product of staff from DFID, DGIS, GTZ, IMF, and OECD, and while consultationshave been considerable, the judgments herein do not necessarily reflect the views of their respectivegoverning bodies, or when applicable, the countries there represented.

Cover photo: Indonesian fisherperson. C. Carnemark, 1993.


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Foreword

More than one billion people two thirds of them women livein abject poverty, surviving on lessthan US$1 per day. Millions of

children do not receive even a basic education.Similar numbers of mothers suffer injury during ordo not survive childbirth, and millions ofhouseholds do not have access to basic sanitation

or water supplies. In response to the plight of theworlds poor, the international communitycommitted itself to the Millennium DevelopmentGoals (MDGs), including the overarching goal ofhalving extreme poverty by the year 2015.

In recognition of the strong linkages betweenpoverty and environment issues, one of theMillennium Development Goals, MDG 7, seeks tointegrate the principles of sustainabledevelopment into country policies and

programmes, and reverse the loss ofenvironmental resources. The livelihoods and foodsecurity of the poor often depend directly onecosystems, and the diversity of goods andservices they provide. Moreover, healthyecosystems provide a range of invisible servicesthat are essential for sustainable development.

To help achieve the MDGs, developing countrygovernments need to raise revenues to invest inschools, healthcare, infrastructure and the

environment. As recognised at the Financing forDevelopment Conference in Monterrey, equitableand efficient tax systems, as well as improvementsin the pattern of domestic public spending areessential to meeting the MDGs.

Environmental Fiscal Reform (EFR) can play animportant role in this regard, helping countriesraise revenues, while creating incentives that

generate environmental benefits and supportpoverty reduction efforts. EFR has the potential tofree-up economic resources and generaterevenues that can help finance poverty reductionmeasures, for example infrastructure that improvesaccess of the poor to water, sanitation andenergy services. By encouraging more sustainableuse of natural resources (such as forests or

fisheries), reducing pollution from energy use andindustrial activities, and stimulating the use ofinnovative clean technologies, EFR can alsoimprove management of the environment. Inthese ways, EFR can directly and indirectlyaddress environmental problems that threaten thelivelihoods of the poor. However, the challengesof undertaking such reforms are manifold.

EFR encompasses a wide range of taxation andpricing instruments, including taxes on the

exploitation of natural resources, taxes andcharges on water or air pollution, and the reformof water or energy subsidies. The suitability ofindividual instruments to specific countries willvary according to the countrys level ofdevelopment, resource endowments, andinstitutional capacity. Although it may present achallenge to design and implement, EFR toencourage sustainable natural resource use willbe particularly relevant to low and middle-income countries, which often rely heavily onnatural resources for their development. Agrowing number of such countries haveembarked on such reforms as part of theirPoverty Reduction Strategies. For rapidlyindustrialising economies, EFR can play animportant role in controlling industrial pollution.

In some circumstances EFR has clear fiscal,environmental and social benefits, but in other


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cases trade-offs are necessary between theseobjectives. EFR can address such trade-offsthrough careful design. This requires analysing the

political context and effectively managing thereform as an inclusive political process, allowingfor strong participation by low-income andmarginalised groups in policy design.Accordingly, this document focuses on the politicaleconomyof EFR. In this regard, it aims to providea starting point for informing decisions aboutwhat reforms are most relevant to a given sectorand country, and how the EFR process can beeffectively designed and implemented.

While this paper concentrates on developingcountries, there is much that industrialisedcountries can do for example: reformingpolicies, such as fishing access agreements thatcould undermine developing countries own

efforts to reach sustainability; introducing (orbroadening) fiscal reforms domestically, such asenergy or carbon taxes to help reduce climate

change that particularly impacts on thedeveloping world; and providing developmentassistance for EFR processes in partner countries.

Experience has taught us that there is nogenerally applicable blueprint for EFR. Rather,effective policies are sector specific and dependon the institutional and political context in whichthey are introduced, and are therefore bestdeveloped by countries themselves. We commitour agencies to support our developing country

partners in the design and implementation offiscal reforms that raise revenue, advanceenvironmental sustainability and assist in reducingpoverty.

MMMMMasood Aasood Aasood Aasood Aasood AhmedhmedhmedhmedhmedDirector GeneralDepartment forInternational Development(DFID)

Heidemarie WHeidemarie WHeidemarie WHeidemarie WHeidemarie Wieczieczieczieczieczorororororek-ek-ek-ek-ek-ZZZZZeuleuleuleuleul

MinisterFederal Ministry for

Economic Cooperationand Development,Germany

CarCarCarCarCarstststststen Sten Sten Sten Sten StaaaaaurururururState Secretary;AmbassadorDenmark

AAAAAthanassios Theodorthanassios Theodorthanassios Theodorthanassios Theodorthanassios TheodorakisakisakisakisakisActing Director Generalfor Development andHumanitarian Aid

European Commission (EC)

RRRRRitvitvitvitvitva Jolkka Jolkka Jolkka Jolkka JolkkonenonenonenonenonenDirector General forDevelopment PolicyMinistry for Foreign

Affairs of Finland

DrDrDrDrDr. Ber. Ber. Ber. Ber. Bernnnnnd Eisenblttd Eisenblttd Eisenblttd Eisenblttd EisenbltterererererManaging DirectorDeutsche Gesellschaft frTechnischeZusammenarbeit (GTZ)

Germany

WWWWWaltaltaltaltalter Fer Fer Fer Fer FustustustustustSwiss Agency forDevelopmentand Cooperation (SDC)

MMMMMaria Noraria Noraria Noraria Noraria NorrfrfrfrfrfalkalkalkalkalkDirector GeneralSwedish InternationalDevelopment CooperationAgency (Sida)

Olav KjrvOlav KjrvOlav KjrvOlav KjrvOlav KjrvenenenenenDirector, Energy andEnvironment GroupBureau for DevelopmentPolicyUnited NationsDevelopment Programme(UNDP)

KlaKlaKlaKlaKlaus Tpfus Tpfus Tpfus Tpfus TpferererererExecutive DirectorUnited NationsEnvironment Programme(UNEP)

Ian JohnsonIan JohnsonIan JohnsonIan JohnsonIan JohnsonVice PresidentEnvironmentally andSocially SustainableDevelopmentThe World Bank


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Contents

Foreword iii

Acknowledgments x

Abbreviations x

Executive Summary 1

Introduction 7

PART 1 The Political Economy of Environmental Fiscal Reform: A General Overview 10

1. The Policy Context for Environmental Fiscal Reform 11

The Fiscal Context 11

The Environmental Context 12

The International Development Context 13

Implications for EFR 15

2. The Benefits of Environmental Fiscal Reform 17The Broad Objectives of Environmental Fiscal Reform 17

Fiscal Benefits 17

Environmental Benefits 19

Addressing These Environmental Issues 20

Poverty Reduction Benefits 21

Trade-offs Between Different Objectives 22

Fiscal Vis--vis Environmental Objectives 22

Poverty Reduction in Relation to Fiscal and Environmental Objectives 23

Possible Uses of the Revenues from EFR 25

The Options 26

Retaining the Tax Revenue 26

Spending Programmes 26Compensation Options 27

Reducing Existing Taxes 28

Other Issues 29

3. The Instruments and Scope of Environmental Fiscal Reform 31

The Instruments of EFR 31

Taxes on Natural Resource Extraction 31

User Charges and Fees 33


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Subsidy Reform 34

Environmentally Related Taxes or Charges 36

Reforms to General Taxation 39

Applicability of EFR Instruments to Developing Countries 41

4. The Acceptability of Environmental Fiscal Reform 43

The Political Context 43

Analysing the Political Context 44

Identifying Winners and Losers 44

Key Stakeholders and Their Interests 45

5. Managing the Environmental Fiscal Reform Process 53

Sensitivity to the Problem and Country Context 53

Culture and Socio-political Context 53

Events 53

Political Motives and Calendar 54International Institutions 54

Building Coalitions 54

Dialogue 54

Winners and Losers 55

Vested Interests 55

Powerful Stakeholders 56

Opportunities for Coalitions 56

Political Champions 56

Technical Skills 56

Strategic and Opportunistic Intervention 56

Challenging Perceptions 57

Mobilising the Public 57

Key Policies, Sector Reform and Decentralisation 57

Policy Windows, the Policy Cycle and Stakeholders 59

Part 2 Environmental Fiscal Reform in Key Sectors 60

6. Natural Resources Commercial-Scale Forestry 61

Introduction 61

Key Features of the Forestry Sector 61

EFR in the Forest Sector: Instruments and Policies 62

Past Experience with Fiscal Instruments 64

Affected Stakeholders: Perspectives and Interests 65The Poor 65

Politicians 66

Investors 66

Government Administration 66

Development Agencies and the International Community 67

Civil Society 67

Managing the Reform Process: Key Points 67


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7. Natural Resources Commercial Fisheries 69

Introduction 69

Key Features of the Fisheries Sector 69

Access Agreements 70Affected Stakeholders: Perspectives and Interests 72

Artisanal Fishing Communities 72

Domestic Commercial Fishers 72

Distant Water Fleets 72

Distant Water Fleet Countries 72



8. Pollution Industrial Activities 77

Introduction 77

Key Features of Industrial Pollution 77

EFR in the Context of Industrial Pollution 78

Previous Experience with Emission Taxes 79

Affected Stakeholders: Perspectives and Interests 79

The Poor 80

The Non-poor 80

Industry 80


Civil Society 81

Development Agencies 81


9. Pollution Fossil Fules 85Introduction 85

Key Features of the Fuel Sector 85

EFR in the Fossil Fuel Sector 86

Realising the Potential Benefits of Price Reforms 87


The Poor 90


Politicians 90

Upstream and Downstream Petroleum Industry 91

Energy-intensive Industry 91

Other Industry 91


10. The Provision of Power Services 93

Introduction 93

Key Features of the Power Sector 93

EFR in the Power Sector 94


The Poor 97


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Politicians 98


Industry 98

Civil Society 99Managing the Reform Process: Key points 99

11. The Provision of Water Services 101

Introduction 101

Key Features of the Water Services Sector 101

EFR in the Water Services Sector 102

Objectives of Price Reform 102

Past Experience with Water Pricing 103

Affected Stakeholders: Perspectives and interests 103

The Poor 103

The Non-poor 103

The Private Sector 103

Politicians 104


Managing the Reform Process: Key points 104

Part 3 What Should Be Done and How to Achieve It 106

Summary and Recommendations 107

Introduction 107

EFR Can Support Fiscal, Environmental and Poverty Reduction Goals 107

What Do We Mean By EFR and What Can It Do 107

The Instruments of EFR 107

Balancing the Objectives Within a Comprehensive Approach 108

Using the Revenues 108

The Political Economy of EFR 108

Integrating EFR into the Policy Cycle 109

Agenda Setting Stage Problem Definition 110

Policy Development Stage - Defining the Options and Building Support 110

Decision making and Implementation Stage 113

Monitoring and Evaluation Stage 114

Principles to Guide Donor Assistance 114

Notes 116

References 120

Boxes

1 Energy Subsidy Reform in China 122 What Does the WSSD Plan of Implementation Say About EFR? 133 Environment in the Poverty Reduction Strategy of Cambodia 154 The Polluter Pays Principle (PPP) 195 Innovative Price Reforms to Promote Improved Access of the Poor to Electricity in Argentina 226 The Distributional Effects of EFR on the Poor 24


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7 Constitutional Restrictions on Earmarking: Chile 278 EFR and the Double Dividend Theory 289 The UK Government s Statement of Intent on Environmental Taxation 29

10 Resource Profits as Unproductive Expenditure 3011 Natural Resource Rents 3212 Cambodian Forestry Taxes 3213 Taxes or User Charges? 3314 Avoiding the Low-level Equilibrium Trap: The Case of Conakry, Guinea 3415 Removing Pesticide Subsidies in Indonesia 3516 Measuring the Price Effect of Taxes 3717 Environmental Effectiveness of Indirect Tax Instruments 3718 Potential Fiscal Gains from Petroleum Product Taxation in Russia and Central Asia 3819 Colombian Pollution Charge System 3920 Reform of Environmental Taxation in Poland 4021 Transmission Channels for the Effects of EFR 4522 Impacts on the Poor of Liquefied Petrol Gas (LPG) Subsidies in India 46

23 Fuel Imports Undermine Transport Policy of Government in Poland 4724 Private Sector Resistance to Price Reforms in South Africa 4725 Chinas Pollution Levy System (PLS) as a Source of Revenue for State Governments 5026 EU Fishing Agreements in West Africa 5127 Coalition Building in Thailand: Phasing Out Unleaded Petrol through Price Reform 5528 Mobilising Public Support for Electricity Price Rises in Ghana 5829 Linking Electricity Sector Reforms with EFR: The Case of South Africa 5830 Forestry Reform and Impacts in Cameroon 6331 Economic and Environmental Benefits of Fiscal Instruments: the case of Namibia 7332 EU Partnership Agreements 7333 EU Fishing Agreements with Mauritania 7434 A Regional Strategy to Impose Access Fees: The Forum Fisheries Agency of the Pacific 7435 Taxation of Water Effluent in South Africa 78

36 Environmental Funds in Central and Eastern European (CEE) Countries CEE countries 7937 Fuel Subsidies in Indonesia and the Islamic Republic of Iran 8638 The Difficulties of Fuel Price Hikes in Indonesia 9139 Expanding the Distribution of Electricity in South Africa 9540 Subsidy Reform in the Indian Power Sector 9641 The Challenge of Providing Free-basic Services to Poor Households in South Africa 9742 The Forest Law Enforcement Governance and Trade Process and The Extractive Industries

Transparency Initiative 111

Figures

1 Links between Environmental Management, Poverty, and the Millennium Development Goals 142 The Benefits of Environmental Fiscal Reform 183 The Stages of the Policy Cycle 594 The Share of Taxation in the Retail Price of Petroleum Products in Nairobi, Kenya 865 Diesel Prices in 165 Countries (as of 10 December 2002) 886 The Stages of the Policy Cycle 109

Table

1 Environmental Performance of Selected EFR Instruments 212 Poverty Impacts and EFR 253 Fisheries in Small Developing Countries 714 Potential State Revenues for a Fuel Price Increase of 1 US Cent Per Litre 89


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Acknowledgments

This report has been developed within thescope of the environmental fiscal reform(EFR) work programme of the OECD-DACENVIRONET Forum. The drafting process

included several rounds of consultation withstakeholders and benefited from the preparationfor, discussions in, and the conclusions ofworkshops on EFR in the forest sector (hosted by

the World Bank in October 2003 in Washington,D.C.), the fisheries sector (hosted by the FAO inOctober 2003 in Rome) and of a synthesisworkshop (hosted by Germany in November2003 in Berlin).

This report has been prepared by a teamconsisting of: Richard Boyd, Julian Harlow, LeoHorn and Paul Steele (DFID); Piet Klop (DGIS);Stephan Paulus, Jan Peter Schemmel, JohannesScholl and Mattias Witt (GTZ); Mani

Muthukumara and Jim Prust (IMF); GeorgCaspary and Remi Paris (OECD).

The writing team benefited greatly fromcomments from: Gabriele Gotzen and PhilippKnill (BMZ), Tom Crowards, Simon Gill, John

Hudson and Adrian Wood (DFID); Marc Deboisand Simon LeGrand (EC); Thomas Sterner(Gothenborg University); Daniel Drger, Claus-Michael Falkenberg, Harald Lossack, GerhardMetschies, Evy von Pfeil, Jochen Renger, NicolaSchuldt-Baumgart, Jan Schwaab and BertholdSchirm (GTZ); Garvan McCann (Ireland Aid);Stephen Barg (IISD); Charles Abdallah (Lebanon);

Subhash Garg (Ministry of Finance of India); KaiSchlegelmilch (Ministry for Environment ofGermany); Chris Heady, Carl-Christian Schmidtand Ronald Steenblik (OECD); Cecil Morden(South African Treasury); Arnaud Comolet, PeterHazlewood and Rathin Roy (UNDP); Anja vonMoltke, Thiery Oliviera and Mark Radka (UNEP);Leslie Johnson (USAID); Juha Honkatukia (VATT,Finland); Jan Boj, Nalin Kishor, Anil Markandya,Tuan Minh Le, Anand Rajaram, PriyaShyamsundar, Nicola Smithers, and Giuseppe

Topa (World Bank).

Publishing and printing of this paper was fundedby contributions from DFID, GTZ, SDC, Sida,UNDP, and the World Bank.


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Abbreviations

AAC Annual Area Charge (in Cameroon)ADB Asian Development BankBMZ German Ministry for Economic Cooperation and DevelopmentCAC Command and ControlCAP Europes Common Agricultural PolicyCEE Central Eastern EuropeanCFP Common Fisheries PolicyDFID Department for International Development

DIW German Institute for Economic ResearchDRC Democratic Republic of CongoDSM Demand-side Management MeasuresDWF Distance Water FleetsECLAC Economic Council for Latin America and the CaribbeanEF Environmental fundsEFR Environmental Fiscal ReformEITI Extractive Industries Transparency InitiativeEPB Environmental Pollution Board in ChinaESMAP Energy Sector Management Assistance Programme from the World BankEU European Union

FAO Food and Agricultural OrganisationFFA Fisheries Forum AgencyFLEG Forest Law Enforcement Governance and Trade ProcessGDP Gross Domestic ProductGRT Gross Registered TonnageGTZ German Technical CooperationHIPC Heavily Indebted Poor CountriesIBRD World BankICAO International Civil Aviation OrganisationIEA International Energy AgencyIFREMER Institut Francais de Recherche pour Lexploitation de la MerIISD International Institute for Sustainable Development

IMF International Monetary FundIUU Illegal, unreported and unregulated fishingLDC Least Developed CountriesLEA Local Environmental Agencies in ChinaLPG Liquefied Petrol GasMBI Market Based InstrumentsMCS Monitoring, Control and SurveillanceMDG Millennium Development Goal


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NGO Non-Governmental OrganisationOECD Organisation for Economic Cooperation and DevelopmentOED The World bank Operations Evaluation Department

PER Public Expenditure ReviewsPLS Pollution Levy SystemPRS Poverty Reduction StrategyPURC Public Utilities Regulatory Commission in GhanaRED Regional Electricity Distributors in South AfricaRGC Royal Government of CambodiaSEB State Electricity Boards in IndiaTERI The Energy and Resources InstituteUK United KingdomUNDP United Nations Development ProgrammeUNEP United Nations Environmental ProgrammeUS United StatesUSAID United States Agency for International DevelopmentUSD United States DollarVAT Value Added TaxVATT Finnish Government Institute for Economic ResearchVED Vehicle Excise Duty in the UKWRI World Resources InstituteWSSD World Summit on Sustainable DevelopmentWTO World Trade Organisation


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Executive Summary

Objectives, Scope and

AudienceThe international community has committed itselfto the Millennium Development Goals (MDGs),including the overarching target of halvingextreme poverty by the year 2015. To help

achieve the MDGs, developing countrygovernments need to mobilise revenue to invest inschools, healthcare, infrastructure and theenvironment. This is where Environmental FiscalReform (EFR) can play an important role. Indeed,the recent UN Summits on Financing forDevelopment and on Sustainable Development inMarch and September 2002 respectively,recognised the potential contribution of EFR-related approaches. The latter stressed thatpoverty reduction and improved environmentalmanagement go hand-in-hand.

Despite the potential of EFR to raise revenue,improve environmental management and fightpoverty its use is frequently delayed andconstrained by political and institutional factors.Overcoming these factors requires thoroughanalysis of the political context, followed byeffective management of the reforms as aninclusive political process. Accordingly, to assistgovernments in successfully adopting EFR, thisreport focuses on the political economyof EFR.

The report is intended for: financeandenvironmental officials in developing countries;sector specialistsworking in forestry, fisheries,energy, water, transport etc.; civil societygroupsand parts of the private sector; and developmentagency staff, who support developing countrypartners with fiscal or environmental policy.

What Do We Mean By

EFR and What Can It

Do?The term environmental fiscal reform (EFR) refersto: a range of taxation or pricing instruments thatcan raise revenue, while simultaneously furtheringenvironmental goals. This is achieved by providingeconomic incentives to correct market failure in themanagement of natural resources and the controlof pollution.

Broadly speaking, EFR can: 1) mobilise revenuefor governments; 2) improve environmentalmanagement practices and conserve resources;and 3) reduce poverty. By encouraging moresustainable use of natural resources, and reducingpollution from energy use and industrial activities,

EFR can address environmental problems thatthreaten the livelihoods of the poor. The revenuesraised by EFR can also be used to financepoverty reduction measures. EFR can thereforecontribute to poverty reduction, and in turn, helpachieve the Millennium Development Goals ofhalving absolute poverty by the year 2015 andreversing the loss of environmental resources.

The Instruments of EFR

EFR encompasses a wide range of taxation andpricing instruments, which can be used to addresscountry- and sector-specific environmental andresource use issues, including:

Taxes on natural resource use(e.g. forestry andfisheries) - to reduce the inefficient exploitation ofpublicly owned or controlled natural resources


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resulting from operators not paying a price thatreflects the full value of the resources they extract.

User charges or fees andsubsidy reform- toimprove the provision and quality of basicservices such as water and electricity, whileproviding incentives to reduce any unintentionalenvironmental effects arising from their inefficientuse.

Environmentally related taxes to make polluters(industrial activities, motor vehicles, wastegenerators) pay for the external costs of theiractivities, and encourage them to reduce these

activities to a level that is more socially desirable.

Balancing the Objectives

within a Comprehensive

ApproachIn some cases there are synergies betweenrevenue mobilisation, improved environmentalmanagement and resource conservation, andpoverty reduction, while in other cases trade-offs

will arise.

Environmentally related taxes and similar pricereforms are not always the most effective way forgovernments to raise revenue, nor are theynecessarily the best approach to protecting theenvironment. The value of EFR lies in its ability tomake a contribution to both objectives at the sametime.

There will also be occasions where fiscal and

environmental objectives will be in conflict withpoverty reduction goals. Reform of subsidies anduser charges are areas of EFR that can have anegative effect on the poor. But it is possible tosoften undesirable distributional impacts throughcarefully designed instruments.

In recognition of these trade-offs, EFR should notbe seen as a substitute for other approaches to

fiscal and environmental management. Rather, itshould be used to augment existing approaches.EFR should therefore be viewed as one part of a

comprehensive mix of policies, combining fiscal,regulatory and other instruments to achieve soundeconomic and environmental management.

The Political Economy of

EFRUnderstanding the political context whendesigning and implementing EFR is absolutelycrucial if the political and institutional challenges

facing it are to be overcome.

A key step in analysing the political contextinvolves identifying likely winners and losers. Thiswill help with devising ways to build broad-basedsupport for reform, and inform the design ofcompensatory or mitigation measures for thelosers if these are deemed necessary.

Equally important is the need to understand theperspectives and interests of affected

stakeholders if they are to be effectivelymanaged, and if coalitions in favour of reformare to develop. In the context of EFR there are anumber of stakeholders, notably: poor andvulnerable groups, non-poor households, theprivate sector, civil society groups (NGOs, themedia, academic groups etc.), politicians,bureaucrats (at all levels of government),development agencies and other internationalactors.

The acceptance of EFR also depends crucially onwidespread support for the proposed use of anyrevenues raised.

The EFR Policy Cycle

When implementing EFR, different issues will ariseat each stage of the policy cycle. Theperceptions, interests and importance of affected


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stakeholders will also vary across the cycle. ForEFR to get off the ground and be successful, it isvital that key issues are recognised and the

interests of relevant stakeholders are consideredat each stage of the cycle. Moreover, donors canplay an important role at each stage.

AAAAAgengengengengenda Settda Settda Settda Settda Setting Sting Sting Sting Sting Stage Page Page Page Page Prrrrroblem Defoblem Defoblem Defoblem Defoblem Definitinitinitinitinitionionionionion

EFR must start with identifying and defining anissue firstly, as a problem, and secondly, as aproblem that in the view of the general public needs to be addressed. In addition toadequately framing the problem, a soundunderstanding of the issue(s) to be tackled is a

precondition for successfully putting the topic onthe policy agenda. Understanding an issuerequires knowledge of its impacts that is itseconomic, environmental and socialconsequences and their causes. These impactsmust be placed in the context of the manypressing issues facing a country, in order toestablish the relative importance of the issue.

Establishing the relative importance of the issuemust be based on a sound scientific basis if theattention of policy makers and the general public

is to be captured, and claims over the severity ofthe issue are to be believed. Having access torobust data is vital for challenging adverseperceptions and overcoming opposition fromvested interests. Donors can play an importantrole in this regard by supporting the work ofuniversities and other research institutions, as wellas international organisations as they developthe evidence basis for reform.

PPPPPolicolicolicolicolicy Devy Devy Devy Devy Development Stelopment Stelopment Stelopment Stelopment Stage Defage Defage Defage Defage Defining the Oining the Oining the Oining the Oining the Optptptptptionsionsionsionsions

The case for EFR needs to be developed alongtwo lines, although these should not be thought ofas separate processes. The mix of instruments toaddress the problem at hand needs to beidentified and subjected to a rigorous assessment,taking account of existing socio-political andinstitutional conditions. At the same time politicaland public support for reform should be mobilisedand strengthened.

Instruments should be designed in the light of thespecific sector context and policy objective(s).Information on the success or failure of EFR in

specific contexts in other countries can help.Donors have a role to play here by making suchinformation available.

During instrument design it is also important thatexisting and planned interventions in other policyareas are taken into account, to ensure that theproposed mix of pricing or tax instruments aresupportive of the governments overall policyagenda and any other planned reforms. A reformprocess is likely to be more successful if it is

integrated into other ongoing national processes(e.g. more general reforms to the tax system), or atleast takes these into account. Comprehensiveapproaches to development (such as PovertyReduction Strategies and sustainabledevelopment strategies) also provideopportunities to integrate EFR into country-leddevelopment plans. Medium-term expenditurereviews in particular, address issues closelyrelated to EFR, including tax collection andpricing reforms.

In the context of environmentally related andnatural resource taxes, it is generally simplest andmost efficient to design new tax instruments withinthe context of existing regulatory and institutionalframeworks.

Analysing the mix of instruments involvesquantifying the expected fiscal, environmentaland social benefits (notably for the poorestgroups in society) relative to the impacts ofexisting policies and their beneficiaries. It alsoinvolves identifying potential winners and losersfrom the reform process, the extent of the gainsand losses, and possible compensation measures,as well as the net fiscal, environmental and socialimpact of employing these measures. Donors canassist governments in developing the capacityrequired to undertake such analyses, and inidentifying win-win options. They can also help


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research groups and universities, NGOs and themedia to participate in the assessment process.

PPPPPolicolicolicolicolicy Ay Ay Ay Ay Advdvdvdvdvocacocacocacocacocacy Sty Sty Sty Sty Stage Building Supportage Building Supportage Building Supportage Building Supportage Building Support

Defining a problem and proposing pricing ortaxation instruments as a possible policy responseis not enough. Political and public support for EFRmust be secured when designing, analysing andweighing up the various options. Wherecorruption and patronage are serious problems,resistance to EFR will be particularly strong. Inthis case, building strong alliances is absolutelyvital.

Public awareness campaigns based on accurateinformation, presented in a way that is easy tounderstand, and broad based consultation withaffected stakeholders (including representatives ofcivil society, the private sector and vulnerablegroups) can help build the necessary support forreform. Proponents of EFR should actively explorethe potential for alliances with other, like-mindedstakeholders. However, it should not be assumedthat dialogue between stakeholders will lead toconsensus differences of opinion will oftenremain. Donors can encourage transparency,access to information, public participation, andaccountability, which are all prerequisites forsound policy.

Decision-making anDecision-making anDecision-making anDecision-making anDecision-making and Implementd Implementd Implementd Implementd Implementatatatatation Stion Stion Stion Stion Stageageageageage

Some form of public announcement usuallyprecedes the introduction of proposed reforms,preferably as far in advance of the instrumentbeing introduced as possible, to give affectedparties the time to effectively prepare and adaptto the proposed changes. Where adaptation is

expected to be a lengthy and difficult process, itis often a good idea to phase-in the reformsgradually, in a programmed fashion. This will helpmitigate the financial pain of those who stand tolose most from the reforms.

Donors can play an important role by helping tofinance the transition costs of reform, which will

help overcome political resistance. Governmentscan also help by making strategic use of therevenue and compensation measures. For

example, it may be worth considering the use ofsome of the revenue to compensate for anyundesirable distributional impacts that may arise.Governments can also assist industry withtransition costs by helping them to identify cost-effective abatement technologies or processes.This might involve disseminating information onthe latest clean production technologies andassociated financial benefits. Such measures willhelp foster support for the reforms.

MMMMMonitonitonitonitonitoring anoring anoring anoring anoring and Evd Evd Evd Evd Evalalalalaluatuatuatuatuation Stion Stion Stion Stion StageageageageageGovernment agencies responsible foradministering the reforms will need theappropriate technical capacity in order tofunction as a credible monitoring andenforcement agency. Credibility is essential tosustain support for reform, and rebut criticismsfrom, for example, affected industries that have adirect interest in portraying the administratingagency as incapable of doing its job.Environmental agencies must also be credible vis-

-vis the Ministry of Finance. This is particularlycrucial when environmental agencies areentrusted with the collection and management oftaxes or charges, and/or when the proceeds fromthese instruments are earmarked to theseagencies for environmental purposes. Credibilityconcerns can be mitigated and greater publicsupport fostered if some of the revenues are usedto ensure a reliable flow of adequate funding formonitoring and enforcement activities.

Donors can play an important role in providingtechnical assistance to develop the capacity ofthose agencies responsible for monitoring andenforcement. EFR requires a long-termcommitment from interested governments todesign, build support for, implement, evaluate andrefine EFR. Hence, donors also need to provide along-term perspective in their support of suchprocesses.


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Evaluation is necessary to assess the effectivenessand efficiency of the instrument in meeting itsstated objectives. This in turn helps establish

whether there is room to improve the design andimplementation of the instrument, both to helpmeet existing objectives and when applying thesame instrument to similar problems in the future.It also generates information that can be madeavailable to stakeholders, which provides avehicle for public consultation and can enhanceaccountability and public support.

Again, donors can provide technical assistance todevelop the necessary capacity to plan for, and

undertake, evaluation exercises.

Principles to Guide

Donor AssistanceIt is evident from the previous discussion thatdonors have an important role to play in helpingdeveloping country partners assess andrealisethe full potential of EFR. In fulfilling this roledonors should:

Emphasize country ownership and be sensitive tothe local context First and foremost there mustbe in-country demand for EFR. Donors shouldencourage country ownership, but should notforce the pace. Strong country ownership willfacilitate the harmonisation of related activitiesacross donors, which will shield countries fromexcessive donor influence, and possiblyconflicting approaches to EFR.

Donors also need to be sensitive to the politicalchallenges of implementing EFR, which willdepend on specific local economic,environmental, social and cultural conditions. Theyshould avoid imposing blueprints for reform.Rather, donors should focus on providingfinancial, technical, institutional and politicalassistance in support of a countrys own efforts.

Be prepared to act opportunistically- In a volatilepolitical and economic setting, it is crucial to takeadvantage of windows of opportunity as they

present themselves. A new government orpolitical leader especially, if it has the supportof the populace can be a catalyst for majorpolicy shifts. Ongoing sector (e.g. in forestry,fisheries, agriculture) and utility reform processes(e.g. water, power) can also provide a launchingpad for EFR, as can fiscal and environmentalcrises. Donors should be prepared to helpproponents of reform seize such opportunities asand when they arise.

Be pragmatic Textbook solutions will seldom bepractical. In some occasions it may be necessaryto deviate from standard fiscal practice in orderto secure political and /or public support forimportant reforms. For instance despite theclear problems associated with earmarking taxrevenues it may be necessary to allocate someportion of the tax to a particular use in order toprogress the reforms. For similar reasons, it mayalso be necessary to consider the use of othercompensatory measures, such as reduced rates oftax or targeted subsidies, given adequate

safeguards and regular reviews.

Strive for policy coherence Policy coherence onseveral dimensions is vital if donors support forEFR is to be credible, and if partner countriesefforts to implement EFR are not to beundermined.

Donor governments should work towardsalignment of their development and tradepolicies. For example, donors with export creditagencies should strive to ensure that exportinterests do not impair the signals for improvedresource efficiency or emission reductionsprovided by EFR, or development policyobjectives more generally. Consideration shouldalso be given to policies in the agriculture andfishery sectors for example, which promote


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activities that have the potential to undermine theobjectives of EFR.

The alignment of donor policies with respect tointernational agreements and country-ownedand led strategies, such as the MDGs,

sustainable development strategies, PovertyReduction Strategies, Medium-term ExpenditureProgrammes and Sector-wide approaches is

another way to improve the coherence of donorsefforts toward country-owned objectives.


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Scope and ObjectivesThe term environmental fiscal reform (EFR) meansdifferent things to different people.

In this report, we will take EFR to mean: a rangeof taxation or pricing instruments that can raiserevenue, while simultaneously furtheringenvironmental goals. This is achieved by providingeconomic incentives to correct market failure in themanagement of natural resources and the controlof pollution.

By encouraging more sustainable use of naturalresources, such as forests and fisheries, and byproviding incentives to reduce pollution fromenergy use and industrial activities, EFR alsoaddresses environmental problems that make adifference to the livelihoods of the poor. Indeed,

because of the interdependence of environmentaldegradation and poverty, a sound environment iscrucial to poverty reduction and sustainablegrowth, particularly in low-income countries(DFID, EC, UNDP and World Bank, 2002).

The revenue generated can also be directed,through programmes of targeted expenditure, topoverty reduction. For example, the revenuecould be used to finance poor peoples access towater, sanitation or energy services. Past

experience suggests that the potential of EFR toraise revenue is one of the primary reasons whydeveloping country governments and Ministriesof Finance in particular, are likely to pursue it.

EFR is therefore concerned with a l imitedintersection of two large policy areas fiscalpolicy and environmental policy. Despite being

limited, it is an increasingly significant area ofdevelopment policy, because of the potentialcontribution EFR has to make to poverty reductionin developing countries. It is also an area thatmay not have received enough attention in thepast, from both fiscal or environmental expertsand their associated institutions.

Despite the potential of EFR to yield clear, fiscal,environmental and social benefits, it is frequentlydelayed and constrained by political andinstitutional factors. In the latter case, improvedincentives for environmental management requirean effective legal, regulatory and administrativeframework. There are also groups in society that,for reasons of self-interest, could resist EFR. Toassist governments in overcoming resistance toEFR, this report concentrates on the politicaleconomy of the reform process: It analyses the

political context, outlines how winners and losersare identified and illustrates how an effectivereform process is best designed and managed.This analysis is crucial if the political andinstitutional challenges facing EFR are to beovercome. Greater understanding of the politicalcontext of EFR will facilitate coalition building andthe selection of strategic interventions in thereform process.

Overall, the report seeks to identify the fiscal,

environmental and poverty reductionopportunities that EFR presents policy-makers.These are seen in relation to specific sectors andcountries, the likely obstacles to pursuing theseopportunities, and how these obstacles are mosteffectively managed.

With this narrow focus, there are many importantareas of fiscal and environmental policy we do

Introduction


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not cover. In particular, on the environment side,we do not deal with the more general requisitelegal and regulatory frameworks for the

implementation and realisation of environmentalpolicy objectives. Nor do we discuss other so-called market-based instruments, such asmarketable permits or allowances that, like taxes,provide economic incentives to reduceenvironmental degradation, but, unlike taxes, arenot generally designed to raise revenue1.

On the expenditure side, the discussion is limitedto subsidy reform (the freeing up of financialresources through reform of existing subsidies) and

the potential partial earmarking of revenue forenvironmental expenditures, such as paying forfishery management costs from the capture offishery rents. This report does not have the scopeto explore the integration of EFR into existingprocesses for budgetary analysis nor how EFRinteracts with the appraisal of, for example,Poverty Reduction Support Credits, Programmaticand Sector Lending. Nonetheless, evaluation ofhow EFR fits with these budget-related toolsshould be part of the detailed design process ofputting EFR into practice.

Report StructureThe report is in three parts. Part One considersthe benefits, instruments and political economy ofEFR, while Part Two looks at the application ofEFR to specific, key sectors in developingcountries. Recommendations are presented in PartThree.

Part OneChapter 1 deals with the changing context forEFR.Chapter 2 looks at the benefits of EFR and howthe revenues raised can be used.Chapter 3 identifies the different instruments ofEFR.Chapters 4 and 5 consider the political economyof EFR.

Part Two

Chapters 6 to 11 explore how EFR can be

applied in the forestry, fisheries, industrial, fossilfuel, power and water sectors with a focus on thepolitical and institutional challenges.

The sectors covered in Part Two are based onwhat we consider offers the most scope for EFR interms of revenue mobilisation, environmentalimprovement and poverty reduction and thepotential trade-offs between these objectives.There may be a good case for EFR in otherareas, such as mining, solid waste managementand transport more generally - for example,motor vehicle taxes and congestion-typecharging - but our present scope leaves theseareas for future consideration.

Part Three

Chapter 12 draws conclusions and offers policyrecommendations.

Target AudienceThe report is intended for:

Finance officials in developing countries: to

encourage them, when looking at options toraise revenue, to consider fiscal instrumentsthat have the potential to simultaneouslydeliver environmental improvements and, inturn, economic and social development.

Environmental officials in developing countries:

who would like to use fiscal instruments torealise environmental improvements.

Sector specialistsworking in forestry, fisheries,energy etc: who would like to understand howfiscal reforms could be used to encouragemore sustainable resource use in their sector.

Civil societygroups (non-governmentalorganisations, academics etc.) and parts ofthe private sector, which could be influential inpromoting EFR.


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Development agency staff, particularly those

who support developing country partnerswith fiscal and, or environmental policy.

With such a varied audience, including many whoare not experts in the relevant fiscal andenvironmental disciplines we have tried to writethe report in non-technical language.

Complementary InitiativesWith the issues of financing sustainabledevelopment and environmental fiscal reformsrising on the international agenda there are a

number of other processes on related topics thatare worth mentioning. These include work withinbilateral agencies and UNEP. UNEP has, forinstance, established a Working Group on

Economic Instruments that has produced a guidefor policy makers in developing countries on theuse of economic instruments for environmental

policy making, including: environmental taxes,charges, pollution permits and deposit refundsystems. This UNEP guide offers tools for acomprehensive assessment of the country contextand conditions. It provides practical guidance onidentifying when economic instruments may bemost appropriate and discusses means tostrengthen the support framework needed tointroduce them (UNEP, 2004a). UNEP has alsoconducted a number of country projects assessingthe potential for reform in the fisheries, energyand agriculture sector, as well as assistingcountries to implement reform. These projects arecountry-driven and based on stakeholderconsultations within the countries.


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Part 1 The Political Economy of Environmental

Fiscal Reform: A General Overview


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The Policy Context for

Environmental Fiscal Reform

The current policy framework for EFR isbest understood in the context of theevolving global debate on internationaldevelopment policy. In particular it needs

to be set against a background of economic andfiscal reform and the increased recognition oflinkages between poverty and the environment.

The Fiscal ContextDespite the potential environmental benefits,interest in EFR has historically arisen out of fiscalneed, or more acutely, as a result of a fiscal crisis.For example, the debt crisis and deterioratingbalance-of-payments position of many

developing countries in the early 1980s led tostructural adjustment in the economies of thesecountries, in an effort to restore macroeconomicstability. Those adjustments typically involvedreforms to public expenditure and pricing andtaxation policy, as governments sought to mobilisemore revenue and improve the efficiency ofpublic spending.

Reform of pricing policy, although not motivatedby environmental objectives, has been the mostsignificant driving force behind the removal ofsubsidies harmful to the environment. For example,subsidy reform has led to increases in the price ofenergy products, public water supply andagricultural inputs, such as pesticides. Both Chinaand Russia increased energy prices during the1990s, which yielded sizeable environmentalbenefits (Box 1 looks at the experience of China).However, in considering the total benefits of

price reforms it is important that the social(distributional) impacts are taken into account,and these impacts are usually more complex.

As part of the effort to mobilise revenue, theoverall design and administration of the taxsystem has also come under scrutiny. In the past,many developing countries have had complex taxsystems, with multiple tax bands for differentgoods and services, and many still do. Suchsystems, when administered by a relatively poorlypaid public sector that lacks resources, sometimeslead to tax evasion and corruption. In response,an increasing number of developing countrieshave been introducing simpler, more transparentand broadly-based taxes, in which consumers orproducers are responsible themselves for payingthe correct amount of tax to the appropriateagency (say, through self-assessment returns).However, inefficiencies in the tax systems are stillpresent.

Structural adjustment was often accompaniedby the privatisation of many industries andincreased trade liberalisation.

PPPPPrivatisationrivatisationrivatisationrivatisationrivatisation: The last two decades have seenmuch more focus on the role of the private sectorin development policy. However, privateenterprises seek to recover the full cost of serviceprovision, when a service may previously havebeen subsidised. As a result, in many countries,such as Bolivia and Ghana, increased privatesector involvement in the provision of energy andwater services has raised questions about the

1


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effect of higher prices on the poor and how thepoor can be shielded from higher tariffs.

TTTTTrrrrrade Liberade Liberade Liberade Liberade Liberalisationalisationalisationalisationalisation: The emergence of the WorldTrade Organisation and the recent DohaDevelopment Agenda has highlighted the issue ofsubsidies particularly in the context of tradedgoods.

The Environmental

ContextThe Earth Summit in Rio in 1992 drew attentionto the dire state of the global environment:Humanity stands at a defining moment in history.We are confronted with a perpetuation of

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economy, China reconomy, China reconomy, China reconomy, China reconomy, China remoemoemoemoemovvvvved price contred price contred price contred price contred price controls on coal,ols on coal,ols on coal,ols on coal,ols on coal,ananananand encourd encourd encourd encourd encouraged the devaged the devaged the devaged the devaged the development of privelopment of privelopment of privelopment of privelopment of privatatatatate coale coale coale coale coal

mines, which nomines, which nomines, which nomines, which nomines, which now prw prw prw prw produce aroduce aroduce aroduce aroduce arounounounounound 5d 5d 5d 5d 50 per cent of0 per cent of0 per cent of0 per cent of0 per cent ofChinaChinaChinaChinaChinas coal. Sus coal. Sus coal. Sus coal. Sus coal. Subsidy rbsidy rbsidy rbsidy rbsidy ratatatatates fes fes fes fes for coal, which accountor coal, which accountor coal, which accountor coal, which accountor coal, which account

fffffor 7or 7or 7or 7or 73 per cent of China3 per cent of China3 per cent of China3 per cent of China3 per cent of Chinas commers commers commers commers commercial needs, fcial needs, fcial needs, fcial needs, fcial needs, fellellellellellfrfrfrfrfrom 6om 6om 6om 6om 61 per cent in 191 per cent in 191 per cent in 191 per cent in 191 per cent in 19888884 t4 t4 t4 t4 to 1o 1o 1o 1o 11 per cent in 191 per cent in 191 per cent in 191 per cent in 191 per cent in 19999995.5.5.5.5.

SuSuSuSuSubsidy rbsidy rbsidy rbsidy rbsidy refefefefeforororororm anm anm anm anm and ind ind ind ind industrial rdustrial rdustrial rdustrial rdustrial restrestrestrestrestructuring hasucturing hasucturing hasucturing hasucturing hasprprprprproduced multoduced multoduced multoduced multoduced multiple benefiple benefiple benefiple benefiple benefits: Fits: Fits: Fits: Fits: Financial savings, enerinancial savings, enerinancial savings, enerinancial savings, enerinancial savings, energygygygygy

savings, incrsavings, incrsavings, incrsavings, incrsavings, increased qeased qeased qeased qeased quality of coal, anuality of coal, anuality of coal, anuality of coal, anuality of coal, and rd rd rd rd reducededucededucededucededucedpollpollpollpollpollututututution. Enerion. Enerion. Enerion. Enerion. Energy intgy intgy intgy intgy intensity in China, once among theensity in China, once among theensity in China, once among theensity in China, once among theensity in China, once among thehighest in the world, has been in sthighest in the world, has been in sthighest in the world, has been in sthighest in the world, has been in sthighest in the world, has been in steaeaeaeaeady declinedy declinedy declinedy declinedy decline

since rsince rsince rsince rsince refefefefeforororororms stms stms stms stms startartartartarted in 19ed in 19ed in 19ed in 19ed in 19777778, dr8, dr8, dr8, dr8, dropping fropping fropping fropping fropping from 7om 7om 7om 7om 7999995 t5 t5 t5 t5 tooooo22222444441 metric t1 metric t1 metric t1 metric t1 metric tons of oil eqons of oil eqons of oil eqons of oil eqons of oil equivuivuivuivuivalent per millionalent per millionalent per millionalent per millionalent per million

intintintintintererererernatnatnatnatnational $ bional $ bional $ bional $ bional $ by 19y 19y 19y 19y 199999999999. This has also ha. This has also ha. This has also ha. This has also ha. This has also had a majord a majord a majord a majord a majorimpact on Chinaimpact on Chinaimpact on Chinaimpact on Chinaimpact on Chinas grs grs grs grs greenhouse gas emissions.eenhouse gas emissions.eenhouse gas emissions.eenhouse gas emissions.eenhouse gas emissions.

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the enerthe enerthe enerthe enerthe energy intgy intgy intgy intgy intensity of the economyensity of the economyensity of the economyensity of the economyensity of the economy.....

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fffffor the ror the ror the ror the ror the rururururural poor of China, most of whom ral poor of China, most of whom ral poor of China, most of whom ral poor of China, most of whom ral poor of China, most of whom rely fely fely fely fely for aor aor aor aor a

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ttttto poor households (in the northero poor households (in the northero poor households (in the northero poor households (in the northero poor households (in the northern rn rn rn rn region) in theegion) in theegion) in theegion) in theegion) in theffffforororororm of coal vm of coal vm of coal vm of coal vm of coal voucheroucheroucheroucherouchers ans ans ans ans and other hard other hard other hard other hard other hardship initdship initdship initdship initdship initiatiatiatiatiativivivivives.es.es.es.es.

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benefbenefbenefbenefbenefititititited fred fred fred fred from widesprom widesprom widesprom widesprom widespreaeaeaeaead intrd intrd intrd intrd introductoductoductoductoduction of aion of aion of aion of aion of advdvdvdvdvancedancedancedancedancedstststststooooovvvvves that ares that ares that ares that ares that are both more both more both more both more both more enere enere enere enere energy efgy efgy efgy efgy efffffficient anicient anicient anicient anicient and lessd lessd lessd lessd lesspollpollpollpollpollutututututing. In the mediing. In the mediing. In the mediing. In the mediing. In the medium-tum-tum-tum-tum-terererererm measm measm measm measm measururururures ares ares ares ares are beinge beinge beinge beinge being

ppppput in place tut in place tut in place tut in place tut in place to ro ro ro ro reduce the depeneduce the depeneduce the depeneduce the depeneduce the dependence ofdence ofdence ofdence ofdence ofhouseholds on solid fhouseholds on solid fhouseholds on solid fhouseholds on solid fhouseholds on solid fuels, buels, buels, buels, buels, by encoury encoury encoury encoury encouraging them taging them taging them taging them taging them tooooo

change tchange tchange tchange tchange to naturo naturo naturo naturo natural gas anal gas anal gas anal gas anal gas and other liqd other liqd other liqd other liqd other liquid fuid fuid fuid fuid fossil fossil fossil fossil fossil fuels.uels.uels.uels.uels.SSSSSwitwitwitwitwitching frching frching frching frching from coal tom coal tom coal tom coal tom coal to ro ro ro ro renewenewenewenewenewable enerable enerable enerable enerable energy sourgy sourgy sourgy sourgy sources (inces (inces (inces (inces (in

partpartpartpartparticular, solar enericular, solar enericular, solar enericular, solar enericular, solar energy, wingy, wingy, wingy, wingy, wind enerd enerd enerd enerd energy, hgy, hgy, hgy, hgy, hyyyyydrdrdrdrdropoopoopoopoopowwwwwerererererananananand clean biomass td clean biomass td clean biomass td clean biomass td clean biomass technologies) wechnologies) wechnologies) wechnologies) wechnologies) was alsoas alsoas alsoas alsoas alsoencourencourencourencourencouraged. The raged. The raged. The raged. The raged. The rururururural poor aral poor aral poor aral poor aral poor are expecte expecte expecte expecte expected ted ted ted ted to be theo be theo be theo be theo be the

main benefmain benefmain benefmain benefmain beneficiaries of the diriciaries of the diriciaries of the diriciaries of the diriciaries of the direct generect generect generect generect generatatatatation ofion ofion ofion ofion ofemploemploemploemploemployment opportunityment opportunityment opportunityment opportunityment opportunities in bio-eneries in bio-eneries in bio-eneries in bio-eneries in bio-energy rgy rgy rgy rgy relatelatelatelatelatededededed

sectsectsectsectsectororororors.s.s.s.s.

SourSourSourSourSource:ce:ce:ce:ce:DFID (2000).DFID (2000).DFID (2000).DFID (2000).DFID (2000).

Box 1 Energy Subsidy Reform in China

disparities between and within nations, aworsening of poverty, hunger, ill health andilliteracy, and the continuing deterioration of theecosystems on which we depend for our wellbeing. As part of a package of possible policyresponses, the Rio Summit promoted the greateruse of economic (incentive-based) approacheswithin environmental policy in particular, theuse of so-called market-based instruments

(MBIs). The emphasis on economic approachesrecognised that the environmental challenge wasbeyond the remit of environment ministries alone.In order to curb the environmentally damagingconsumption and production patterns, fiscalpolicy had to play a role in support of traditionalapproaches based on direct regulation (so-calledcommand-and-control approaches).


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The Financing for Development conference inMonterrey, Mexico in 2001 reaffirmed the use ofMBIs and subsidy reform as powerful and

necessary tools for generating finance forsustainable development.

The 2002 World Summit for SustainableDevelopment (WSSD) in South Africa againhighlighted the environmental problems facingthe planet, with particular emphasis on the linksbetween the state of the environment andpoverty reduction. The Johannesburg Plan ofImplementation adopted at the WSSD alsoreferred to pricing and fiscal instruments for

environmental management (see Box 2).

The International

Development Contextthe World Bank estimates that the ad-ditional foreign aid required to reach the Mil-lennium Development Goals by 2015 isbetween 40 and US$60 billion per year. Thisestimate is consistent with other agencies es-timates of the costs of achieving individual

goals, such as those for education and health.By itself, this additional aid will not be suffi-cient to attain the goals, as many countries willhave to reform their policies and improve ser-vice delivery

World Bank (2002)

The international development agenda is nowstrongly focused on poverty reduction, asdemonstrated by the commitment of donors anddeveloping countries alike to the MillenniumDeclaration of 2000. The global communityidentified eight Millennium Development Goals(MDGs), with the overarching goal to halveabsolute poverty by 2015. Reversing the loss ofenvironmental resources is another importanttarget. The World Summit on SustainableDevelopment (WSSD) in 2002 reaffirmed theMDGs, and stressed how improvedenvironmental management could help alleviate

poverty, for example, by improving access tosanitation as a cost-effective way to improvehealth.

The linkages between sound environmentalmanagement and poverty reduction, as capturedby the MDGs, are illustrated in Figure 1.

While the goals of international developmenthave been clarified, there has also been agrowing awareness of the complexity ofachieving them, and in particular the complexrole of institutions and incentives both formaland informal. Since the end of the Cold War,there has been a growing focus on theinstitutional and political issues of development,known as good governance.

Box 2 What Does the WSSD Plan ofImplementation Say About EFR?

TherTherTherTherThere are are are are are a fe a fe a fe a fe a few rew rew rew rew refefefefeferererererences in the WSSD Planences in the WSSD Planences in the WSSD Planences in the WSSD Planences in the WSSD Planon the use of EFR in the conton the use of EFR in the conton the use of EFR in the conton the use of EFR in the conton the use of EFR in the context of wext of wext of wext of wext of watatatatater,er,er,er,er,enerenerenerenerenergy angy angy angy angy and polld polld polld polld pollututututution fion fion fion fion for exor exor exor exor example:ample:ample:ample:ample:

19(b) Cont19(b) Cont19(b) Cont19(b) Cont19(b) Continue tinue tinue tinue tinue to pro pro pro pro promotomotomotomotomote the inte the inte the inte the inte the intererererernalisatnalisatnalisatnalisatnalisation ofion ofion ofion ofion ofenenenenenvirvirvirvirvironmentonmentonmentonmentonmental costs anal costs anal costs anal costs anal costs and the use of economicd the use of economicd the use of economicd the use of economicd the use of economic

instrinstrinstrinstrinstruments, tuments, tuments, tuments, tuments, taking intaking intaking intaking intaking into account the appro account the appro account the appro account the appro account the approachoachoachoachoachthat the pollthat the pollthat the pollthat the pollthat the pollutututututer should, in principle, bear theer should, in principle, bear theer should, in principle, bear theer should, in principle, bear theer should, in principle, bear the

costs of pollcosts of pollcosts of pollcosts of pollcosts of pollututututution, with due rion, with due rion, with due rion, with due rion, with due regaregaregaregaregard td td td td to the po the po the po the po the puuuuublicblicblicblicblicintintintintinterererererest anest anest anest anest and without distd without distd without distd without distd without distortortortortorting inting inting inting inting intererererernatnatnatnatnationalionalionalionalionaltrtrtrtrtraaaaade ande ande ande ande and ind ind ind ind invvvvvestment.estment.estment.estment.estment.

222226(b) Emplo6(b) Emplo6(b) Emplo6(b) Emplo6(b) Employ the fy the fy the fy the fy the full rull rull rull rull range of policange of policange of policange of policange of policy instry instry instry instry instruments,uments,uments,uments,uments,inclinclinclinclincluuuuuding rding rding rding rding regulategulategulategulategulation, monition, monition, monition, monition, monitoring, voring, voring, voring, voring, volololololuntuntuntuntuntarararararyyyyy

measmeasmeasmeasmeasururururures, markes, markes, markes, markes, market anet anet anet anet and infd infd infd infd infororororormatmatmatmatmation-based tion-based tion-based tion-based tion-based tools,ools,ools,ools,ools,lanlanlanlanland-use management and-use management and-use management and-use management and-use management and cost rd cost rd cost rd cost rd cost recoecoecoecoecovvvvvererererery ofy ofy ofy ofy of

wwwwwatatatatater services, without cost rer services, without cost rer services, without cost rer services, without cost rer services, without cost recoecoecoecoecovvvvvererererery objecty objecty objecty objecty objectivivivivivesesesesesbecoming a barbecoming a barbecoming a barbecoming a barbecoming a barrier trier trier trier trier to access to access to access to access to access to safo safo safo safo safe we we we we watatatatater ber ber ber ber byyyyy

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basin apprbasin apprbasin apprbasin apprbasin approach.oach.oach.oach.oach.

444440(k) Emplo0(k) Emplo0(k) Emplo0(k) Emplo0(k) Employ marky marky marky marky market-based incentet-based incentet-based incentet-based incentet-based incentivivivivives fes fes fes fes fororororor

agriculturagriculturagriculturagriculturagricultural ental ental ental ental enterererererprises anprises anprises anprises anprises and fd fd fd fd farararararmermermermermers ts ts ts ts to monito monito monito monito monitorororororananananand manage wd manage wd manage wd manage wd manage watatatatater use aner use aner use aner use aner use and qd qd qd qd quality, intuality, intuality, intuality, intuality, inter alia,er alia,er alia,er alia,er alia,

bbbbby applying sy applying sy applying sy applying sy applying such methods as small-scaleuch methods as small-scaleuch methods as small-scaleuch methods as small-scaleuch methods as small-scaleiririririrrigatrigatrigatrigatrigation anion anion anion anion and wd wd wd wd wastastastastastewewewewewatatatatater rer rer rer rer recececececyyyyycling ancling ancling ancling ancling and rd rd rd rd reuse.euse.euse.euse.euse.


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This emphasis in turn has led to renewed interestin the role of the state, now widely seen to havea key role in identifying the right policies forpoverty reduction and in financing investmentsfor poverty reduction and sustainabledevelopment. In the late 1990s, the Poverty

Reduction Strategy (PRS) process was launched inlow-income countries to achieve good policies forpoverty reduction and the right investments. Thisapproach was supported by developmentagencies that were keen to move from scatteredprojects to a more country led, strategicframework for development assistance.

There is also growing recognition of the need tomainstream environmental issues into the PRSprocess, as many poor people depend on naturalresources for their livelihoods. They are oftentherefore the most vulnerable to environmentaldegradation and pollution. The extent to which

environmental issues are mainstreamed into thePRS process is mixed (Boj et al, 2004).Nonetheless, the available evidence shows thatas the process matures, environmentalmainstreaming is improving. This is illustrated bythe analysis of the poors dependence on naturalresources in Cambodias PRS paper (see Box 3).

FIGURE 1 Links between Environmental Management, Poverty, and the Millennium Development

Goals

Source: DFID, EC, UNDP, and World Bank (2002).


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In a significant number of cases, the PRS countrypapers refer to EFR either for fiscal orenvironmental reasons.

Given the need, emerging from the PRS process,to implement investment plans, subject to theidentified sector priorities, the budget process ofdeveloping countries has been receiving greaterattention. Development agencies are providinggrowing support for management of publicexpenditure and, where appropriate, somedonors are providing direct financial support tothe government budget.

The debate about the role of the state has alsobegun to focus on decentralisation, which maycreate incentives for EFR. For example, thegrowing power of Provinces in South Africa hasled them to search for additional sources ofrevenue, including the possible use ofenvironmentally related taxes (OECD 2001a).However, increased fragmentation, unclearresponsibilities and inconsistency in standards,rules and regulations resulting from fiscaldecentralisation can hinder the uptake of certain

EFR measures.

Implications for EFRWithin the multiple policy contexts discussedabove, EFR has been receiving increasedrecognition as a tool that governments canimplement along side other policy measures tohelp achieve fiscal, environmental povertyreduction objectives.

Environmentally related fiscal instruments havebeen increasingly used in OECD and middle-

Box 3 Environment in the PovertyReduction Strategy of Cambodia

SustSustSustSustSustainable naturainable naturainable naturainable naturainable natural ral ral ral ral resouresouresouresouresources management ances management ances management ances management ances management andddddconservconservconservconservconservatatatatation has become an intion has become an intion has become an intion has become an intion has become an integregregregregral part ofal part ofal part ofal part ofal part of[R[R[R[R[Roooooyyyyyal Goal Goal Goal Goal Govvvvvererererernment of Cambodia] Rnment of Cambodia] Rnment of Cambodia] Rnment of Cambodia] Rnment of Cambodia] RGCGCGCGCGCs strs strs strs strs stratatatatategyegyegyegyegy

fffffor sor sor sor sor sustustustustustainable economic grainable economic grainable economic grainable economic grainable economic grooooowth anwth anwth anwth anwth anddddddevdevdevdevdevelopment. The Relopment. The Relopment. The Relopment. The Relopment. The RGC rGC rGC rGC rGC recognises thatecognises thatecognises thatecognises thatecognises that

sssssustustustustustainable economic grainable economic grainable economic grainable economic grainable economic grooooowth anwth anwth anwth anwth and devd devd devd devd developmentelopmentelopmentelopmentelopmentcannot be achievcannot be achievcannot be achievcannot be achievcannot be achieved without wise managemented without wise managemented without wise managemented without wise managemented without wise management

ananananand conservd conservd conservd conservd conservatatatatation of countrion of countrion of countrion of countrion of countryyyyys rs rs rs rs renewenewenewenewenewable anable anable anable anable anddddd

non-rnon-rnon-rnon-rnon-renewenewenewenewenewable naturable naturable naturable naturable natural ral ral ral ral resouresouresouresouresources. Aces. Aces. Aces. Aces. Among othermong othermong othermong othermong otherthings, attthings, attthings, attthings, attthings, attententententention will be paid tion will be paid tion will be paid tion will be paid tion will be paid to impro impro impro impro improoooovvvvvededededed

management anmanagement anmanagement anmanagement anmanagement and conservd conservd conservd conservd conservatatatatation of fion of fion of fion of fion of fisheries anisheries anisheries anisheries anisheries andddddffffforororororest rest rest rest rest resouresouresouresouresources the impact of which on the poorces the impact of which on the poorces the impact of which on the poorces the impact of which on the poorces the impact of which on the poor

ararararare ve ve ve ve vererererery signify signify signify signify significant.icant.icant.icant.icant.

SourSourSourSourSource:ce:ce:ce:ce:Cambodia PCambodia PCambodia PCambodia PCambodia Pooooovvvvverty Rerty Rerty Rerty Rerty Reducteducteducteducteduction Strion Strion Strion Strion Stratatatatategy (200egy (200egy (200egy (200egy (2003, p. 53, p. 53, p. 53, p. 53, p. 58).8).8).8).8).

income countries, but not been implemented tosuch an extent in low-income countries.Experience with such instruments in OECDcountries is mixed, but there have been successstories (see, for example, Schlegelmilch 1999,EEA 1996 and 2000, OECD 2001b and UNEP2004a and b).

A large amount of useful analytical andconceptual work has also been undertaken in thisarea.2Such studies show that the implementationof EFR often meets political resistance and if itsfull potential is to be realised the politicaleconomy of the reform process must be fullyappreciated as a precondition to successfulimplementation. Equally, it is analysis ofexperience with EFR thus far which will identifythe most favourable conditions for successfulimplementation.


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2

The Benefits of Environmental

Fiscal Reform

In this chapter we explore the fiscal,environmental and poverty reduction benefitsof EFR in detail, examining cases in whichbenefits must be traded-off against one

another, and how such trade-offs can beappropriately managed. In examining thesetrade-offs it will become evident that EFR is notalways the most effective way for governments toraise revenue, nor is it necessarily in all cases thebest approach to protecting the environment; thevalue of EFR lies in its ability to assist withmeeting both objectives at the same time, andthe ancillary poverty reduction benefits thataccompany a better environment. Hence, EFRinstruments need to be seen as complementarytoregulatory approaches to environmental

management, and as an integral part of a policymix rather than stand alone measures.

As the benefits of EFR are inseparable from theuse made of revenues arising from reform, welook at the main options for using the revenues.

The Broad Objectives of

Environmental Fiscal

ReformBroadly speaking, EFR can: 1) mobilise revenuefor governments; 2) improve environmentalmanagement practices and conserve resources;and 3) reduce poverty. By encouraging moresustainable use of natural resources, and reducingpollution from energy use and industrial activities,EFR can address environmental problems that

threaten the livelihoods of the poor. The revenuesraised by EFR could also be used to financepoverty reduction measures.

These three benefits of EFR, as shown in Figure 2,often complement one another. The poor, forexample, can be supported by improvements tothe environment such as in water and air quality and by pro-poor investments (in health,education and access to sanitation services)financed by revenue raised through EFR. In somecases trade-offs between objectives may arise,for example, where reform raises the price ofwater or power consumed by the poor. Suchimpacts may be mitigated in the way that thereform package is designed, for instance by usingtariff structures that protect low-incomehouseholds.

Fiscal Benefits

A primary goal of fiscal policy, especially in poorcountries where public services are under-funded,is to raise revenue to finance governmentexpenditure programmes. This revenue needs tobe raised efficiently with minimum distortion tothe national economy and at minimum

administrative costs. While there are a number ofconventional fiscal instruments that more or lessfulfil these criteria, EFR opens the door to a newtax base, supplementing other revenue raisingefforts.

Developing countries face formidable challengesin raising revenues through conventional fiscalinstruments such as income or sales taxes - the


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main sources of tax in the OECD. In somedeveloping countries many workers are employedin agriculture and the informal sector, whereearnings fluctuate, are seasonal and generallypaid in cash. This means that conventionalincome taxes are hard to collect. And few people

buy from retailers who keep accurate records, sosales taxes, such as VAT, are also difficult tocollect. The scope for taxing corporations is alsolimited, since the corporate sector is usuallysmaller than in OECD countries; and includesunprofitable state-owned enterprises that build upuncollected tax arrears, due to political obstacles.Unlike OECD countries, many developingcountries rely on (trade) taxes on imports andexports for revenues but these are ofteninefficient, damaging to growth and incompatible

with moves towards trade liberalisation (IMF,2001).

Excise duties applied to energy products andtaxes on natural resource extraction offer goodpotential for raising environmentally relevant taxrevenue, but it is important to ensure that thepotential for revenue does not create increased

pressure on the resource base. In the resource-rich Cameroon, for example, forestry taxes raisedUS$50 million for the State in 2002 (see Box 28below), while EU Access Agreements account forroughly 30 per cent of government revenues inGuinea Bissau (IFREMER, 1999). Yet there is

evidence that in many places potential revenuesare not being captured (Ivers et al, 2003 andBostock and Cunningham, 2004). For example, itis estimated by Hoddes (2001) that in Cambodiaup to US$100 million is lost each year fromuncollected forest taxes (only US$13 million isactually collected).

The potential of EFR to raise revenue depends onmany factors, including:

The design of the instrument. How it is implemented and enforced, this in

turn depending on administrative capacity,corruption, etc.

How consumers and producers respond, asreflected by the elasticity of demand andsupply.

The BenefThe BenefThe BenefThe BenefThe Benefits of Enits of Enits of Enits of Enits of Envirvirvirvirvironmentonmentonmentonmentonmental Fal Fal Fal Fal Fiscal Riscal Riscal Riscal Riscal RefefefefefororororormmmmmFIGURE 2


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Box 4 The Polluter Pays Principle(PPP)

The principle tThe principle tThe principle tThe principle tThe principle to be used fo be used fo be used fo be used fo be used for allocator allocator allocator allocator allocating the costsing the costsing the costsing the costsing the costs

of pollof pollof pollof pollof pollututututution prion prion prion prion prevevevevevententententention anion anion anion anion and contrd contrd contrd contrd control measol measol measol measol measururururures tes tes tes tes tooooo

encourencourencourencourencourage the rage the rage the rage the rage the ratatatatational use of scarional use of scarional use of scarional use of scarional use of scarcececececeenenenenenvirvirvirvirvironmentonmentonmentonmentonmental ral ral ral ral resouresouresouresouresources ances ances ances ances and td td td td to avo avo avo avo avoid distoid distoid distoid distoid distortortortortortionsionsionsionsions

in intin intin intin intin intererererernatnatnatnatnational trional trional trional trional traaaaade ande ande ande ande and ind ind ind ind invvvvvestment is the so-estment is the so-estment is the so-estment is the so-estment is the so-called Pcalled Pcalled Pcalled Pcalled Pollollollollollutututututer Per Per Per Per Paaaaays Pys Pys Pys Pys Principle. This means thatrinciple. This means thatrinciple. This means thatrinciple. This means thatrinciple. This means that

the pollthe pollthe pollthe pollthe pollutututututer should bear the expenses of carer should bear the expenses of carer should bear the expenses of carer should bear the expenses of carer should bear the expenses of carrrrrryingyingyingyingyingout those measout those measout those measout those measout those measururururures decided bes decided bes decided bes decided bes decided by py py py py puuuuublic ablic ablic ablic ablic authorituthorituthorituthorituthoritiesiesiesiesies

ttttto enso enso enso enso ensururururure that the ene that the ene that the ene that the ene that the envirvirvirvirvironment is in anonment is in anonment is in anonment is in anonment is in an

acceptacceptacceptacceptacceptable stable stable stable stable statatatatate. In other wore. In other wore. In other wore. In other wore. In other words, the costs ofds, the costs ofds, the costs ofds, the costs ofds, the costs of

these measthese measthese measthese measthese measururururures should be res should be res should be res should be res should be reflecteflecteflecteflecteflected in the cost ofed in the cost ofed in the cost ofed in the cost ofed in the cost ofgoods angoods angoods angoods angoods and services, which cad services, which cad services, which cad services, which cad services, which cause polluse polluse polluse polluse pollututututution inion inion inion inion inprprprprproductoductoductoductoduction anion anion anion anion and/or consd/or consd/or consd/or consd/or consumptumptumptumptumption. Such measion. Such measion. Such measion. Such measion. Such measururururureseseseses

should not be accompanied bshould not be accompanied bshould not be accompanied bshould not be accompanied bshould not be accompanied by sy sy sy sy suuuuubsidies thatbsidies thatbsidies thatbsidies thatbsidies thatwould crwould crwould crwould crwould createateateateate signife signife signife signife significant disticant disticant disticant disticant distortortortortortions inions inions inions inions in

intintintintintererererernatnatnatnatnational trional trional trional trional traaaaade ande ande ande ande and ind ind ind ind invvvvvestment.estment.estment.estment.estment.

SourSourSourSourSource:ce:ce:ce:ce: OOOOOECD Guiding PECD Guiding PECD Guiding PECD Guiding PECD Guiding Principles Concerrinciples Concerrinciples Concerrinciples Concerrinciples Concerning thening thening thening thening theIntIntIntIntIntererererernatnatnatnatnational Economic Aional Economic Aional Economic Aional Economic Aional Economic Aspects of Enspects of Enspects of Enspects of Enspects of Envirvirvirvirvironmentonmentonmentonmentonmental Pal Pal Pal Pal Policolicolicolicolicyyyyy(a(a(a(a(adoptdoptdoptdoptdopted bed bed bed bed by the Council on 2y the Council on 2y the Council on 2y the Council on 2y the Council on 26 M6 M6 M6 M6 Maaaaay 19y 19y 19y 19y 1972).72).72).72).72).

EFR instruments can help governments movetowards a more incentive-based market economy,reducing former inefficiencies. To realise this

potential, it is important that EFR is supportive ofgeneral tax reform objectives and conforms togeneral principles of good taxation, such asability to pay. Conversely, broader tax reformscan be made more supportive of environmentalobjectives excise duties on petrol products, forexample, are a key aspect of most tax systems. Bylevying different rates on different fuels to reflecttheir relative environmental benefits, consumerscan be encouraged to shift to less polluting fuelsources.

Environmental Benefits

In order to appreciate the environmental benefitsof EFR it is first necessary to identify, in broadterms, some of the key environmental andresource use issues facing developing countries.

SpecifSpecifSpecifSpecifSpecific Enic Enic Enic Enic Envirvirvirvirvironmentonmentonmentonmentonmental Issal Issal Issal Issal Issuesuesuesuesues

The exploitation of publicly owned or controllednatural resources in developing countries is, ingeneral, not appropriately priced. As a

consequence the pattern of exploitation istypically economically and socially inefficient,with gains accruing to some (mostly private)parties, but with much greater net losses ofwealth for society as a whole. Very often, thesolution to this problem requires the simultaneouslyimplementation of several policy options (see, forexample, UNEP, 2004a). EFR can be part of thesolutio

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