How will societies fund themselves in the future: polluters must pay
Thomas Vergunst
Programme Director, Finance Sector Education at Cambridge Institute for Sustainability Leadership (CISL)
"Business as usual is not delivering what we need to prevent catastrophic consequences."
This is according to the IMF Managing Director, European Commission President and the Director-General of the World Trade Organisation. They did not mince their words in an open letter to the Financial Times ahead of the annual UN climate conference in 2023, and went on to say:
‘We can — and we must — step back from the brink. That means a fair price on pollution to cut emissions for our children and their children, without emptying coffers or fragmenting global trade.'
Such calls for a fair price on pollution are a stark reminder that the operating context for businesses, and the financial institutions that finance them, is fundamentally changing. Governments will inevitably be forced to start raising taxes on activities that cause social and environmental harms, and this may happen sooner than many corporations expect.
Why might this be the case?
Government debt and future spending
It’s widely recognised that government spending will have to increase dramatically over the coming decades if countries are to achieve their international climate commitments and pay for the growing needs of ageing populations (1.5 billion people above the age of 65 are projected to be alive in 2050, up from a mere 129 million in 1950). Adding to this challenge is the fact that debt levels in many countries are already at historic highs and there is limited fiscal headroom to increase spending without raising taxes.
Governments pay for their debts and spending through taxation. In 2020, the average tax revenue raised by OECD countries as a proportion of GDP was 34% (Figure 1).
Figure 1: Total government tax revenues as a proportion of GDP
Governments raise revenues in a variety of ways, for example, corporation taxes, value-added taxes, and personal income taxes. Income taxes are an important source of government revenues and made up 24% of total tax revenues across OECD countries in 2020, and over 40% in the United States (Figure 2). Social security contributions made up a further 26% of the total tax take. Taxes on labour, therefore, provide a sizable chunk of government revenues each year.
Is there a risk of this important revenue stream being eroded over time?
Figure 2: Income taxes as a proportion of total government tax revenues
Erosion of income taxes
One way in which personal income taxes may be eroded is through a reduction in working age populations (15 – 64 years). The working age population is already falling in Europe and North America. Eastern and South-Eastern Asia are at a tipping point with a steady decline expected over the remainder of this century. In contrast, Sub-Saharan Africa will be home to 2.3 billion economically active people by 2100, way surpassing the total working age population historically achieved in any other part of the world (Figure 3).
Figure 3: Projections of working age populations in different parts of the world
In addition to demographic shifts, another trend that will erode personal income taxes is AI and associated technologies. If you believe Elon Musk, for example:
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"[t]here will come a point where no job is needed".
Sam Altman, is of the opinion that:
"Soon, AI tools will do what only very talented humans can do today’ and he expects "this to go mostly in the counter-intuitive order – creative fields first, cognitive labor next, and physical labor last".
More recently, the International Monetary Fund cautioned that:
rapid advances in AI “raises profound concerns about massive labor disruptions and rising inequality”.
The scale of AI neural networks is growing exponentially, with a significant uptick in the pace of change over the last two to three years (Figure 4). While it is too soon to say exactly how AI will displace the need for human labour, it is very likely that there will be significant disruptions to labour markets over the years and decades ahead. This could decimate income taxes which are reliant on people having well paid, reliable jobs (given high levels of debt, even a temporary dislocation in labour markets and associated income taxes would leave countries vulnerable).
This now raises an obvious question: how will governments fund themselves in future?
Figure 4: The drive to bigger AI models
Shifting the tax burden from desirable to undesirable activities
Governments will face an urgent need to innovate revenue generation strategies in the coming years. Potential avenues for increased revenue generation include a diverse range of measures such as taxes on the following:
Many of these taxes already exist in countries around the world as governments start to shift the tax burden from favourable elements, like labour, to less desirable economic activities, such as pollution. Leveraging these taxes will not only facilitate the pursuit of social and environmental goals but will provide a vital income stream for governments. A win-win from a government perspective, but with substantial implications for corporates.
Strategic implications for corporates and financial institutions
Some forward looking corporations have published Environmental Profit & Loss accounts (EP&L). An EP&L account provides a monetary valuation and analysis of a company’s environmental impacts across its entire value chain. Traditional P&L accounts help companies to identify financial inefficiencies. EP&L’s do the same but for environmental factors.
You can see from the examples in the table below that the estimated environmental costs across corporate value chains can be significant. Even if a small fraction of these costs were to be internalised through environmental taxes, it would substantially impact the cash flows and profit margins of these companies. This creates a strategic imperative for business leaders to get ahead of these trends and transition their business models so that they remain resilient and competitive as part of a low carbon, resource constrained world.
Table 1: Example of EP&L’s accounts for three companies compared to their net income and EBITDA
The need for leadership
Transitioning a business model, particularly one built up over many decades, takes time and clear-sighted leadership. It cannot be done overnight. We urgently need current and future leaders – and the millions of colleagues working within organisations of all sizes – to be taking a long-term view and proactively supporting the transition to a more sustainable economy. Early action is in the long-term financial interest of corporates and financial institutions. It’s also clearly in the interest of our children and their children. We all have a role to play in stepping back from the brink and forging a new way forward, whether our motivations be financial self-interest or concern about the world that our children will inherit.