Tax incentives and the environment

Among strategies for the improved abatement of pollution, Congress has overwhelmingly preferred the traditional regulatory approach, as exemplified in the standard-setting mechanisms of existing legislation for federal water and air pollution control. However, in recent years proposals for federal legislation which creates economic incentives of various kinds have attracted congressional attention. The Tax Reform Act of 1969 includes such an incentive in § 169 of the Internal Revenue Code, which now permits the taxpayer to amortize over a five-year period a portion of the cost of his investment in qualified pollution control facilities.¹ IRS guidelines for implementing the amendment are set out at 36 Fed.Reg. 9017 (May 18, 1971). EPA has also published guidelines for determining which facilities qualify for the tax writeoff.36 Fed.Reg. 9509 (May 26, 1971).

An economic incentive may be broadly defined to include all types of financial constraint, i.e., all social policy implements which attach a money penalty, or reward, to the performance of an activity. No list of possible variations of economic incentives could be exhaustive, given this broad definition, but analysts readily distinguish incentives as either positive or negative. Negative incentives, or disincentives, attach a cost to the performance of an activity. A disincentive, for example, may take the form of a tax, a damage payment, a charge, a penalty, a fee or even the establishment of a limited number of salable pollution "rights".² Positive incentives attach rewards to the performance of an activity. They include subsidies, bounties, low-interest loans, grants, accelerated depreciation, tax credits of various kinds and favored treatment in government contracts. The new provision of § 169 is just such a positive incentive.

If used in concert with the standard-setting mechanisms of the conventional regulatory approach and with new or renewed liability imposed by the courts, economic incentives could become an effective supplementary technique for pollution abatement. However, positive economic incentives which are built into the Internal Revenue Code, and the provisions of § 169 in specific, appear for the reasons given below to be of questionable efficacy, especially on economic grounds. On the other hand negative incentives programs appear more capable than positive ones of accomplishing economic and environmental policy objectives.

[1 ELR 10084]

Positive and negative economic incentives compared

The leading criticism made of positive economic incentives in the tax code is that once enacted into law the provisions provide too weak an incentive for the taxpayer to invest in pollution control equipment.³ The deduction or other tax advantage simply will not prompt a change in behavior and will be taken into account only incidentally in management decisions. For such provisions to be effective, the polluter must already be very near a decision to install pollution abatement equipment, either because the costs incurred through state or federal enforcement of pollution statutes are likely to be high (not at present a strong liklihood), because early investment will be cheaper while demand for such equipment is low, or because good public relations, good relations with various levels of government (especially state), or personal commitment to environmental quality all weigh heavily in the taxpayer's decision-making. Much stronger reasons, however, are likely to discourage his investment. First, under most positive incentives proposals (and definitely under § 169) investment in pollution control facilities will almost always be a large net loss item to the firm. Pollution control equipment does not usually produce significant direct profits or profitable recovery from wastes (and cannot produce a net gain from profits under the terms of § 169). A firm about to make a $1 million investment in pollution control equipment, and able to take advantage of a 30 percent tax credit for such an investment, will still face a non-productive net capital expenditure of $400,000 to $550,000 under present law and according to present accounting practices.⁴ Furthermore, with government funds scarce and the prospects said to be good for lower defense expenditures, the firm may delay investment in the expectation that direct grant programs will be enacted which leave the firm a good deal more internal choice about how to control its pollution other than with capital-intensive techniques. Research and development, now proceeding apace, may reduce capital costs in pollution control equipment through technological improvements and prompt delay in the expectation that better equipment may be purchased subsequently at lower prices. Finally, funds diverted to net loss investments cannot be used for profit-making investments that conceivably could offset any costs incurred from legal liability for pollution.

The positive tax incentives just discussed become effective when the taxpayer decides for whatever reasons to take a net loss, the impact of which he can reduce somewhat by taking advantage of the tax break. But he does have to decide initially if he is going to take the loss. With the imposition of a negative incentive, however, such as a tax on waste discharges into streams or on sulfur dioxide emissions into the air, the taxpayer has no choice but to bear some loss, i.e., the tax imposed on him, unless he reduces his effluences. Of course the tax charge may be set so low that it is an insignificant increment to the total cost of doing business. In this situation, perhaps both positive and negative incentives approaches will be equally ineffectual: the taxpayer will not want to invest heavily in non-productive capital equipment from which gains of all kinds are limited, nor will he look for ways to avoid payment of a trifling effluent tax. Holding other things equal the question then becomes, as the benefit under the tax break incentive and the loss under the tax charge is increased, which is most likely to take effect first and prompt the taxpayer to reduce his effluence? The answer clearly is that the tax disincentive would take effect before the tax break. First, most tax disincentive proposals are designed to set the tax high enough to have a defined impact on the level of output of target pollutants. Positive incentives, contrariwise, do not stress lowering specific pollutant levels, but rather encourage larger investments in pollution control equipment, at the option of the taxpayer. In fact, a polluter who took full advantage of capital investment tax write-offs might actually reduce the level of his effluence very little, if at all. Second, in response to a disincentive the taxpayer is completely free to reduce pollutant emissions by whatever means he chooses. He may invest capital in pollution control equipment, but he may also invest more in labor, or in pollution-free (or more nearly pollution-free) raw materials, or he may vary both his production processes and his pollution abatement processes so that he reduces his output of the specified pollutant and pays less tax. For some pollutants and producers easy reductions in pollution may be possible for the first few tons of a pollutant. Also, a smoothly graduated tax disincentive applies a constant pressure to abate which can be met by a wide variety of small, incremental steps that shave dollars and cents off the tax owed. Contrariwise, capital-intensive responses to positive incentives function by jumps and start as the successive lump sums required for a series of expensive abatement devices are committed. Third, the firm can write off only a portion of capital investment with a tax scheme; a large part of the capital investment cannot be written off under current tax break [1 ELR 10085] proposals and must be taken as a loss.⁵ But the total cost of the tax disincentive is the amount of the tax itself; all the tax due on additional tons of pollutant can theoretically be saved.

The second point made above — that tax break proposals usually favor capital-intensive investments above possible investments in other factors of production — may be generalized into the second major criticism of positive tax incentives plans. Such plans unbalance the play of economic factors in firms' decision-making processes by making capital improvement (or some other item) less expensive and therefore more desirable to firms than it would normally be if left to the usual search which firms make for least cost alternatives. In other words, with a tax subsidy the firms may choose a means of abating pollution that is less efficient and does not make the best overall use of limited economic resources. For instance, a firm may be seduced away from an alternative for pollution control which has low overall costs and low capital costs, because capital investment subsidies are available which favor an expensive, capital-intensive investment alternative. All in all society will have subsidized a wasteful mode of production.

The point concerning economic efficiency may be pushed one step further. Tax break incentives, at least as they are conceived today, have built into their structure the assumption that present levels of pollution are unavoidable and will continue. By focusing on the final phases of a very long and complex industrial process, they actually encourage practices which pollute by stressing the removal of pollutants instead of the adoption of entire processes which pollute less from beginning to end. Tax disincentives, on the other hand, leave producers free to avoid the tax any way they like, including the abandonment of production of an item which entails heavy pollution in its manufacture.

Economic efficiency also bears upon the third major criticism to be made of positive tax incentives; however, we prefer to state this criticism, initially at least, by asking which group — the "polluters" or the "polluted" — has the initial right to use environmental resources.⁶ Positive tax incentives can easily be viewed as payments which the public makes to polluters to get them to stop polluting. Hence positive incentives plans tend to assume that polluters have the right to spoil a resource such as air or water and that they must be paid not to exercise that right. Negative incentives plans assume just the opposite. In such plans polluters must pay the public before they may spoil a resource, the right to which is assumed to belong to the public. The importance of the assumptions involved cannot be overstressed.

Very nearly the same point may also be made in terms of economic efficiency. Economic efficiency requires that the producers and consumers of particular goods and services pay prices which reflect the real costs to society of producing and consuming those goods and services. If a product costs $8 to manufacture and is sold for $10, economic efficiency would require the producer to pay the entire $8 and his customers to pay the entire $10. No third source of payment should relieve the producer or his customers from paying the entire costs of production and consumption. But in a positive tax incentives scheme, just such a third source of cost-avoidance is available, because the producer is permitted to avoid paying a portion of his tax. The effect is the same as if the public had paid part of the cost of the product.(If the manufacture of the product causes pollution, hopefully the public subsidy will reduce the level of pollution which the public must endure.)

Contrariwise, polluters pay the public in a negative tax incentives plan. A more realistic total price for goods which pollute may therefore be developed. For any pollution which the polluter causes, the public receives payment for the damage done. (Ideally, of course, payments would be made by only those who pollute to only those who are polluted, not to the public at large.)

Economic incentives programs are criticized for causing distortions in revenue-gathering, which is the primary function of public taxation. Of course positive economic incentives erode tax collection in a way negative ones do not, by creating loopholes — some of which are notorious for their inequities — through which taxpayers may escape tax payment. The generation of extra tax income does not cause the same concern.⁷ But in any event, the use of the Internal Revenue system to achieve economic and social goals has been widely accepted. Disagreement now centers upon the wisdom of enacting particular policy implements. Just as the existence of a national debt makes possible the use of fiscal policy implements (e.g. changes in interest rates, paying off federal obligations, etc.) which help control inflation and recession, so the existence of the Internal Revenue system makes available an entire range of policy [1 ELR 10086] implements the impact of which could not otherwise be achieved.

An interesting problem, not treated here, is whether economic efficiency might not be better served by centralizing effluent control for several firms. Where practicable, large economies of scale might be effected. Both positive and negative economic incentives might be used to prompt cooperation in the use of a centralized effluent treatment facility; however, as presently conceived positive and negative incentives plans would probably tend to discourage such centralization, since they are keyed to individual firms' needs and levels of effluence.⁸

Specific shortcomings of § 169 of the Tax Reform Act of 1969

Under § 169 a taxpayer may now deduct the cost of certified pollution abatement equipment over a five-year period, although normal rules of depreciation for tax purposes would have established a longer useful life for the equipment. For the equipment to be eligible, the plant in which it is located must have been in operation before 1969. On the other hand, equipment placed in service after 1974 is ineligible (i.e., the plan has an automatic termination date). Only the proportion of the cost of the equipment attributable to the first 15 years of its normal useful life can be deducted.

Only "certified pollution control facilities" are eligible, which basically means that the facility must be used exclusively for water and air pollution abatement, that the facility must be used for pollution abatement alone and serve no other purpose, that it may not merely diffuse, rather than abate, pollution, that state water and air pollution authorities must certify to the Environmental Protection Agency that use of the facility is consistent with state law and policy, and that EPA has certified that the facility complies with federal regulations and policies.

In their article, McDaniel and Kaplinsky, supra, use the concept of tax expenditures, developed by Stanley S. Surry, to calculate the effect of the § 169 deduction as if it were an investment credit, a direct grant, an interest-free loan, and a reduction in interest rates or traditional financing. McDaniel and Kaplinsky concluded that § 169 is inequitable and inherently irrational as a program of direct federal financial assistance.⁹

Nor does it appear that § 169 overcomes the specific objections raised above with respect to positive tax incentives programs in general. First, § 169 is carefully and strictly limited to certified non-profit making facilities. While this policy prevents the taxpayer from taking advantage of the additional tax write-off for income-producing property, it also insures that only loss-producing investments, i.e., those which do not produce a net gain from profits, will be made as the result of whatever incentive § 169 does afford. As pointed out above, the incentive for profit-producing investment is likely to be much greater than for a net loss-producing one. Any funds available for investment will more likely be invested for profit. Section 169 merely offers an opportunity to limit losses; it does not offer a strong inducement to reduce pollution. As a result, there is no incentive to coordinate plant efficiency so that overall processes of which the abatement facility is a key part are on balance profit-producing.Furthermore, no incentive exists to invest in equipment which recovers wastes that may be resold at a profit.

Second, § 169 assumes that capital-intensive investment should be favored over:

(1) Purchasing land on which to construct treatment ponds; (2) chemical precipitation; (3) labor for operation and maintenance; (4) labor for more careful control of production processes; (5) use of dispersion equipment such as high smokestacks; and (6) fuel substitution. This last alternative is the least costly method in more than 50 percent of the cases involving sulphur oxide pollution abatement. (footnotes omitted)¹⁰

Also, § 169 does not provide tax assistance for the cost of fuel desulphurization facilities or other facilities that remove pollutants from fuel, apparently because such expenditures cannot be separated from income-producing activities.¹¹

Thus, § 169 is likely to cause a misallocation of economic resources within polluting firms toward inefficient solutions to their abatement problems as the firms are enticed away from non-capital investments by artificially less expensive capital-intensive abatement techniques made more attractive by § 169.

Third, § 169 favors property which is likely to have a long useful life. Taxpayers purchasing pollution abatement devices with a useful life of five years, or less, receive no break from amortization over the five-year period to which they are already entitled.

Fourth, § 169 does not single out the worst pollutants and processes for especially favorable treatment, which it would do if it reflected the higher social value of controlling the most egregious forms of pollution. Rather, it misallocates resources by allowing any taxpayer with an investment in any certified pollution control facility, no matter how insignificant its over-all contribution to pollution control, to recover part of his investment.

1. Tax code incentives for pollution control antedate the new provision of the 1969 amendments. When in 1966 seven percent investment credit was lifted, an exception was made which allowed credits for pollution control facilities to continue. When in 1968 Congress repealed the tax-exemption of industrial development bonds, bonds for pollution control facilities were excepted. "Since World War II more than 80 tax bills have been introduced into Congress to encourage investment in pollution control equipment." McDaniel and Kaplinsky, "The Use of the Federal Income Tax System to Combat Air and Water Pollution: A Case Study in Tax Expenditures," 1 Environmental Affairs 12 (1971).

2. For the idea of developing a market in salable pollution rights, see J. H. Dales, Pollution, Property and Prices, Chap. VI (Toronto: 1968).

3. The shortcomings of the use of positive economic incentives as environmental policy implements have been carefully analyzed in two recent law review articles. Marc J. Roberts, "River Basin Authorities: A National Solution to Water Pollution," 83 Harv.L.Rev. 1527 (1971); James E. Krier, "The Pollution Problem and Legal Institutions: A Conceptual Overview," 18 U.C.L.A. L.Rev. 429 (1971). See also, McDaniel and Kaplinsky, op. cit.

4. Roberts, op. cit., p. 1531.

5. Notice, however, that firms paying the higher rate of corporate income tax will receive the greatest proportionate benefit. Thus the numerous smaller firms which may be operating nearer the margin and therefore more inclined to avoid investment in pollution control will benefit much less than their larger corporate cousins for whom the tax break may not be as important.

6. Krier, op. cit., p. 468.

7. Problems do exist about how the extra taxes should be spent: Should they go into general revenue? Should they be earmarked for environmental improvement? Should they be redirected to the specific industries from which they came through positive tax incentives for pollution control equipment? Through direct grants?

8. See Roberts, op. cit., esp. p. 1534.

9. Their detailed analysis appears op. cit., pp. 17-23; 33-44.

10. McDaniel and Kaplinsky, Id., p. 27.

11. McDaniel and Kaplinsky, Id., p. 16.