ifo Viewpoint 257: The Climate Bonus: An Ineffective Tool

A More Prudent Approach: Reducing Tax Distortions

It is uncertain whether Germany will reimburse citizens for the incremental CO₂ pricing, especially with the challenges of adhering to the federal budget's debt brake. However, if such a refund occurs, it would be advisable to opt against the widely advocated climate bonus mechanism. Despite its popularity, it is not the best method for redistributing CO₂ tax revenues. Instead of providing blanket payments to all citizens, a more economically prudent approach would be to reduce tax distortions by lowering taxes like income and value-added tax (VAT). These reductions would offer greater relief to citizens by minimizing the costs associated with tax distortions.

The idea of using revenues from environmental taxes both to protect the environment and to reduce other distortionary taxes is known as the 'double dividend' of environmental taxation. However, the proposed climate bonus scheme forgoes this potential dual benefit. Furthermore, it intertwines the reimbursement of tax revenues with redistributive objectives, which ideally should be pursued through established, separate mechanisms. The redistributive implications of the climate bonus scheme may result in numerous losers, raising doubts about its ability to secure the anticipated political support for climate policies.

The Two Effects of the CO₂ Price

To understand this, it is necessary to consider two effects that come with a CO₂ price alongside its intended role in steering behavior. A CO₂ price has both a distributional effect and a work incentive effect.

1. The distributional effect arises from varying household burdens. The poorest households bear a relatively heavier burden as the CO₂ component in their consumption expenses is the highest. Yet, the additional costs impact all households to some extent.
2. The work incentive effect operates as an incentive to work less for the following reason: The CO₂ price reduces the value of each earned euro, as many goods become pricier. This diminishes work incentives since leisure is not taxed, unlike income and consumption. The ongoing debate about the “Bürgergeld” (social benefits for low income households) underscores that many people believe there are not enough incentives to work. The introduction of a CO₂ price exacerbates this issue, regardless of its intended role in steering towards environmental protection.

Climate Bonus: Focusing on Redistributional Effects, with Questionable Outcomes

A sensible approach to refunding CO₂ price revenues to citizens would consider both work incentives and distributional impacts. However, the climate bonus concept disproportionately emphasizes distributional effects, and it does so questionably. Under this proposal, lower-income households could not only receive compensation for the CO₂ price but might end up receiving more than they pay in CO₂-related expenses. Meanwhile, households with moderate to higher incomes may not receive full compensation for the additional costs. Environmental economist Rick van der Ploeg's study suggests that combining CO₂ pricing with the climate bonus might leave 70% of all citizens worse off. This makes it unlikely that the policy would boost political support for climate initiatives.

Meanwhile, the climate bonus would not tackle the issue of work incentives. It does not change the fact that the CO₂ price lowers work incentives. Essentially, the combination of the CO₂ price and climate bonus would introduce an additional instrument that redistributes resources in a highly targeted manner while simultaneously reducing work incentives. The overall economic pie might shrink, though the distribution would be more even.

Some may consider more redistribution desirable in principle. However, the government already has the established tax and transfer system, which enables enhanced redistribution at any time, even if that may potentially reduce work incentives. If policymakers intend to strengthen redistribution, they can do so deliberately through these existing mechanisms, eliminating the need for the introduction of a climate bonus.

Better Alternatives to the Climate Bonus

How can we optimize the way in which we return the revenue generated by the CO₂ price to the citizens? In theory, one approach could be to compensate different income groups based on their average burden from the CO₂ price. This would address both the distributional and work incentive effects of the CO₂ price. In a recent study, we propose that the ideal solution would seek to offset both the impact on labor supply caused by the CO₂ price and its effects on income distribution. In this scenario, the motivation to reduce CO₂ emissions would remain intact, as the compensation would be linked to historical data on CO₂ consumption among various income groups. One practical way to put this into action could involve a combination of a modest increase in the tax-free income threshold, a reduction in marginal tax rates, and an increase in the “Bürgergeld”.

Another option would involve reducing the value-added tax. Lowering the VAT could be a simpler approach, albeit somewhat less precise in its targeting. Additionally, it might be unclear to what extent the reduction would be passed on to consumers. Nevertheless, questions regarding the distribution of costs also emerge with income taxes.

These solutions, however, fail to account for the fact that households with similar incomes can experience widely varying impacts from CO₂ prices. This is particularly evident in cases such as rural commuters who have long commutes to work. This issue could be addressed by increasing commuter tax deductions. The situation becomes more complex for households relying on oil heating systems, but transitional lump-sum payments could potentially offer relief. Even though the proposed measures may not ensure precise compensation for all households through CO₂ tax revenue refunds, they offer a much more targeted relief compared to the climate bonus scheme. This approach could boost political support for the entire package compared to the climate bonus. Furthermore, it could save the considerable effort associated with the administrative implementation of an entirely new transfer instrument.

Occasionally, there is the argument that citizens and voters would only fully understand the return of CO₂ price revenues through a tangible climate bonus, rather than through less visible tax reductions. However, this argument does not hold water. A combination of increasing the tax-free allowance, enhancing the “Bürgergeld”, and lowering marginal tax rates would be visibly reflected on every citizen's paycheck and bank account at the end of the month. To make it even more explicit, the relief amount could be explicitly labeled as a “Klimabonus” on the payslip.

Clemens Fuest
Professor of National Economics and Finance
President of the ifo Institute

Dominik Sachs
Professor of Macroeconomics and Public Finance at the University of St. Gallen

Published under the title “Das Klimageld ist nicht das richtige Instrument“, Frankfurter Allgemeine Zeitung, December, 16 2023