Implementation issues.

A system of tax incentives for poiiution abatement investments would require administrative procedures to assess entitlement to the incentive; the costs of this administrative system would constitute deadweight resource costs of the system, to be set against the potentiai environmentai gains. Using the direct tax system to provide poiiution abatement incentives is thus very different to using the indirect tax system to encourage reduced pollution; in the latter case, the modification of an existing tax allows the environmental incentive to make use of an existing administrative system at little extra administrative cost, whilst using the direct tax system to provide incentives for poiiution abatement investments may involve significant additional administrative costs. Is there likely to be any administrative saving from using the tax system for administration of subsidy in the form of a tax incentive rather than using a separate administrative system established for the purpose of paying direct subsidy?

Many of the operations needed to assess eligibility for the tax incentive would be very simiiar to those that would be required if, alternatively, a system of direct subsidy for poiiution abatement investments were used. These procedures would need to include an assessment of the investment expenditures against criteria designed to identify pollution-abatement investments from investments with no (or insufficient) poiiution abatement function. They would aiso require procedures to ensure that the investment expenditures had indeed been incurred, and that other formal conditions for subsidy entitlement had been met.

The first group of procedures, to identify the environmentai aspects of eligibility for the subsidy, may be more effectively undertaken by government environmentai agencies rather than by the fiscal authorities. In the case of a subsidy paid in the form of a tax incentives, the environmental agency would then need to communicate its decision about environmentai eligibility to the tax authorities; this need for inter-agency communication might be avoided by a system of direct subsidy.

4. Tax Expenditures

The second group of procedures could probably be undertaken as efficiently by the fiscal authorities as by environmental agencies. There may, indeed be some possible scope for economies of scale in combining the verification of the formal aspects of entitlement with other fiscal administration. These verification procedures might include checking that firms possess the relevant invoices, receipts and other evidence that the investment expenditure for which the tax expenditure or subsidy is being claimed had in fact been incurred. However, even where these activities can be combined with existing fiscal procedures, there will probably be a countervailing additional cost in terms of the extra complexity of tax administration, and so the possible savings from this source may easily be overstated. There may also be some administrative savings from using the tax system as a mechanism for payment of the incentive, although again these are unlikely to be large. One key aspect of the administration of subsidies for pollution abatement measures (whether paid through the tax system or directly) is the identification of qualifying expenditures. Where and how should the boundary between pollution-abatement investment expenditures and other expenditures not related to pollution abatement be drawn?

The issue is straightfonward only in the first case of the three set out in Section 4.1 - that of "add-on" abatement measures with no private benefit. In this case, the investment in abatement facilities is clearly separable from other investment costs, and all of any expenditure clearly would qualify for the incentive. The identification of qualifying investments is less unambiguous in the second case, of "add-on" measures with some private benefit. Here, although the measure can be identified separately from other investments, it is no longer clear that its sole purpose is pollution abatement; if the private benefit were sufficient, the measure would be undertaken anyway, without subsidy. In this case, policy faces a choice between accepting that a proportion of the investments subsidised would have been undertaken anyway for commercial reasons, and introducing rules designed to identify only those pollution abatement measures which would not otherwise have been undertaken. Such rules to identify cases of "additionality" from the subsidy will be complex, and will require - in principle - substantial amounts of information of a type not readily available to public agencies, such as information on the private profitability of the investment in the absence of subsidy. The administrative problems in assessing eligibility are still greater in the third case, of investments in production technologies which have pollution and other consequences which cannot be separated. Here there may be no correct answer at all to the question of the amount of the investment which is attributable to pollution abatement; the pollution abatement is simply one consequence inseparable from the other effects of the technology which has been chosen. It may, perhaps, be possible to proceed by trying to devise some more or less rough-and-ready rules to judge how much subsidy to pay to integrated technology choices of this sort, but these are almost certain to be imprecise, given that they are attempting to separate something which cannot, in principle, be separated within the investment total.

The problem posed by the existence of abatement investments of the third type goes further than simply the costs of trying to devise a workable scheme for treating such investments. The tax treatment applied to investments of one type will affect the balance of incentives for choosing between the various possible abatement measures available to investors; an over-generous resolution of the problem of treating investments of the third type would tip the balance of incentives

4. Tax Expenditures

in favour of investments of that type in preference to pollution-abatement investments of other forms. As discussed in Section 4.1, an efficient pattern of pollution abatement may require that different poiluters choose different abatement methods, depending on their circumstances. Efficiency requires that the tax incentives should not encourage inappropriate methods to be chosen; other things (especialiy the environmental impact) being equal, the tax incentive should generally be neutral between different abatement methods. Where it is not possible to identify precisely the pollution abatement component of particular investments, this neutrality may be enormously difficult to achieve.

Even-handed tax treatment of a number of possible pollution abatement investments may be difficult to achieve, if in some cases they are of types 1 or 2 and in other cases they are of type 3. In the former case it may be possible to limit the size of the subsidy to the value of the add-on pollution abatement component oniy; however, in the latter case, the subsidy couid, with almost equal justification, be paid on the whoie investment, on none of it, or on some arbitrariiy-chosen fraction.

How iarge is it iikely that the response wouid be, in terms of additional abatement investment, to a given levei of investment incentive, offered in the form of acceierated depreciation for specified categories of pollution abatement investments? Existing empirical evidence relating to the effect of general investment incentives on the level of investment provides ambiguous evidence as to whether tax incentives induce greater levels of investment. Certainly the empirical work in the late 1960s and early 1970s (Hall and Jorgensen, 1967; Feldstein and Flemming, 1971) concluded that fiscal incentives in the direct tax system could influence both the level and the location of investments. Subsequent studies have a wide dispersion in results, and provide no clear empirical consensus (Chirinko, 1989). It appears that temporary incentives may have rather larger effects on investment than permanent incentives at the same level, because they may induce changes in the timing of investments as well as in the investment ievel. For example, the very large, and temporary, incentive which arose during the reform of the UK corporate tax system in 1984 appears to have had an appreciable impact on investment leveis during the 1980s (Bond, Denny and Devereux, 1992).

The relevance of evidence about the effectiveness of générai investment incentives to the particular case of pollution-abatement incentives may be siight. The size of the response to environmental investment incentives depends on what are the obstacies impeding higher levels of such investment. Market faiiures may not be easiiy corrected by fiscal measures, since one aspect of market faiiure in this area may be poor responsiveness of potential investors to price signais.