For a Double Dividend in Climate Policy

The reactions of politicians, companies and society to the high energy prices caused by the war are a good illustration of how to deal with the social consequences of the energy transition, which inevitably come with higher prices for fossil energies. What is needed is targeted social compensation that focuses on vulnerable households.

The prices for gas and electricity have literally skyrocketed. The green energy transition will also lead to an increase in fossil fuel prices, although not as quickly and as dramatically. The resulting costs must be absorbed in a socially compatible way. The federal government is currently fast-tracking the advantages and disadvantages of various subsidy programmes such as the energy allowance, fuel discount and gas price cap.

As a climate policy measure, many government advisors recommend returning the revenues from CO₂ emissions trading to citizens in a socially balanced way, for example in the form of a lump sum that is the same for everyone. For example, Switzerland distributes part of the revenue from the CO₂ tax to everyone who lives there and has health insurance. The amount is offset against the health insurance contribution. The federal government formulated something similar in the coalition agreement: “To offset a future price increase and ensure acceptance of the market system, we will develop a social compensation mechanism [...] (climate income).”

This climate income (“Klimageld”) means that everyone receives a lump sum. If every person in Germany received 100 euros, it would cost about 8 billion euros. In practice, it is not so easy to pay out a lump sum because there are no comparable payments with which it could be combined. Switzerland has the advantage that everyone has health insurance there and insurance premiums are not graded according to income. In Germany, this is more complicated: for example, the second relief package of the federal government of May 2022 provides that all employed persons liable to income tax receive an energy allowance of 300 euros via their pay slip, which they have to pay tax on. Self-employed persons receive this lump sum through a reduced advance tax payment. Recipients of social benefits receive 200 euros per person, recipients of unemployment benefits 100 euros. Retired persons who were initially not taken into account were only granted a direct payment of 300 euros with the third relief package of the federal government in September 2022. This third package also includes payments of 200 euros to university and vocational students. Housing benefit recipients receive a heating allowance, the amount of which depends on the number of persons in the household. To ensure that the climate income can be paid out to everyone via the same channel in the future, a payment via the tax identification number is to be developed in the near future.

Why pay a climate income? On the one hand, it would make climate measures, and in particular the CO₂ price under the emissions trading schemes, more appealing to the population. The state does not collect the money to become richer, but returns it to the households. Surveys also confirm that people are more willing to support a carbon price if they know that the revenue will be returned to the population. On the other hand, such a measure, i.e. CO₂ pricing together with climate income, is ‘progressive’ in tax terms: Wealthy households take the burden, poorer households are relieved. This is because richer households tend to have a larger carbon footprint as they live in larger homes that require more heating energy, own more and larger vehicles with higher fuel consumption and travel more frequently by plane. However, relative to income, the financial burden is lower for wealthier households. According to statistics, the carbon footprint of a household with twice as much income is larger, but not twice as large as that of the household with the lower income.

A CO₂ price alone is therefore ‘regressive’, as people with low incomes would pay relatively more of their income. However, together with climate income, which is the same for everyone, the bottom line is that it brings relief to poorer households and burdens richer ones. In addition, it has a positive side effect as it causes a behavioural change towards lower-emission products through the carbon price.

So is it a good idea? Not entirely. The revenues from the CO₂ levy and emissions certificate trading are not the only ones at the federal level. There are also taxes and other levies. These government revenues are offset by expenditures. If the revenues are not sufficient to cover the expenditures, the state incurs additional debt. However, it is not obvious at first glance which funds are used for which expenditures. This is referred to as the non-affection principle or total coverage principle. It describes the budgetary principle that all revenues of a public budget serve to cover all expenditures, i.e. they are not earmarked. Even if they were earmarked, this would be for purely political and not economic reasons. For example, there are special funds in the federal budget such as the “Energy and Climate Fund”, which stems from emissions trading, among other things, and is intended to finance climate protection measures.

Even though a coherent link between inputs and outputs is suggested here, it is clear that this expenditure could also have been financed by tax revenues. Ultimately, total expenditure equals total revenue (plus debt), regardless of where it comes from. In this respect, the link between climate revenues and CO₂ revenues may be media-effective – the state does not enrich itself from the new revenues – but it is irrelevant for the balance sheet. The state then enriches itself more from other revenues, because it could have used the money to reduce taxes.

And this leads to the core question: What should this additional government revenue be used for? More specifically, how should government revenues and expenditures be adjusted if additional revenues are generated by CO₂ pricing? A look at the financial literature shows a variety of possibilities. But one is not there – to pay out the money as an equal lump sum for all.

This is because taxes (or pricing) have a ‘distorting’ effect. Sometimes this distortion is intentional, for example in the case of CO₂ pricing, which encourages people and companies to emit less pollution simply because it is more expensive. But often it is not. For example, the splitting of income taxation between spouses, which provides the highest tax benefit when one partner earns little or does not work at all, is one of the main reasons why women in Germany are much more likely to work part-time than in other industrialised countries. The second earner then has to pay relatively high taxes, which reduces the incentive to work many hours. A major area of research in economics is therefore concerned with the question of how such inefficiencies in tax collection can be reduced.

British Prime Minister Margaret Thatcher wanted to combat these distortions with a radical solution in the late 1980s. She introduced a poll tax, which was the same for everyone. For the taxpayer, this is neutral in terms of incentives and thus better than any income tax: Since you pay the same amount whether you earn much or little money, a head tax makes it more worthwhile to work more hours. But socially, of course, this is exactly the problem – if the senior doctor pays the same as the nurse, this is socially unjust. Accordingly, the poll tax led to protests and 18 million Britons refused to pay it. The introduction of this tax was the beginning of the end for Margaret Thatcher’s political career. She resigned as British Prime Minister in November 1990.

Let us now return to the counterpart of the lump-sum tax, namely the lump-sum payment as in the case of climate income. It has neither an individual incentive effect – like the flat tax, since everyone receives the same amount – nor is it socially just, since the senior doctor receives the same amount as the nurse. Rather, it is a missed opportunity. In contrast, many have long argued for a CO₂ price in combination with social policy measures or tax cuts. Science has coined the term “double dividend” for this. Double dividend because the CO₂ price makes environmentally harmful behaviour more costly and thus less attractive. That is the first dividend. If you use the revenue to reduce distorting taxes which in turn become less distorting, you get a second dividend. Another option would be to use the funds to reduce the debt so that later generations will have to pay less tax. If you use the funds for social policy measures, for example by supporting poorer households, you also get a second dividend. Moreover, low-income households in particular often need further assistance in addition to financial relief, e.g. for investments in energy efficiency measures, as a ZEW study from 2022 shows. Low-income households often cannot afford to replace their refrigerator with a more efficient appliance that would actually pay for itself quickly. Issuing a temporary voucher can significantly increase the likelihood of replacing an inefficient appliance. With a lump-sum climate income for all, the chance for a second dividend is missed.

Now, in the biggest energy crisis since the founding of the Federal Republic, we are learning this lesson the hard way. The federal government’s aid programmes are criticised for not distributing the funds in a targeted manner. Millionaires have already stated in the media that they would donate their energy allowance because they do not need it. And the gas price cap proposals, which are linked to the previous year’s consumption, do not distinguish whether the consumption was caused by heating a poorly renovated flat of a large family or a lawyer’s office. However, the measures are intended to cushion temporary extreme price shocks (as ex-post insurance) and not, as in climate policy, to mitigate permanent moderate additional costs (as part of social policy). A differentiated approach with a focus on protecting vulnerable households can ensure that there is a double dividend in climate policy as well. The government should start planning such an approach now and also create the legal conditions for the necessary data sets to be linked.

The article was first published on the german blog "Blog politisiche Ökonomie".