Financing the green transition: The political economy of investment tax credits

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Green policies create economic winners and losers and the unequal distribution of these gains and losses across the population raises questions about the political viability of such measures. This column explores how best to finance the green transition, presenting evidence from a theoretical study of the impact of the introduction of Incentive Tax Credits (ITCs) into a model economy. The authors argue that a mix of debt- and tax-financed ITCs can be used to incentivise investment in green capital, while guaranteeing that most of the population would support the scheme, both at the time of introduction and in the distant future. Without viable political support, there is little hope of getting urgently required policies off the ground.


Environmental policies often generate winners and losers. An example is when a firm’s production process generates airborne pollution, affecting people’s wellbeing (through respiratory diseases and other issues). The problem is not necessarily the pollution itself, but the fact that the firm has not had to pay a market price for the right to pollute – because there is no market in the first place. Introducing government policies to compensate for this lack of market may mean cutting company profits, which shareholders may not like, but it can bring benefits to ordinary citizens through improved air quality.

Our latest research considers one such policy, recently introduced in many countries around the world: the provision of incentives to firms to adopt clean capital through an Investment Tax Credit (ITC). These are subsidies paid by the government to firms (and, in some cases, households) for the purchase of new, clean capital. A properly designed ITC can substitute for markets to achieve social objectives (in this case, a cleaner environment).

But what about the obstacles blocking a desirable policy such as an ITC focused on the adoption of green technologies? Economic theory helps us identify situations in which joint action can lead to social gains relative to a decentralised outcome. But identifying these gains is not the same as acting on them. This requires a political system that works effectively not only to identify the gains from collective action but also to reap them. Because the benefits of such policies are unevenly distributed across the population, it may be difficult to convince a majority of voters of the desirability of the ITC, even if there are overall welfare gains. Our work analyzes the differential impact of green ITCs across the income distribution and traces the implications for the financing structure of such environmental policies.

 

Tension across generations

An ITC operates through time. It subsidises current investment in order to accumulate more capital for the future. In our example, this is green capital, which has the added benefit of improving the environment. But there are examples of ITCs across a broad range of countries that were put in place simply to promote capital accumulation.

As always in economics, there are costs and benefits. One cost arises from the need to raise revenue to pay for an ITC. In the most extreme case, a government will need to increase taxes immediately to pay for the subsidy. But the benefits of the increased investment and, through it, the cleaner environment will accrue to future generations.

There is an asymmetry here: the costs are borne now while the benefits appear later. This is an ‘intertemporal’ (across time) tension that may limit support for the ITC among a current group of voters.

 

Tension within a generation

Ignoring the tension between generations, an ITC has differential effects within a cohort as well. Our research focuses on three channels.

The first concerns the beneficiaries of the ITC. Those who benefit directly are the owners of the firms that invest. Specifically, these are the shareholders who benefit from both increased dividends and stock appreciation as a result of the ITC. Importantly, even in economically advanced countries, stock market participation is surprisingly low. For instance, evidence from different sources shows that between 1989 and 2023, the average asset market participation rate in the US was usually around 50% and never went far beyond 60% (Cooper and Zhu, 2016; Gallup 2023).

The second major impact is on workers, especially those who do not hold any firms’ stocks. For these individuals, the ITC will affect their wages through the effects of capital accumulation on labour productivity. If the accumulation of more green capital makes workers more productive, then wages will rise, and workers will benefit. But if capital substitutes for labour, then the ITC will lead to lower wages and job losses.

Third, there are taxpayers. If the ITC is paid out of current taxes, then the distribution of tax obligations will depend on the progressivity of the tax schedule. At one extreme, suppose the tax system is sufficiently progressive so that the relatively rich (as measured by income) have a higher tax rate and thus pay a larger share of the tax liability. If these are the same individuals who own the firms, then the payment of taxes to support the ITC is commensurate with the group that directly benefits from the subsidy. But for a less progressive tax system, there is an inherent redistribution from those who do not participate in the asset market to those who do. This redistribution may be socially undesirable and block an ITC.

 

Model economy

In our research, we provide a quantitative analysis of these inter-temporal and intra-temporal interactions. This is based upon a dynamic economic model that allows us to identify winners and losers of an ITC, both within and across generations. Our model features two industries. Households invest in new capital for either or both of the industries and purchase used capital from each other. Compared to other studies on the topic (see, for instance, Lanteri and Rampini (2023)) the age of capital does not play a crucial role but whether green or brown capital is used for production has a differential effect on pollution levels.

The model allows us to study the accumulation of green capital, subsidised by the ITC, and how this affects different groups. The key factor is the technology the firm uses to produce output. If capital and labour are complements, then the accumulation of capital will make labor more productive, and wages will rise. Through this spillover, the ITC benefits workers as well.

Regardless of productivity, workers’ income is taxed. The degree to which the tax is progressive has a direct bearing on the distributional consequences of the tax burden resulting from the ITC.

A key consequence of within-generation variation is the different views of a proposed ITC. By and large, capital owners will benefit, and so may workers through higher wages. The ITC must be paid for, and this increased tax burden may offset the gains. Of course, the ultimate beneficiaries of the ITC are future generations who benefit from a cleaner environment.

Ultimately, it is the position of the median voter that matters. This is because we assume that the ITC will be enacted if and only if the majority supports it through a majority vote.

 

Quantitative findings

The interplay of these forces is complex. To better understand the conditions for the passage of an ITC, we conduct a quantitative analysis of a model economy. The economy starts in a steady state, where, in the absence of any intervention, it would remain over time.

As a first exercise, we abstract from the political decision-making process and introduce the ITC exogenously as a surprise. We then trace out the various implications both across individuals within a cohort and over time. Our model allows us to study a setting where the median voter is a beneficiary of the ITC, as she invests in the asset market and benefits from the tax credit. This is in line with the empirical evidence from the US and provides interesting dynamics from a political economy point of view.

The ITC is set at 10%, which is relatively small to keep the economy close to the steady state equilibrium without intervention.

Importantly, for our initial exercise, the resources to finance the ITC come from taxes on labor income. These taxes are progressive so that individuals with higher incomes pay a higher marginal tax rate.

Figure 1: Distributional effects of an ITC

Source: Authors’ calculations Notes: incremental changes in welfare for different types of agents (comparing steady-state lifetime values, measured in consumption equivalents); brown bars stand for workers or investors employed in the brown ( polluting ) sector, and green bars for the ones employed in the green sector.

Figure 1 shows the distributional consequences of introducing a small green ITC. This allows us to compare welfare when the ITC is not in place to when it has been in place for a long time. Welfare is measured as the percentage change in consumption that an individual would have to receive to be indifferent between living in a world without the ITC and a world with the ITC (a positive number, therefore, means that the household gains from the ITC). In our model, households choose whether they want to be workers or investors, but each household is assigned to work in either the green or brown industry, and they cannot switch between the two. The green bars stand for workers and investors employed in the green sector, whereas the brown bars stand for the ones working in the brown sector. We can see that green investors benefit from the positive effect on wages and the increased return on their portfolio. While they contribute to the financing of the ITC by paying higher taxes, this cost is more than offset by the reduction in pollution. The story is similar for green workers, but since they do not invest, they cannot benefit from higher asset market returns. Conversely, both brown investors and workers suffer from a reduction in wages but because brown investors hold diversified portfolios which include green assets, they also experience capital gains.

Next, we turn to an analysis of the political economy of green investment tax credits. Specifically, we analyse the dynamics when the households living in our model economy can vote on the introduction of a green ITC by majority vote. We then examine how the financing of the ITC may affect political support.

Figure 1: Long-term welfare benefits of a green ITC (left panel) and political approval for an ITC (right panel)

Source: Authors’ calculations

The left-hand panel of Figure 2 illustrates the large welfare gains that the ITC can generate intertemporally if it is imposed at the time indicated by the vertical dashed line. On the x-axis, we plot time (years, for instance) and the y-axis stands for welfare in our model economy. As can be seen in the left panel, welfare gains can be large if only the ITC is in place for a couple of periods. The right panel of Figure 2 shows that there are large differences in political support for the ITC over time. When the ITC is introduced, around 49% of the population would actually support it. For the generation alive at that time, the increases in labour income taxes needed to finance the introduction simply outweigh the benefits of the ITC. In the long run, however, there will always be a majority in favor of keeping the ITC rather than eliminating it. This implies that the policy would never be implemented because whenever the ITC is put to a first vote, the people would reject it. This is true even though there may be large welfare gains in the long run.

This is where the crucial role of the financing structure of the ITC becomes apparent. The tax increases required to finance the ITC prevent political support for its introduction. The question, then, is how changes in the financing scheme of the ITC can alter this outcome. One natural way to shift the cost of the ITC over time is to allow the government to issue debt. Of course, government debt needs to be repaid by higher taxes in the future, so debt financing is simply a way to shift the incidence of taxes across generations. And indeed, we show that financing part of the ITC with debt is sufficient to overcome the initial political gridlock. In our quantitative analysis, financing as little as 1.5% of the ITC by issuing new debt is sufficient to lift political support above the 50% mark. Financing part of the ITC with debt reduces the need to raise taxes, increases households’ disposable income and hence consumption, and makes it more likely that they will invest in the asset market and benefit from the ITC. The debt-financing does not only shift the costs across time but also within a given generation. The issued debt enters the portfolios of investors, which are at the same time the main beneficiaries of the ITC, thereby aligning better the costs and benefits of the ITC.

 

Conclusion

As climate change progresses and the urgency of government action to address increasing pollution and rising temperatures increases, the financing of such policies becomes a critical issue to study. Our quantitative exercises suggest situations in which policymakers may rely, at least in part, on debt issuance to finance environmental policies.

Our research highlights simple mechanisms that illustrate how debt-financed ITCs can be used to incentivize investment in green capital while guaranteeing that most of the population would support the ITC, both at the time of introduction and in the distant future. If this is not guaranteed, such policies – while effective in addressing the impacts and causes of climate change – may never be implemented.

 

Authors: Michael Barczay and Russell Cooper

 

References

  • Blanchard, Olivier. “Reconciling the tension between green spending and debt sustainability.” Peterson Institute for International Economics Blog (Dec 19, 2023), https://www.piie.com/blogs/realtime-economics/reconciling-tension-between-green-spending-and-debt-sustainability
  • Cooper, Russell, and Guozhong Zhu. “Household finance over the life cycle: What does education contribute?” Review of Economic Dynamics 20 (2016): 63-89.
  • Gallup. “What Percent of Americans own Stocks?” (May 24, 2023), https://news.gallup.com/poll/266807/percentage-americans-owns-stock.aspx.
  • Heal, Geoffrey. “Intertemporal welfare economics and the environment.” Handbook of Environmental Economics 3 (2005): 1105-1145.
  • – Lanteri, Andrea, and Rampini, Adriano. “Financing the Adoption of Clean Technology.” Unpublished Manuscript (2023).