The Great Green Tax Shift – Evidence from Germany

I would like to dedicate today’s post to ecological fiscal reforms and eco-social market economies. It is inspired by Paul Krugman’s essay Earth in the Balance Sheet: Economists Go for the Green in The Accidental Theorist (1998). In the essay Krugman proposes a green tax shift away from taxes on employment and income towards pollution taxes. Therefore the first half the post looks at the concept of such a green tax shift. In the second half I want to take Germany as a textbook example to provide evidence for the wide-ranging benefits of such a tax shift.

What is the concept of a green tax shift? A green tax shift (also called ecological fiscal reform) is a reform of a country’s tax system by shifting existing taxes towards pollution taxes. Its aim is to facilitate a long-term transition to sustainable development (Beauregard-Tellier, 2006). These pollution taxes as well as taxes on other negative externalities include for example carbon taxes, waste disposal taxes or taxes levied on companies for effluents that lead to a degradation of the environment. The IMF goes further than this and names a second dominant economic instruments for controlling pollution, namely tradable permits and emissions taxes (Norregaard & Reppelin-Hill, 2000).

The main idea of a ecological fiscal reform is to induce companies to internalize the social costs they impose on society via fiscal policy. This is because in the past companies have benefited from facing production costs far less than their true social costs. Things like the depletion of resources, pollution and disposal of waste water into rivers do not have a price tag on them and are therefore not factored into the private costs of firms. This problem is normally associated with public goods (like fresh air and water) which suffer from the free rider problem or the tragedy of the Commons. Public goods are by definition non-excludable and non-rival inducing people to overuse resources, pollute etc. However, the ecological fiscal reform also targets individuals through taxes on fossil fuel or electricity consumption. Therefore such a green tax shift is both levied on consumers and producers.

The green tax shift concept is more complex than introducing pollution taxes. It recognises that – like any tax – it comes with side effects, i.e. incentives to work and save less ultimately reducing GDP. To mitigate this effect, the revenue collected by the green taxes is offset by reductions in taxes like social security (Krugman, 1998). To keep GDP stable a country should pursue a revenue neutral tax shift and maintain the same tax progressiveness. In addition, the country probably has to take measures to mitigate the effects on the country’s poorest people because they tend to spend relatively more of their income on gas, electricity, water and transport (BBC, 2004).

Nonetheless, the burden for such a green tax shift to work is high. Reforms need to be accompanied by the improvement of local amenities. One issue is to ensure the supply of local products and services to reduce greenhouse gas (GHG) emissions to a minimum level. This could work in practice if people need to spend less on transport and have a higher share of their income available for locally sourced products and services. Also, such a green tax shift only works if lifestyle becomes more focused living “locally” in the community. In such an environment there would be no need for commuting anymore. There are many levers that need to be put in place to make this vision reality. Examples are more telework or local permaculture (e.g. urban farming in Cuba).

What would be the potential benefits of such a shift? Firstly, if the revenue from green taxes exceeds the amount needed for the tax relief in other areas it could be used to subsidise research and development in sustainable energy. Furthermore, one would hope to see a change in the society’s attitude towards more environmentally friendly cars, housing and consumption goods. What is more, it could lead to a rethinking in the real estate sector favouring green buildings if their return on investment increases to levels above the one of conventional buildings.

According to Krugman (1998, p.171) there are three main problems that have led the Great Green Tax Shift to be a “complete political nonstarter”; he calls them three I’s:

  1. Ignorance
  2. Interests
  3. Ideology

As far as I understand, ignorance is associated with the credibility of levying taxes on the one hand and lowering taxes on the other hand. Public debates tend to be biased towards tax increases, ignoring the tax relief in other categories. Secondly, interests play an important role. “Anti-environmental” groups like energy companies tend to lobby governments actively while society is less powerful when it comes to lobbying “pro-environment”. Lastly, ideology is a major burden. The left-wing tends to declare pollution as evil and that “it is immoral to put a price on it” (Krugman, 1998, p.172) because it would ultimately justify pollution and the right-wing completely refuses government action in favour of free markets. In addition to these problems mentioned by Krugman one should also note that determining the correct level of taxation and designing a complete new green tax collection system poses a huge challenge. It could lead to further distortions and unintended consequences.

In the remainder of the post I want to look at Germany and its Ecological Tax Reform Act passed on 24 March 1999. This reform led to an initial increase in fossil fuel taxation and a new tax on electricity consumption. Over the period from 2000 to 2003 there were four further tax increases. The objective of the Ecological Tax Reform Act is to mitigate carbon dioxide emissions and foster job creation as well as more innovation (IEA, 2013). The reform was mainly a green tax shift because up to 90% of the revenue from the green taxes went to “offset payroll contributions from employers and employees with much of the remainder going towards the funding of renewable energy schemes” (IEA, 2013, p.28). A drawback of the reform is that there are some exemptions for certain manufacturers in energy-intensive industries.

green tax shift.png

What were the effects of the green tax shift in Germany? For this I obtained data from the World Bank’s World Development Indicators on aspects like Germany’s GDP and GHG emissions. Most notably GHG emissions fell – mainly in the transport sector – and people reduced their energy consumption. The fall in GHG emissions is even more impressive because GHG emissions have decreased despite people using more transport. This finding is in line with the concept discussed before, i.e. inducing people to change habits towards cleaner cars and new technologies.  The IEA also reports that environmental taxes on transport as percentage of total taxation have fallen from 5.2% in 2005 to 4% in 2010. This refutes the argument that a green tax shift could be a major burden for the economy. This can also be seen in the diagram. It seems that GDP per capita has not been constrained by the Ecological Fiscal Reform Act. What is more, research and innovation seem to have taken off to new levels if one uses Researchers in R&D (per million people) as an indicator. The IEA also notes that Germany is now “among the world leaders in terms of energy-efficient buildings” (2013, p.41) due to heat demand reduction, its upcoming clima-neutral policy for new buildings and reduction in primary energy demand. Hence, rather than an adverse effect on GDP the green tax shift seems to have had positive effects due to higher R&D and the search for new cleaner technologies. This induces more sustainable wealth-creation and a future-oriented economy. Innovation is one of the drivers of productivity and a main determinant of long-term growth (see augmented Solow growth model). This seems to hold for Germany as fiscal policy has induced the society to rethink. Therefore the IEA rightly concludes that Germany has mastered the green tax shift and that the Ecological Tax Reform Act has allowed the country to decouple economic growth from GHG emissions with the help of renewable energy and improved energy efficiency.

That’s me for today! I hope you enjoyed today’s topic as much as I did. I was surprised to find such a forward-looking essay on a more eco-social market and ecological fiscal reforms in a book of the 1990s while it took the OECD until 2011 to publish an Environmental Taxation Guide for Policy Makers. Germany is only one of few OECD countries having implemented such a shift but the concept has the potential to change a lot!

Thanks for reading!


BBC (2004, October 26). Green taxes ‘would hit poor most’. BBC News. Retrieved from: [Accessed 20/04/2016].

Beauregard-Tellier, F. (2006). Ecological Fiscal Reform. Ottawa, Canada: Parliamentary Information and Research Service. Retrieved from: [Accessed 20/04/2016].

IEA (2013). Energy Policies of IEA Countries: Germany 2013 Review. Paris, France: International Energy Agency. Retrieved from: [Accessed 20/04/2016].

Krugman, P. (1998). The Accidential Theorist: And other Dispatches from the Dismal Science. New York, N.Y.: W.W. Norton & Company.

Norregaard, J., and Reppelin-Hill, V. (2000). Taxes and Tradable Permits as Instruments for Controlling Pollution: Theory and Practice (Working Paper No. WP/00/13). Retrieved from International Monetary Fund website: [Accessed 20/04/2016].

OECD (2011). Environmental Taxation: A Guide for Policy Makers. Retrieved from: [Accessed 20/04/2016].

World Bank, 2016. World Development Indicators. [data] Retrieved from World Development Indicators (WDI) database: [Accessed 20/04/2016].


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