The primary purpose of all forms of taxation, whether on energy or on non-energy items, is to raise money for the government to finance its expenditures. Taxes finance the majority of government expenditure (the rest being financed by borrowing, which will have to be repaid from future taxation) so that the general level of taxation is determined by the requirements for government spending. However, the same total revenue can be raised by many different combinations of taxes, so that the tax rates on individual items and groups of items can be adjusted to reflect other criteria. First, the balance between direct taxation of incomes and the indirect taxation of goods and services will reflect the ease of collection, with low-income developing countries relying more on indirect taxes, which are easier to collect. Second, the relative tax rates on different goods will reflect the impacts on household welfare.
Principles of tax design have been developed, following the seminal work of Ramsey, which suggest that goods with higher price elasticities of demand (sensitivity to a given percentage changes in prices) should attract the lowest tax rates and those with lower price elasticities should attract higher tax rates. This principle can be elaborated to take account of the degree to which consumers will substitute between particular goods as the tax rate of one is raised relative to that on the other. A further consideration for tax design is that, under certain assumptions, it is not optimal to tax goods when they are used as an input to another good (such as the case of fuel oil used for generating electricity) because it is less damaging to welfare to tax the final good itself. The generalized Ramsey rule can then, in principle, be used to calculate a set of tax rates that raises a given sum of money at the least loss of economic welfare to households in the economy. The set of ‘‘optimal taxes’’ that satisfy these principles is in practice difficult to calculate precisely because of the very large informational requirements that it has and also because it rests on a number of assumptions that do not hold exactly in most countries.
Two further adjustments to the principles of determining the relative tax rates on different goods are of considerable practical importance. Because many governments are concerned with equity and income distribution, there is a common suggestion that tax rates on those goods that form a relatively higher share of the budget for low-income households should be lower and tax rates on those goods that are relatively more important for high-income groups should tend to be set relatively high.
A final consideration comes from the fact that the energy consumption and use of various forms of energy, as well as conferring benefits of energy on those that use them, create damage and impose costs (both indirect and direct) on those who do not use them. This consideration has led some governments to raise taxes further on such alternative fuels in order to discourage their use and reduce the negative effects on nonusers (the ‘‘polluter pays’’ principle). This element is referred to as a Pigovian tax. An extension of this principle is that it is socially more beneficial to correct an externality by taxing the offending good, rather than by subsidizing a substitute good that creates a smaller external effect.
