By Hania Kronfol and Eduardo Antonio Jimenez Sandoval
Tax policy is a popular tool for governments around the world seeking to influence behaviour, including for encouraging environmentally sustainable investment. But is it really an effective way to accelerate the transition to a greener economy? A Prosperity Insight Note, based on findings from a new World Bank database of Corporate Income Tax (CIT) incentives, reveals that tax incentives are rewarding polluting economic activities in more cases than they are promoting sustainability.
We divided incentives into three categories:
- Green sector-oriented incentives: those which stimulate investment in green products, such as batteries for electric vehicles;
- Green process-oriented incentives: those which benefit investment in greener production processes, such as recycling of byproducts;
- Incentives for polluting sectors: those which support sectors contrary to environmental objectives, such as fossil fuel production.
This analysis across 40 economies—including high-income and developing economies—from 2009 to 2020 relied on publicly available resources, like tax guides, and covered information on the types, generosity and conditions of CIT incentives offered at the country-level.
Despite the growing awareness of the need to address climate change, data showed that tax incentives rewarding polluting activity are far more prevalent than those supporting environmental sustainability. Between 2009 to 2020, only about 2.6 percent of CIT incentives were green sector-oriented and about 3.4 percent were green process-oriented.
The average share of CIT incentives for polluting activities overshadowed these at 9.5 percent. The proportion of green incentives remained surprisingly stable over time, although there was a decline in the share of polluting incentives in the more recent years (2017 to 2020). High-income economies offered more green incentives than developing economies. Polluting incentives were considerably more prevalent in developing economies compared to high-income economies, averaging 10.5 percent of total CIT incentives compared to 5.1 percent, respectively.
In fact, many economies are simultaneously offering both green and polluting incentives. Of the 40 economies, only 4 offer green incentives and correspondingly do not offer any polluting incentives. More than half offer more polluting incentives than green.
Most green incentives are provided through accelerated depreciation, tax holidays, and reduced tax rates, accounting for over 85 percent of such incentives. Overall, both green and polluting incentives are roughly evenly split between profit-based instruments, which are determined as a percentage reduction of firm profit, like tax holidays and reduced tax rates, and cost-based instruments, which reduce the after-tax cost of capital expenditures, like accelerated depreciation and investment tax credits.
If tax incentives are to be used, governments should aim for the highest levels of consistency and transparency–continuously re-evaluating their impact and alignment with a country’s broader objectives. Governments may need to re-evaluate co-existing green and polluting incentives, considering the long-term implications to support a green transition.
Tax incentives should also be designed strategically, in a cost-effective manner. Tax holidays, the second-most prevalent type of incentive offered, are considered the least cost-effective based on global empirical evidence. Tax holidays are also challenging in light of the Global Minimum Tax, which establishes a global minimum effective corporate tax rate of 15 percent for large multinational enterprises (MNEs).
While CIT incentives may play a role in promoting sustainable investment, there is still a critical gap in understanding their suitability and impact in fostering greener private investment. Further research, leveraging the new World Bank CIT Incentives Database, could provide insights into the effectiveness of these instruments and how they interact with other interventions, like direct subsidies and regulations. This would help ensure that well-intended policies are also well-designed and well-executed.
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