The fiscal implications of net zero transition

Ahead of the 26th UN Climate Change Conference of the Parties (COP26) meeting in Glasgow later this month, the government has published a report on the likely impact of a move to a net zero carbon status by 2050. In the report, Net Zero Review, the government has emphasised the likely costs to the public purse of the transition over the next 30 years, and the fact that these will need to be met either by higher taxation or reduced spending (or both), but falls short of indicating any particular tax changes that may need to be introduced.

Chapter 6 of the report, entitled “The fiscal implications of net zero transition”, highlights the main fiscal challenges ahead. Chief amongst these is the reduction in fuel duty as motorists move away from petrol to electric. Fuel and Vehicle Excise Duty (VED) currently contributes £37bn in tax revenues (in 2019/20) and the report highlights that should the current tax system remain unchanged, then tax receipts from this source would gradually reduce towards zero by 2050. Given that VED currently amounts to some 1.7% of GDP, this would have an unsustainable impact on public finances.

The report notes that other pressures on government funding over this period will come from a range of other factors including:

• pre-existing factors giving rise to fiscal pressures, such as the aging population and debt burden from COVID; and
• the expected need for government support and public investment for the decarbonisation programme over this period.

However, the report also highlights the degree of uncertainty involved at this stage. For example, the report points out that whilst the net overall impact of transition on the economy is expected to be small, this masks potential significant sectorial and household changes. “Some sectors will grow and expand, whilst others will decline. Depending on the relative productivity of these sectors and the amount of tax revenue they contribute, this will also have implications for the revenues.”

Although the report falls short of recommending any particular changes, it does contain some indications of future policy. For example, in relation to VED, the report highlights that “motoring taxes will need to keep pace with these changes through the transition to ensure the UK can continue to fund first-class public services and infrastructure”. In doing so, the “government will need to consider both its ability to fund public services and other public policy objectives of Fuel Duty, such as reducing road congestion and promoting the uptake of electric vehicles”.

More generally, the report recognises that considerations of intergenerational fairness demand that a policy of the “polluter pays” be adopted as far as possible. An expanded carbon pricing regime will be an important factor in delivering this “polluter pays” fair transition. However, again the report recognises that as the economy decarbonises, carbon pricing will bring in increasingly lower amounts of revenue and this will not “be sufficient to offset the decline in Fuel Duty and VED during the transition”. It is expected, however, that increased carbon pricing measures will be able to be used to temporarily increase public investment during the transition.

Overall, the report highlights the many uncertainties at this stage in the costs to the government of decarbonisation. These will be impacted by technological and societal changes during the transition period. However, it is clear that significant sources of taxation will be lost and that added public investment will be needed, at least in the short term. The government will have decisions to make about how to make up the lost tax revenues – particularly in the light of additional and increasing pressures of an aging population. The detail of how the government will make up the lost revenues can be left for another day, but the overall message seems clear – taxation will need to increase in the short to medium term.