German Environmental Tax Reform, setting precedent

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

Before

After

Annual increase

ETR

ETR

1999

2000

2001

2002

2003

Petrol

50.1

+3.1

+3.1

+3.1

+3.1

+3.1

65.6

Diesel

31.7

+3.1

+3.1

+3.1

+3.1

+3.1

47.2

Heating Oil

4.1

+2.1

6.2

Natural Gas

0.2

+0.2

0.6

Electricity

+1.0

+0.3

+0.3

+0.3

+0.3

2.1

Tab.1: Table of 5 stages of tax increases

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

The revenue collected from these taxes was mainly used to lower non-wage labor costs, the public
pension system received in 2003 90% of the 18.1 billion euro collected. This huge transfer of resources
to the public pension scheme allowed a reduction in the Social Security Contribution (SSC) rate, which
went down from 20.3% in 1998 to 19.5% in 2005m these cuts benefitted both employers and
employees (Bach, 2005).
In the course of this essay we do both a theoretical and empirical analysis; in the the latter we use data
from the OECD, the Statistisches Bundesamt, etc. Then, we mention a couple of alternatives that
might solve some of the problems the ETR fails to address. Finally, we conclude with some final
remarks on this issue.

2. Analysis
Theoretical
The ETR consisted of a series of pigouvian taxes intended to lower CO2 emissions (Pigou, 1954), the
mechanism of action of the pigouvian taxes is better explained by figure 1 (Wikipedia, 2016). One of
the problems of a pigouvian tax is its implementation, due to the complexity that measuring emissions
individually means; the German government took care of that issue in a rather clever way, instead of
taxing the output (CO2 emissions), they taxed the input (Fossil fuel consumption). When doing this,
they also were aware of the substitution effect that might have taken place amongst the variety of
fossil fuels available in the market, to address this matter they taxed the whole range of fossil fuels.
Later on this essay we show that this system was rather effective lowering both fossil fuel consumption
and CO2 emissions.

Fig. 1 Recovered from: https://en.wikipedia.org/wiki/Pigovian_tax#/media/File:Social_cost_with_tax.svg

Another concern that rises when implementing this kind of taxes, its its redistribution effects. A
higher tax on an input means a rise in the production costs, thus lowering overall production, which
translates into a decrease in the labour demand (Grlach, Knigge, & Lckge, 2005). The response of
the German government was to use the revenue of the ETR in order to lower the Social Security

Contributions (SSC) made by both employers and employees, thus lowering non-wage costs; the
intention was to create jobs while reducing CO2 emissions.
Empirical Evidence
Fossil fuel prices, and in general energy prices, often fail to take into account the true ecological costs
their usage carries. This failure sends the wrong signals to the market leading to an overconsumption,
which creates short and long term ecological problems, such as the climate change. Thus, the aim of
the ETR is to correct the wrong prices, making sure the right signals are sent to the market, this is
what is called the internalization of the problem (Kohlaas, Auswirkungen der Okologischen
Steuerreform auf private Haushalte, 2005).
As aforementioned the ETR consisted of a series of both raises in the oil products, and a cut of the
Social Security Contributions (SSC). The mechanism intended here is as follows, with a raise in the
prices of oil products, firms will lower their consumption; either making more oil-efficient processes,
turning to renewable sources of energy, or by simply reducing their output; in any case, the CO2
emissions will decrease over time without affecting the labour market in the long run. The effect of
ETR in increasing jobs is not defined, but PANTA RHEI calculated that the reform made between
220 000 and 250 000 new jobs already in 2003. And LEAN indicates an increase in employment of
176,000 in 2008 (Beuermann & Santarius, 2006).

140

1.3e+06

130

1.2e+06

120

OilCons

Co2Tons
1.1e+06

110

1.0e+06
900000

1990

1995

2000
year
Co2Tons

2005

2010

OilCons

Fig. 2. Co2 Emissions per year (tons) and oil consumption (millions of tons).
Note: Adapted from: https://www.quandl.com/api/v3/datasets/BP/OIL_CONSUM_DEU.xml (British
Petroleum , 2016) and http://dx.doi.org/10.1787/93d10cf7-en (OECD, 2014), (Accessed on 06 March 2016).

Figure 1 shows a sharp decrease in the consumption of oil after and during the implementation of the
ETR. The average consumption from 1990 to 1998 was approximately 134 million of tons, from 1999
to 2003 was approximately 129 million of tons, and from 2004 to 2012 was approximately 117 million
of tons; thus proving extremely effective in reducing oil consumption.
Furthermore, the graph also shows a severe reduction in C02 emissions, which, as shown by the chart,
is strongly correlated with the oil consumption.

10

88

86

6
CleanENer

PercFosilFuel
84

82

80

1990

1995

2000
year
PercFosilFuel
CleanENer

2005

2010

CleanENer

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

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

Its also remarkable the slow, but steady, decline in the participation of fossil fuel in the generation of
energy. Moreover, one of the objectives of the ETR was to promote the substitution of fossil fuel
energy for green energy, which as shown by figure 2 has recently been gaining importance as a source
of energy.
Tax Burden
The German Institute for Economic Research (DIW) prepared a series of reports in which they
analysed in deep the effects of the tax reform on every sector. They found that the elasticity-price for
the private demand f fossil fuels decreases at a rate of 2% for every 10% in the increase of the price,
making it a very inelastic demand (Knigge & Grlach, Berlin). Hence, if the demand is inelastic the
burden is going to fall on the consumers, as we later show this burden is compensated by the creation
of new jobs and the increase in GDP (Gayer & Rosen, 2014).
They found that the use of the revenues of the taxes to lower SSC shifted the tax burden from the
work factor onto energy consumption, worked. The GDP increased in almost half a percent in
comparison to simulations with out the ETR; CO2 emissions also showed improvement when

compared to the simulations, managing a reduction of 20 millions of tons in only 2003c (Knigge &
Grlach, Berlin).
The studies attribute the positive effects to the investments made by the firms in energy reduction
technologies.

120

110

20

40

120

60

OilPr

OilCons

80

130

100

140

International Oil Prices and its possible effect

1990

1995

2000
year
OilCons

2005

2010

OilPr

Fig. 4 Oil consumption per year and oil price (in 2014 US dollars).
Note: Adapted from https://www.quandl.com/data/EIA/PET_RWTC_D-Cushing-OK-WTI-Spot-Price-FOBDaily?utm_medium=graph&utm_source=quandl (U.S. Energy Information Administration Data , 2016)

However, it is also important to highlight the effect international oil prices might have had in the
decrease of the oil consumption. The last decade saw the highest oil prices of all times, which may
have helped this noble enterprise, further research should be conducted on this topic.
Alternatives
Even though there is a decrease in emissions as a result of the ETR it is hard to quantify how big the
real impact is. Hence, it might be useful to point out some alternative policies to reduce emissions.
First of all, it is worth mentioning an idea sketched out in the beginning of the analysis. In a perfect
world taxing the output its more effective in reducing both the emissions and the costs associated
with these reductions. This would not only lead to lower consumption of fossil energy resources, but

would also give incentives to i.e. use better filters to lower the pollutant agents released into the air.
However, measuring the emissions of every firm in reality carries huge administrative costs, which
outweigh the benefits of such a policy.
On the other hand, another approach is to fix the quantity of emissions the society is willing to tolerate
(i.e. via emission bonds), provided that the conditions are right (Coase, 1960). A market for emission
bonds would provide the companies with the highest needs for emissions with the ability to maintain
their emissions, while firms who can reduce their contamination levels at a lower cost would do so.

Fig. 5 Emissions trading

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

This type of policy has been used since the Kyoto protocol proclamation in 1992 for emission-trade
between countries; its been adopted in the EU since 2005 for the same purposes between companies,
a better explanation of this mechanism is showed in figure 5.
Final Remarks
First of all, it is pretty clear that CO2 emissions have sharply decreased since the implementation of
the ETR in 1999; however, it is still unclear whether this reduction is caused by the ETR, or the
presence of high oil prices in the past decade along with other economic facts, such as the financial
crisis. Nevertheless, the ETR is credited with having managed to take some pressure off the pension
system, by transferring roughly 90% of the tax revenue towards the Social Security system (Bach,
2005).

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

Bibliography
Bach, S. (2005). Be- und Entlastungswirkungen der Okologischen Steuerreform nach Produktionsbereichen.
Deutsches Institut fr Wirtschaftsforschung. Berlin: DIW Berlin. Retrieved from
Ecologic.eu: http://ecologic.eu/sites/files/download/projekte/18501899/1879/1879_1_sektoral.pdf
Beuermann, C., & Santarius, T. (2006). Ecological tax reform in Germany: handling two hot
potatoes at the same time. Energy Policy, 917-929.
British Petroleum . (2016, 03 06). Quandl . Retrieved 03 06, 2016, from Quandl:
https://www.quandl.com/api/v3/datasets/BP/OIL_CONSUM_DEU.xml
Coase, R. (1960). The Problem of Social Cost. Journal of Law and Economics, 1-44.
Grlach, B., Knigge, M., & Lckge, H. (2005). Wirkungen der Okologischen Steuerreform auf Innovation und
Marktdurchdringung. Berlin: Ecologic.
Gayer, T., & Rosen, H. (2014). Public Finance, Global Edition (10th Ed. ed.). Cambridge: McGraw-Hill
Higher Education.
Knigge, M., & Grlach, B. (Berlin). Auswirkungen der Okologischen Steuerreform auf Unternehmen. 2005:
Ecologic.
Kohlaas, M. (2005). Auswirkungen der Okologischen Steuerreform auf private Haushalte. Berlin: DIW.
Kohlaas, M. (2005). Gesamtwirtschaftliche Effekte der okologischen Steuerreform. Berlin: DIW.
OECD. (2014). Air and GHG emissions. Retrieved 03 06, 2016, from OECD:
http://dx.doi.org/10.1787/93d10cf7-en
OECD. (2016). OECD. Retrieved 03 06, 2016, from 10.1787/aac7c3f1-en
Pigou, A. (1954). Some Aspects of the Welfare State . Diogenes, 1-11.
Stern, N. (2007). The economics of climate change: the Stern review. Cambridge: Cambridge University Press.

U.S. Energy Information Administration Data . (2016). Quandl. Retrieved 03 06, 2016, from
https://www.quandl.com/data/EIA/PET_RWTC_D-Cushing-OK-WTI-Spot-Price-FOBDaily?utm_medium=graph&utm_source=quandl
Wikipedia. (2016). Wikipedia. Retrieved 03 06, 2016, from
https://en.wikipedia.org/wiki/Pigovian_tax#/media/File:Social_cost_with_tax.svg
Wikipedia. (2016). Wikipedia. Retrieved 03 06, 2016, from
https://en.wikipedia.org/wiki/Emissions_trading#/media/File:Emissions.Trading.jpeg