Water taxation and the double dividend hypothesis

July 13th, 2015

Dr. Nicholas Kilimani, Prof. Jan van Heerden & Dr. Heinrich Bohlmann, University of Pretoria, South Africa

This research investigates the possibility of designing a tax policy that is capable of minimizing the costs of environmental regulation while achieving economic objectives such as raising tax revenue.1,2 In this regard, a specially developed water CGE model (UgAGE-water) is used to investigate the economic impact of a water tax on the economy.

Water resources are increasingly becoming stressed in terms of quantity and quality. These strains are emanating from increased economic activity, population growth, as well as changes in climate.3 Unfortunately, the current water pricing policy in Uganda is largely market based and does not seem to adequately capture the full cost of increasing water scarcity or the cost of delivering water supply to communities and industries. In this regard, we contend that a well-designed tax can induce efficient water use and also harness resources for financing the development and expansion of an efficient water supply infrastructure.

This research was motivated by a policy of the Ministry of Finance, Planning & Economic Development of the Government of Uganda to levy a Value Added Tax (VAT) on commercially distributed water.4 While the primary objective is assisting in raising revenue to match fiscal targets, we study the extent to which it might lead to other costs and benefits.

The notion of a “double dividend” was introduced in the early 1990s based on the idea that revenues from an environmental tax could be used to offset other distortions and simultaneously reduce environmental degradation.5,6. However, given the fact that the impacts of such policy measures are likely to vary from one country to another, one cannot know apriori, the effects of such a policy on an economy.7 Most importantly, policy makers need to understand the environment-economy specific impacts in order to balance between the need to maximise the economic gains from the tax and the associated costs.

In this study, a weak double dividend is found to hold. This is in line with a large volume of literature where environmental taxation and revenue recycling policies often result in the price interaction effects outweighing the revenue recycling effects. As a result, it is not possible to realise a strong dividend from such taxation policies. Furthermore, the realisation of any form of dividend depends upon the design of the taxation and revenue recycling regime. (see here for our empirical test of the double dividend in Uganda).8

The model

We developed a Computable General Equilibrium (CGE) model for Uganda to analyze the impact of a tax on water on Uganda’s economy. These class of models allow for economy-wide interactions when evaluating a policy intervention, rather than relying on estimating the effects in a single industry. We evaluate three revenue recycling schemes following the tax. The first set of simulations is an imposition of a UGX 500 (USD 0.20 per m3) tax on commercially supplied water.9 In the second set, we sequentially simulate how the revenue can be recycled in the economy to offset other distortions through the provision of sales, production, and export tax breaks, making the overall scheme revenue neutral.

The theoretical structure of UgAGE is based on the ORANI-G model documented in Horridge10 with various add-ins to facilitate the detailed modelling of water accounts in the country. In this version of UgAGE, we use an aggregated 13-sector database. In UgAGE, all industries share a common production structure, but input proportions and behavioural parameters vary between industries based on available base year data and econometric estimates, respectively. In this regard, the model parameters used are derived from the IFPRI model for Uganda,11 in addition to other relevant studies in the literature12,13,14,15 and informed by the authors’ knowledge of the Ugandan economy.

The research employed different taxation and revenue plough-back scenarios in order to answer questions which are at the core of the double dividend hypothesis:

What is the impact of the policy on the key macroeconomic variables? What are the environmental impacts of a water tax? How is employment affected by the policy intervention?

1) Impact of a water tax policy on the key macroeconomic variables

When a tax is imposed: (i) it increases the cost of production which therefore results in a decrease in the supply of most commodities (the “price interaction effect”); and (ii) it increases government revenue, which can be used to offset other distortionary taxes (the “revenue recycling effect”). Without a concomitant increase in government expenditure, a tax decreases aggregate demand.

The fall in aggregate demand causes a significant reduction in price levels and a decline in real GDP. This leads to a decline in the volume of taxable water used as the level of economic activity is reduced. Taxes also have the effect of increasing domestic prices, which leads to a decline in exports of most commodities and an increase in imports. The effect of a revenue plough-back scheme works in the opposite direction.

2) Environmental impacts of a water tax

In analyzing the environmental effects of the tax (the first dividend), the results show that a tax reduces water use. This implies that for all the policy scenarios, changes in water use following a tax yield an environmental dividend. The same benefits of reduced water use hold for all the three revenue plough-back schemes. From the results, a tax on water consumption always leads to a decrease in water use. In our modelling procedure, this tax is levied on metered water. As such, it is collected as a part of an entity’s water consumption bill. Furthermore, the tax rate was set to in order to ensure compliance and equity, while ensuring more regulated water use than would have been the case without a tax.

3) Impacts of a tax on employment

Generally, changes in employment are closely linked to changes in real GDP. In this research however, the results for the changes in employment per UGX 1 billion of tax revenue follow a slightly different trend for some sectors of the economy. In other words, a double dividend with respect to employment is realized for taxes to certain sectors as well as for certain revenue plough-back schemes, but not for all. For instance, a tax on water for the agriculture and mining sectors results in a decline in employment.

Generally, a tax on industries for which water is a major input in their production activities (such as mining or agriculture), results in a decline in employment. For the agricultural sector, employment declines by an average of 0.85% for all the taxation scenarios both in the short and long-run. In fact, all plough-back schemes fail to generate employment in the sector. The policy implication for such a result is that a careful identification of sectors for this tax is key for the overall success of the policy. Such an approach is critical since the agricultural sector alone employs over 75% of Uganda’s population.

Policy implications

Given the limited use of taxes in environmental regulation and fiscal policy in Uganda, the modelling results highlight the possibility for instituting policy measures that yield double dividends. As this research demonstrates, it is possible to design a policy which widens the tax base, and also regulates the use of environmental resources at the same time. However, this depends upon the sectors on which the tax is imposed, the tax rate and the choice of revenue plough-back scheme. This implies that a deeper understanding of a given economy, and careful policy design are fundamental for the realization of benefits from environmental taxes.

The findings of this study can be extended to other developing economies whose use of environmental tax instruments is still limited and yet such economies stand to suffer from the adverse effects that may arise from environmental resources mismanagement.

References:

A. Yusuf, B.P. Resosudarmo, On the distributional effect of carbon tax in developing countries: The case of Indonesia. Working Paper No. 200705, Centre for Economics and Development Studies, 2007. Fullerton, A. Leicester, S. Smith, Environmental taxes, Prepared for the Report of a Commission on Reforming the tax system for the 21st Century, Chaired by Sir James Mirrlees.[On-line]. Available at: http://www.ifs.org.uk/mirrleesreview/reports/environment.pdf, 2008. C. Bates, Z.W. Kundzewicz, S. Wu, J.P. Palutikof, Eds, Climate Change and Water. Technical Paper for the Intergovernmental Panel on Climate Change, IPCC Secretariat, Geneva, 2008 MFPED, Budget speech for the 2013/14 Fiscal Year. Ministry of Finance Planning and Economic Development-Government of Uganda Kampala-Uganda, 2013. H. Van Heerden J.N. Blignaut, M. Mabugu, R. Gerlagh, S. Hess, R, Tol, M. Horridge, M.P. De Wit, A. Letsoalo, Redistributing environmental tax revenue to reduce poverty in South Africa: the cases of energy and water. S. Afr. J. Econ. Manage. Sci. 9, 4 (2006) 537-552. Letsoalo, J. Blignaut, M. de Wit, S. Hess, R. Tol, Triple dividends of water consumption charges in South Africa, Water Resources Research, 43, 5:(2007)1-32. [On-line]. Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.175.5992&rep=rep1&type=pdf. Blignaut, J.H. Van Heerden, M. Horridge, “Integrated water and economic modelling of the impacts of water market instruments on the South African economy,” Ecological Economics, Elsevier, vol. 66(1),105-116, 2008. EEA. Environmental tax reform in Europe: Implications for income distribution, European Environmental Agency, Technical report No: 16/2011, 2011. Kilimani, J. Van Heerden, H. Bohlmann, Water taxation and the double dividend hypothesis, Water Resources and Economics, 2015, http://dx.doi.org/10.1016/j.wre.2015.03.001. Pearce, The role of carbon taxes in adjusting to global warming. Econ. J, 101, 938-948 , 1991. M. Horridge, ORANI-G: A Generic Single-Country Computable General Equilibrium Model. Practical GE Modelling course 18-22:2001. Centre of Policy Studies, Monash University, 2001. V. Dimaranan, R.A. McDougall, T.W. Hertel, Behavioural Parameters, in Betina, V and Dimaranan (eds) Global Trade Assistance and Producton: The GTAP 6 Data base. Lafayette, IN: Centre for Global Trade Analysis, Purdue University, 2006. Hertel, D. Hummel, R. Keeney, How confident Can we e of CGE-Based Assessments of Free Trade Agreements? Economic Modelling, 4 (2007) 611-635. Boysen, A. Mathews, Impact of EU Common Agricultural Policy reform on Uganda. [On-line]. Available at: http://www.odi.org.uk/sites/odi.org.uk/files/odi-assets/publications-opinion-files/7889.pdf [Accessed on 16th Nov 2013]. 2012. Boysen, A Food Demand System Estimation for Uganda, Discussion Paper 396. Dublin: Institute for International Integration Studies, Trinity College-Dublin, 2012.

Nicholas Kilimani is a Doctoral Fellow in the Department of economics, University of Pretoria, South Africa, and Lecturer in the Department of Policy & Development Economics, Makerere University, Uganda. Jan van Herdeen is a Professor in Economics at the University of Pretoria, South Africa. He is also the Deputy Director, Economic Research Southern Africa (ERSA). Dr. Heinrich Bohlmann is a Senior Lecturer in Economics at the University of Pretoria, South Africa. The article is based on an original piece of research published in Water Resources and Economics titled, ‘Water taxation and the double dividend hypothesis‘.

The views expressed in this article belong to the individual authors and do not represent the views of the Global Water Forum, the UNESCO Chair in Water Economics and Transboundary Water Governance, UNESCO, the Australian National University, or any of the institutions to which the authors are associated. Please see the Global Water Forum terms and conditions here.