Can subsidies rather than pollution taxes break the trade-off between economic output and environmental protection?

Renström T. I., Spataro L.,  Marsiliani L. 2021-  Energy Economics

In the last two decades, socially responsible investing (SRI) has increasingly attracted the interest of investors as well as of academics and policymakers. SRI is an investment approach that integrates Environmental, Social, and Governance (ESG) factors into the selection and analysis of securities within investment portfolios. Its goal is to achieve long-term returns for investors while also influencing the behavior of companies to the benefit of society. In practical terms, SRI involves identifying and investing in companies that meet specific standards of Corporate Social Responsibility through various strategies like screening, advocacy, and community investing.

Public institutions, prompted by international summits and environmental concerns, have implemented or proposed fiscal and regulatory policies to address environmental quality and promote ESG practices. Examples include initiatives such as the Dutch Green Funds Scheme, which offers tax incentives for investments in green initiatives, and the utilization of tax-credit bonds or tax-exempt bonds in the United States. In the European Union, environmental tax revenue in 2018 accounted for about 2.4% of GDP and 6.0% of total government revenue from taxes and social contributions, with energy taxes being the primary contributor.

Market-based instruments like taxes and subsidies are considered to be more economically efficient in addressing environmental externalities within perfectly competitive markets. However, the full potential and implications of these policies, particularly in economies with socially responsible investors, have not been thoroughly explored.

In the article “Can subsidies rather than pollution taxes break the trade-off between economic output and environmental protection?”, recently published in Energy Economics, Thomas I. Renström, Luca Spataro, and Laura Marsiliani aim to bridge this research gap and examine the effectiveness of fiscal policies targeting pollution reduction in financial markets that involve socially responsible investors and their impact on environmental quality as well as on the economy’s performance, per capita consumption, and the “pollution premium”.

The authors develop a theoretical model in a continuous-time dynamic general equilibrium framework, where pollution arises as a by-product of profit-maximizing firms’ production activities. Firms have the option to engage in costly abatement activities to reduce net pollution. Additionally, they incorporate investors’ social responsibility objective through a “warm-glow” mechanism à la Andreoni, where they feel partially responsible for the pollution content of their portfolios and demand a “pollution premium” to hold assets with higher pollution levels.

Within this framework, firms are incentivized to engage in socially responsible activities (abatement), as higher pollution leads to a higher cost of capital in capital markets. The government implements a tax on firms’ pollution flows and a subsidy on their abatement activities. Thus, the authors compare the effects of these two fiscal instruments and find that both can effectively reduce pollution, but their impact on the economy differs.

The pollution tax reduces per capita consumption and the capital invested in the economy, whereas the subsidy can increase both. The rationale behind these results is as follows: the pollution tax acts as a tax on profits, diminishing firms’ marginal productivity of capital and prompting them to reduce capital investment, thereby reducing pollution flows and the “pollution premium”. On the other hand, the subsidy on abatement lowers firms’ production costs, encouraging them to expand their scale. This has two opposing effects. On one hand, increased capital investment tends to raise production, per capita consumption, and pollution (as a by-product of production). On the other hand, it also leads to a greater allocation of resources toward abatement, thereby reducing pollution and increasing per-capita consumption. The net outcome depends on the relative strength of these opposing effects. However, the analysis, based on general assumptions regarding production, abatement technology, and preferences, demonstrates that an increase in the subsidy for pollution abatement results in reduced pollution levels, a lower “pollution premium”, and increased per capita consumption.

Although theoretical in nature, the results of this study can provide insights for policymakers and highlight the potential benefits of aligning fiscal policies with both environmental and economic objectives, also in connection with the Italian National Recovery and Resilience Plan (NRP).

In fact, in an economy characterized by socially responsible investors, the goal of pollution abatement, which is on the political agenda of most developed countries and international organizations, is not necessarily at odds with economic performance. The subsidy for abatement (or, broadly speaking, for cleaner production), while having smaller quantitative effects on pollution compared to the tax on pollution, can positively impact steady-state consumption and capital. This fiscal instrument may be more feasible from a political perspective, especially in economies with investors exhibiting stronger social responsibility motives.

The Italian NRP serves as a comprehensive policy document that guides Italy’s strategy for green transition and, in particular, recognizes the importance of balancing environmental sustainability with economic growth. Hence, it provides a framework for implementing green fiscal policies which, according to the results of the study, can both incentivize green investments and foster sustainable economic development (see, for example, PNRR, pp. 136-139 on “Promoting the production, distribution, and end uses of hydrogen”).

Go to the published article