VoxEU: Paul De Grauwe – Who should pay for the cost of climate policies?

New budgetary rules imposed by the European Commission prevent the costs of public investment from being spread over time, obliging governments to impose 100% of the costs of envinronmental investments on today’s households and firms. Paul De Grauwe suggests a solution.

Paul De Grauwe is John Paulson Chair in European Political Economy, London School of Economics, and former member of the Belgian parliament.

Cross-posted from VoxEU

There should be little doubt that drastic measures are required to protect the planet from environmental catastrophes. But who should pay the bill for these urgent environmental policies? This is the question that is central today and that was placed on the political agenda recently by the “yellow vest” protestations. Many want to save the environment but few want to bear the cost. Yet without resolving this question of who will foot the bill, no progress can be made in developing effective climate policies. 

The problem exists at two levels. There is the question on which shoulders of the current generation the greatest burden will be placed. There is also the question of how the costs will be spread between current and future generations. 

The first question is receiving most of the attention today. It is indeed important to design redistributive policies that will ensure that those with the ‘strongest shoulders’ bear a proportionally larger part of the cost of climate policies. This could be achieved by transferring the whole (or part) of the proceeds from the taxes on fossil fuels to those in the lower income brackets. It appears that although this simple principle is easy to formulate, the political conflicts that arise when one wants to apply it are intense.

The second distributional question, the one between the present and future generations, is of equal importance. This is the one I want to address here. When we impose extra taxes on households and businesses today to finance environmental policies, we actually ask them to pay the full cost of a policy that will benefit the future generations. Many people resist this today, and then rationalise this resistance by denying the urgency of climate change.  It is therefore important to set out a policy that ensures that the costs are spread between current and future generations in such a way that the distribution of these costs also reflects the distribution of the benefits over time.

There is one policy domain where we can actually apply this distributional rule, and that is public investment. The latter, together with private investments, are essential to transform the economy from the use of fossil fuels to renewable energy sources. Public investments must be made in new energy infrastructure, in public transport, in research and development, and in many other areas. 

The formula that achieves the objective of spreading the costs over time is to finance public investment through the issuance of government bonds. The issue of bonds today provides the financing for the investment project while the payment of interest costs is spread over time. Thus, such a financing distributes the costs of the investment between present and future generations. The latter will enjoy most of the benefits of those investments and will also contribute to their costs. Such a financing also makes it possible for the current generation to be partially relieved of the costs of these investments. This reduces the resistance to costly environmental policies.

Unfortunately the European authorities have put sticks in the wheels. The budgetary rules imposed today by the European Commission prevent the costs of public investment from being spread over time. The rule that the government budget must be (structurally) in balance makes it impossible for public investment to be financed through the issuance of bonds. The reason is that the latter creates a structural deficit in the budget and that is forbidden by the fiscal rule. 

The consequence is that when euro area governments want to make environmental investments, they are obliged to increase taxes and/or to reduce other government expenditures (e.g. social security). In other words, they are obliged to force 100% of the costs of these investments to be paid by today’s households and firms. And quite naturally, these resist and rightly so.

The solution to this problem is actually very simple and is sometimes called the ‘golden rule’. The European authorities should allow public investments to be put into a ‘capital budget’. These may be financed through the issuance of bonds. The European rule of structural balance would then only apply to the ordinary budget consisting of current spending and taxes. Since current spending represents more than 95% of the total budget in most European countries, this would ensure that more than 95% of the budget would be subject to the balanced budget rule. 

The only thing that stands in the way of this solution is the dogma that government debt is always bad. Public debt is indeed bad when it serves to finance consumption. Public debt is good when it serves to make productive investments that help keeping the planet safe from future environmental catastrophes. 

The problem with the dogma that government debt is always bad is that it originates from an obsession that only looks at the liabilities side of the balance sheets of governments. We would never do this when we want to evaluate the financial health of private companies. We would always look at both the asset and liabilities sides to make a judgment about the solvency of these companies. Yet when we make such a judgment about a government we close our eyes for the asset side of its balance sheet; a wholly irrational procedure. When the counterpart of the higher government debt consists of productive assets whose returns exceed the cost of the debt, there is no problem of raising this debt.  The debt can then permanently exceed 60%, or 100% for that matter. It then makes no sense for the European Commission to desperately trying to force public debts into unconditional surrender. 

It is time we shed the dogma that government debt is always bad. We have to shed this dogma to make it possible to massively invest in projects that will prevent climate change from destroying the planet. Such investments can only be made if the costs are shared by current and future generations. 

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