Out-Law Analysis 7 min. read

UK tax policy ‘urgently needs reviewing’ to support net zero transition

UK tax policy urgently needs reviewing to manage the significant fiscal risks of the economy’s net zero transition and support both the UK’s transition and global endeavours to combat climate change. 

The UK’s transition to a net zero economy is likely to have a significant adverse impact on UK tax revenues. By 2050, if the UK reaches net zero, the Office for Budget Responsibility (OBR) estimates that annual tax losses could be £36 billion (in today’s terms). Although the Treasury has acknowledged this, no strategy to offset these losses or address the role of UK tax policy in tackling global emissions has yet been published.

Ultimately, tax has a varied and significant role in the net zero transition – it must finance, incentivise and accelerate the transition, and achieve this whilst facing declining tax revenues. For this reason, designing an effective tax policy for a net zero economy is challenging but it is also why transformational changes are needed without delay.

Discussion of tax policy in this context often focuses on support for taxes to penalise fossil fuel usage and encourage businesses to implement eco-friendly practices. However, such measures would be unsustainable – and would not have a meaningful impact on global emissions, since revenues would fall as emissions decline.

Impact of decarbonisation on tax revenue

The UK’s tax system was not designed for a net zero economy. As decarbonisation progresses, the government will need to overhaul the tax system to ensure that it delivers sufficient revenue to sustain public spending, whilst maintaining tax incentives to encourage eco-friendly business investment.

According to the latest Treasury estimates, 4% of total UK tax revenues were based on fossil fuel consumption in 2019-20. These revenues will reduce towards zero as the transition progresses. Without tax policy changes, the OBR forecasts that the loss of tax receipts owing to decarbonisation could be £1.8bn in 2025-26. Whilst it may take another 28 years for the UK to reach net zero, substantial fiscal transition risks could materialise within three years. The government, therefore, needs to urgently address how to offset these losses.

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Penny Simmons

Legal Director

As decarbonisation progresses, the government will need to overhaul the tax system to ensure that it delivers sufficient revenue to sustain public spending, whilst maintaining tax incentives to encourage eco-friendly business investment

The largest carbon usage tax is fuel duty, which raised £21bn in 2021 compared to total public sector receipts of £793bn, according to official figures. Fuel duty tax losses will be driven by the switch to electric vehicles. Based on current tax policies, once the UK’s entire vehicle stock has converted, a revenue loss of £31bn (in today’s terms) is forecast. Estimates are based on current UK targets to ban the sale of new fossil fuel cars from 2030, with hybrid car sales banned from 2035.

The speed at which these tax revenues are declining is unsurprising, since transitioning to electric vehicles forms a key element of the UK’s net zero strategy. Surface transport emissions (almost exclusively from vehicles) account for the largest proportion of UK emissions. Given that the UK’s independent Climate Change Committee (CCC) estimates that 23% of the total reduction in carbon emissions between now and 2050 will come from vehicles, it is logical that the UK’s net zero strategy focuses on reducing vehicle-related emissions. Indeed, to accelerate the transition, targets banning sales of fossil fuel vehicles were brought forward from 2040 to 2030.

However, the faster the switch to electric vehicles, the steeper the decline in fuel duty revenues. Even though reducing vehicle-related emissions should be celebrated, the government needs to determine how to mitigate declining tax revenues.

Costs of decarbonisation

The fiscal risks of declining fuel duty receipts are compounded by the costs of decarbonisation to the UK economy. The CCC estimates that the net transition costs will be £321bn between 2020 and 2050, almost 83% of which is attributable to the decarbonisation of buildings.

It is unclear how the transition will be funded. Undoubtedly, the private sector will bear a significant proportion of costs. Therefore, regardless of future tax changes, businesses are also likely to face increasing costs owing to new decarbonisation regulations, targets and levies.

Notwithstanding the financial contribution that may be required from businesses to meet decarbonisation costs, the OBR predicts that public spending to support decarbonisation will increase significantly over the next decade, with annual costs peaking in 2027. The majority (48%) of public spending is forecast to relate to the decarbonisation of buildings.

Therefore, when introducing measures to counterbalance tax losses, the government must also seek to raise additional revenues to support public spending transition costs.

Offsetting tax losses and decarbonisation costs

The government has not confirmed how reduced tax revenues will be offset and decarbonisation costs met. However, in its Net Zero Review report (135-page / 1.76MB PDF) published in October 2021, the UK Treasury indicated its reluctance to fund the transition through increased borrowing, confirming that tax changes and “new sources of revenue to deliver net zero sustainably” may need to be considered.

Carbon tax

Initially, introducing a carbon tax could alleviate declining fuel duty receipts. The OBR estimates that an economy-wide carbon tax could raise £41bn (in today’s terms) in 2026-27. An economy-wide carbon tax could only constitute an interim solution since it would be based on carbon usage, with receipts gradually declining as the transition progresses; however, it could generate increased revenues until 2035 to help finance the early part of the transition.

The Treasury has acknowledged this, whilst confirming that owing to its unsustainability, a carbon tax could not form part of the UK’s permanent tax base. 

Given that a carbon tax generates revenue from carbon usage, it may also accelerate decarbonisation as businesses and the public attempt to reduce their tax exposure. There is no consensus regarding the effectiveness of a carbon tax in reducing carbon consumption. However, it is undisputable that revenues generated from a carbon tax would be sensitive to the pace of the transition. Ultimately, if the tax accelerates the UK’s transition, it will be less effective at generating revenues. On this basis, a carbon tax should only ever be considered as a possible offset mechanism in the medium term. The government must explore additional sustainable revenue streams.

Motoring taxes

One option for maintaining tax revenues would be to replace fuel duties with a new motoring tax, not based on carbon consumption. The government has indicated that motoring taxes may be introduced as the transition progresses, including in its 2020 ‘green industrial revolution’ 10-point plan. The nature of any replacement tax is unclear. Possibilities being evaluated by the cross-party House of Commons Transport Committee include a road pricing system and expansion of the existing toll road network.

Committee chair Huw Merriman has described road pricing as the “obvious replacement” for declining fuel duty revenues. However, it may be politically unpalatable owing to concerns of a public backlash. Previous attempts to introduce road pricing stalled for this reason. However, given the sacrifices that the public made for the “greater good” during the Covid-19 pandemic, they may be open to persuasion that lost taxes need replacing and that a new road pricing system could constitute a viable and sustainable offset mechanism. In this regard, clear and consistent communication with the public will be vital.

Therefore, introducing a carbon tax coupled with a road pricing system may effectively mitigate declining tax revenues, but neither option focuses on supporting global efforts to combat climate change.

Using tax policy to support transition

Undoubtedly, the UK’s drive to reach net zero is important. As the UK is only responsible for 1% of global emissions, successful decarbonisation across the nation will have minimal direct influence on climate change. However, if the world fails to control global warming, the UK will remain exposed to the increasing physical risks of climate change (e.g. natural disasters). Therefore, whilst the UK government must support the UK’s transition, it must also consider how it can best influence global policies to tackle climate change.

Incentivising innovation and developing new technologies to support decarbonisation may have a significant impact on global efforts to reduce emissions, particularly if those new technologies accelerate decarbonisation across the developing world. Focusing on encouraging innovation would also be consistent with the government’s stated vision to be a global leader in green technologies.

Turning to tax policy, it seems logical that the government should focus on introducing tax reliefs to incentivise business investment in developing “green” technology. Limited tax incentives currently exist to encourage innovation to support decarbonisation. Research and development (R&D) tax reliefs provide corporate tax deductions for certain R&D costs; however, these are not targeted specifically at “green” innovations. Presently, the R&D tax relief system is undergoing a wide-ranging government-led review, which it is hoped will provide an opportunity to introduce enhanced tax reliefs for eco-friendly innovations.

Beyond R&D tax reliefs, the VAT system could also be used to support the transition, possibly through a reduced VAT rate for eco-friendly supplies. In the UK’s recent spring statement, full VAT relief was announced for the installation costs of certain energy saving equipment in residential buildings until 31 March 2027. Whilst this may support the UK’s transition, it may be costly and have minimal impact on global decarbonisation endeavours.

Prioritising UK transition over global endeavours

If the government cannot generate sufficient tax revenues to offset losses and meet decarbonisation costs, when making public spending decisions, it will face a careful balancing act to ensure it supports the UK transition whilst also helping global endeavours to combat climate change. It is arguable that prioritising funds to incentivise business investment in technologies to accelerate global decarbonisation would have a greater impact on climate change than allocating funds to support the decarbonisation of UK residential buildings.

This highlights the importance of the government developing effective tax policies capable of generating sufficient and sustainable tax revenues. This will be a challenging and extensive process – one which the government should begin without delay. Effective communication will be imperative. It is inevitable that certain businesses may be more exposed to tax policy changes than others, particularly those in carbon intensive sectors, or those reliant on the country’s road network and vulnerable to the introduction of road pricing. Therefore, the government should start informing impacted businesses of the challenges ahead, so that they understand the rationale for future tax policy decisions.

A version of this article was first published in the International Law Office (ILO) corporate tax newsletter.

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