The concept of using taxation as a policy instrument to achieve environmental protection goals is not new writing in 1920, the renowned economist A.C. Pigou suggested that the problem of externalities could be addressed by imposition of a tax equal to the marginal cost of the environmental damage in question. I
In 1965, prior to enactment of basic federal or provincial environmental legislation, the Canadian government offered an accelerated capital cost allowance rate for the purchase of air and water pollution control equipment.(2) This early step toward using tax as an environmental policy instrument, was not pursued in the 1970s when governments moved to address environmental concerns by enacting a broad range of environmental laws, but the green taxation concept has recently attracted new attention, as part of the growing interest in economic instruments.
Today, use of tax as an environmental policy instrument is advocated by many environmentalists the most ambitious proposals are for "ecological tax reform" -- a massive transformation of the tax system, which has been defined as "shifting the burden of revenue-generating taxation from desirable activity such as labour and savings to undesirable activity such as pollution.'"(3)
The two main green taxation options centre on incentives and penalties. Tax measures that provide positive financial incentives, in the form of tax exemptions or deferrals, are known as tax expenditures. The concept has been defined as government "spending by not taxing."(4) In 1990, Donald Savoie estimated the total annual cost of federal tax expenditures to be in the neighbourhood of $30 billion.(5) green taxation policy could increase these expenditures by including more environmentally positive tax incentives, like the 1965 measure to encourage purchase of pollution abatement equipment. But there would also be significant cuts. Because many current tax incentives encourage environmentally regrettable activities, such as more rapid exploitation of non-renewable resources, one component of a green taxation policy would centre on elimination of environmentally undesirable tax exemptions and deferrals.(6)
The second option is penalty taxation,(7) imposition of taxes that provide a negative financial incentive for behaviour change. In the environmental policy field the primary theoretical basis for penalty taxation is the argument, stemming from Pigou, that it can be used to correct the market failure which results when firms "externalize" the costs of pollution or resource consumption. Because externality effects are suffered by actors other than the buyer or seller (for example, by the owner of the dirty laundry next door to the smoke-emitting factory or by the fish downstream from the pulp and paper plant), they are not taken into account in the setting of price. Consequently, the market cannot send price signals that move it toward the optimal allocation of resources.
The concept of Pigovian taxation is action by the state to replace those missing price signals. Using the tax system, the state imposes a cost on the externality-generator equal to the marginal cost of the given externality. This is expected to force the firm to face the costs it was trying to externalize. The desired result is a change in the firm's behaviour that is just enough to move the market back to the hypothetical ideal of perfect competition.
The idea is attractively simple. But it requires policy makers to establish a dollar value for each externality in question. This "damage function" is then used to establish the tax rate. …