ECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT D INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECON ECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT MACROECONOMICS, TRADE AND INVESTMENT D INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECON Prosperity Insight Series FUEL TAXATION PROVIDING BETTER Cornelius Fleischhaker, Daniel Navia, Heron Rios PRICE SIGNALS THROUGH Opportunities in Brazil’s Consumption Tax Reform MACROECON | MACROECONOMICS, TRADE AND INVESTMENT PROVIDING BETTER | PRICE SIGNALS THROUGH MACROECONOMICS, TRADE AND INVESTMENT FUEL TAXATION Opportunities in Brazil’s Consumption Tax Reform Cornelius Fleischhaker, Daniel Navia, Heron Rios | D INVESTMENT © 2024 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy, completeness, or currency of the data included in this work and does not assume responsibility for any errors, omissions, or discrepancies in the information, or liability with respect to the use of or failure to use the information, methods, processes, or conclusions set forth. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Nothing herein shall constitute or be construed or considered to be a limitation upon or waiver of the privileges and immunities of The World Bank, all of which are specifically reserved. Rights and Permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. Cover design: Maria Lopez TABLE OF CONTENTS Abstract 1 1. Introduction 2 2. Brazil’s Transport Fuel Emissions and Taxation Prior to the Current Tax Reform 4 3. Estimating Total Carbon Tax and Relative over and under Taxation of Fuels in Brazil 12 4. Optimal Fuel Taxation Based on Assessment of Externalities 15 5. Distributive Impact of Fuel Taxation 19 6. Conclusions and Policy Recommendations 22 PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 1 Prosperity Insight ABSTRACT A new system of consumption taxes in Brazil was approved by constitutional amendment in December 2023, with infra-constitutional legislation under debate in Congress as of July 2024. This legislation will include provisions for a special VAT regime for fuels and create a new excise tax targeting goods with negative health and environmental externalities. This note shows that negative externalities justify significant corrective taxation to be levied on fossil fuels, whereas recent changes to fuel taxes have reduced effective taxation. Estimating the total carbon price implied by current taxes on fuels suggests a tax equivalent to US$68 per ton of CO2 for gasoline, but a subsidy (negative tax) of US$38 per ton for diesel. A special regime for fuels under the new VAT is expected to levy the tax on fuels as a single stage ad-rem rate. This entails the risk for tax erosion, which can be mitigated by including an automatic adjustment mechanism. Externalities could still be properly priced under this regime, either by including them in the ad-rem VAT rate or separate excise tax. While 72 percent of gasoline is consumed by the richest 40 percent of households, higher fuel taxes nevertheless increase the tax burden on the poor, especially when accounting for indirect effects. This impact can be successfully mitigated by using the resulting revenue for targeted transfers or reduced general taxation. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 2 Prosperity Insight 1. INTRODUCTION Fossil fuel use in transportation is a large negative externalities. This taxation should occur contributor to Brazil’s greenhouse gas (GHG) through a per unit tax, prior, and in addition, to emissions and causes other significant negative levying the value added tax (VAT). The ongoing effects to society, such as increased air pollution. reform of indirect taxes in Brazil, which will create Tax theory and international best practice suggest a new excise tax to be levied on goods and services that fossil fuel taxation should reflect these “which are harmful to health or the environment,”1 1. Text in Constitutional Amendment 132 (approved 20 December 2023), Art. 153, VIII. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 3 Prosperity Insight creates an opportunity to improve the price with a single stage ad-rem tax, entails the risk for signals provided by fuel taxes. Brazil is already tax erosion. However, this risk can be contained by working towards implementing the principle including an adjustment mechanism to regularly of pricing carbon externalities in other sectors, update ad-rem rates. The expected tax structure through a proposed Emissions Trading Scheme still allows for proper pricing of externalities, either (ETS). Incorporating carbon externalities in the in the ad-rem VAT rate or in a separate excise tax. tax structure for road fuels would be an effective While higher fuel taxes increase the burden on the complement to these efforts, putting a price on poor, this impact can be mitigated by using the carbon emissions which are not expected to be resulting revenue for targeted transfers or reduced covered by the Brazilian ETS. The Brazilian policy general taxation. makers’ choice for a special VAT regime for fuels PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 4 Prosperity Insight 2. BRAZIL’S TRANSPORT FUEL EMISSIONS AND TAXATION PRIOR TO THE CURRENT TAX REFORM Brazil’s emissions from road transport are and diesel, in combustion engine vehicles including significant and have shown an increasing trend cars, trucks, and buses. Rising transport emissions over the past two decades. Currently, Brazil’s road are the result of an increasing trend in fossil fuel transport emissions account for about 9 percent of use, rising from about 120 million tons of carbon the country’s total emissions. These emissions are dioxide equivalent (CO2e) in 2002 to 200 million caused by the use of fossil fuels, mostly gasoline tons of CO2e in 2022.2 2. Other transport emissions, mostly from air transport, are less significant at 9.5 million tCO2 in 2022. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 5 Prosperity Insight Figure 1: Brazil’s transport emissions in MtCO2e (LHS) and as percent of total without Land-use change (RHS) (1990-2022) 2,500 12% 10% 2,000 8% 1,500 6% 1,000 4% 500 2% 0% 0% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2012 2014 2016 2018 2020 2022 Cargo transport (MtCO2e) Passanger transport (MtCO2e) Total transport (as % of all emissions excluding LUCF) Source: Sistema de Estimativas de Emissões e Remoções de Gases de Efeito Estufa (SEEG). Alternatives to fossil-fuel powered transport ethanol blended in). As electric passenger cars, have existed in Brazil since the 1970s but are light trucks, and buses become more widely recently becoming more widely used due to available, another low emission alternative now the diversification and electrification of the exists for much of the transport sector.3 Although automotive sector. Brazil has been a leader in electric vehicle sales in Brazil are relatively small alternative fuels since the 1970s, developing a compared to total vehicles sold, they have been large-scale program for ethanol-fueled cars growing rapidly as of late (from 49,000 in 2022 to (Proálcool). Since the early 2000s, most passenger 94,000 in 2023). cars sold in Brazil have been flex-fuel, meaning To achieve efficient market outcomes, the they can run on gasoline, ethanol, or any consumption of fossil fuels needs to be subject combination of the two. Today, about 85 percent of to a heavier tax than other goods and services, cars on the road in Brazil use this technology. Given due to their significant negative externalities. this flexibility, ethanol’s use has fluctuated, but has If these negative externalities are not reflected in never realized its full potential in replacing fossil the price of fossil fuels, the result will be continued fuels. At its peak, 41.5 percent of flex cars used overconsumption and neglect to switch to less ethanol (October 2018), but use declined to less harmful alternatives, even though it would be than 20 percent in early 2023 before recovering socially optimal. These alternatives are not just to about 30 percent by January 2024. Despite this alternative fuels and lower emission vehicles but recent increase, most of the flex fleet still runs on also changing to more efficient modes of transport fossil gasoline (with 20 to 25 percent anhydrous 3. See: World Bank: The Economics of Electric Vehicles for Passenger Transportation (2023). PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 6 Prosperity Insight such as urban mass transit or rail transport of Prior to legislative changes in 2022, fuel taxation goods. This scenario is a classic case for Pigouvian was complex, fragmented, and volatile. Taxes taxation, where the cost of the negative externality on road fuels were frequently changed, driven is incorporated in the price faced by consumers.4 by the interaction of fiscal pressures, oil prices, While fossil fuels have long been taxed by the and political sensitivities. When oil prices (in local Federal and State Governments in Brazil, their currency terms) were high and fiscal space allowed approach to such taxation has been shaped by the for it, governments would reduce tax rates on fuels importance of fuel as a convenient tax base, the and implement pricing mechanisms that resulted recurrent pressures created by fluctuations of oil in an implicit subsidy. Conversely, during periods of prices, and the desire to privilege certain fuels for lower oil prices and higher fiscal needs, taxes were reasons related with industrial and sectorial policy. increased, and pricing mechanisms converged with Environmental impacts, including those related supply costs. The resulting fuel prices have been to GHG emissions, human health costs, and other broadly in line with those practiced in neighboring externalities have played a very limited role in and peer countries (Figure 2). shaping Brazil’s fuel tax policies. Figure 2: Gasoline and diesel prices per liter, selected countries, June 2024 (US$ per liter) $2.00 $1.50 $1.00 $0.50 $0.00 y le a o a u a il a a ia a a az ic a r ic di bi in in i i i ss es iv Pe Ch gu ex r m In nt Ch Br l Af Ru n Bo u lo M ge do Ur h Co Ar In ut So Gasoline Prices (USD/Liter) Diesel prices (USD/Liter) Source: Trading Economics & Global Petrol Prices. Fuel taxation is split between several federal ICMS tax, the Federal Contribution to the Social and state taxes, adding to the complexity of Integration Program/Social Contribution on Billing Brazil’s overly complicated tax system. The three (PIS/COFINS) tax, and the Federal Contributions taxes levied on liquid fuels are the state-level on Intervention in the Economic Domain (CIDE) 4. Named after British economist Arthur Cecil Pigou, who pioneered this idea in “The Economics of Welfare” (1920). PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 7 Prosperity Insight tax. ICMS and PIS/COFINS are goods and services ICMS rate (18 percent at the median), though taxes, affecting a broad set of goods and services this was less the case for diesel (18 percent) and and constituting the largest indirect taxes in Brazil.5 ethanol (24 percent). However, the level of over- CIDE, introduced as part of a fiscal adjustment taxation of gasoline varied significantly across effort in 2001, is an excise tax with selective states. Revenue from PIS/COFINS, and CIDE on application. However, all three taxes use special fuels represented approximately R$27.4 billion regimes with differential tax rates for fuels. As (0.4 percent of GDP and 1.3 percent of total a result, fuel taxation has tended to be one of Federal Revenue) in 2019 (Figure 3). The Federal the most complex sectors in what is already an PIS/PASEP and COFINS taxes are charged as an ad overly complex tax system. The ICMS regime has valorem rate on most goods and services across historically been particularly complex, as different the value chain, with deductibility of previous states apply different rates and assessment tax payments, similar to a VAT. However, this methodologies, frequently using a forward was not applied to fuels which are subject to a attribution of payments, to streamline revenue single-phase system, with a specific amount per collection and avoid fraud. Nevertheless, revenue liter. This ad-rem charge has varied over time, losses from evasion of fuel taxes are estimated to so over-taxation or under-taxation relative to be high.6 standard rate has varied on the prevalent price for fuels over time. The CIDE tax on fuels was reduced Brazil’s fluctuating fuel taxation has created several times (Figure 4) until the tax rate for diesel a varying yet important source of revenue was set to zero in 2018. Before 2022, the rate on for states, while revenue for the Federal gasoline was R$0.10 per liter. This rate was zeroed Government has decreased in recent years. temporarily in 2022 and then reestablished at its Total ICMS tax on fuels stood at 1.3 percent of previous level in 2023. As a result, CIDE revenues Brazil’s GDP in 2021, accounting for close to have been small, at most rising to 0.1 percent of 17.5 percent of overall ICMS. Most states taxed GDP in 2016 and decreasing to about 0.02 percent gasoline at a significantly higher ICMS rate in 2022-23. (28 percent at the median) than their standard 5. The ICMS is the largest tax in Brazil by revenue, raising about 7 percent of GDP. PIS/COFINS raise about 3.5 percent of GDP, making it the second largest federal tax after the personal income tax. Legally, PIS/COFINS and CIDE are defined as contributions, rather than taxes, as their use is subject to earmarking, however, they function as taxes, since they are compulsory charges not tied directly to a benefit received by the taxpayer. 6. See FGV (2021) for a description of fraud practices and estimation of tax revenue lost. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 8 Prosperity Insight Figure 3: Fuel tax revenue 2014-2023 (percent of GDP) 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 ICMS CIDE PIS/COFINS Source: Ministry of Finance and Conselho Nacional de Política Fazendária (CONFAZ). Note: PIS/COFINS data only available for 2021 and 2022. Figure 4: Trajectory of the CIDE fuel rate 2001-2023 (RS$ per liter) 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 01 02 03 4 05 06 07 8 9 10 0 11 11 12 13 14 5 16 17 8 19 20 21 22 23 23 00 01 00 00 01 01 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 ,2 ,2 ,2 ,2 ,2 ,2 ., ., e, ., ., ., , ., ., ay ay ay pt t b. ay ay ar ay c ar l c n Oc Ju De De Fe Ju Se M M M M M M M M Law Law Decree Decree Decree Decree Decree Decree Decree Decree Decree Law Decree 10,663 10,636 5,060 6,446 6,875 7,095 7,570 7,591 7,764 8,395 9,391 192 1163 Gasoline Diesel Source: World Bank calculation based on Lemes Proque et al. (2022) available at: https://www.sciencedirect.com/science/article/pii/S0739885922000270. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 9 Prosperity Insight In 2022, a rapid sequence of policy changes tax. Another law (Lei Complementar 194/22) resulted in fuel tax simplification and reduction, established a ceiling on the ICMS rate on fuels creating large revenue losses for Brazilian and other essential goods and services. These governments, especially the States. The increase laws resulted in large revenue losses for State and in global oil and refined products prices triggered Federal Governments. States’ aggregate ICMS tax by the 2022 Russian invasion of Ukraine sparked collection from fuels declined by 23 percent (in a swift sequence of legislative and judicial events real terms) from its peak in mid-2022 to the third which resulted in significant changes to Brazil’s quarter of 2023, with some States losing as much taxation of fuels. A 2022 law (Lei Complementar as 47 percent (Figure 5). However, national fiscal 192/22) transformed ICMS on fuels from a VAT- effects were even greater given that the change in like tax with numerous state-specific complexities, legislation also brought federal taxes on fuels (PIS/ into a single-stage, nationally uniform ad-rem COFINS, CIDE, import tax) to zero. Figure 5a: States’ ICMS revenue on fuels (in constant December 2022 R$, billion) 160 20.00 18.00 140 16.00 120 14.00 100 12.00 80 10.00 8.00 60 6.00 40 4.00 20 2.00 0.0 0.00 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 07 17 12 22 24 06 08 09 10 11 13 14 15 16 18 19 20 21 23 05 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 12-Months Sum of ICMS on Fuel (Inflation-adjusted, in billions) Grand Total ICMS on Fuel (Inflation-adjusted, in billions) Grand Total Source: CONSEFAZ. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 10 Prosperity Insight Figure 5b: Change ICMS fuels revenue by state (percent, at maximum of 12-months loss) 10 0 -10 Percent -20 -30 -40 -50 MS PR AM TO AC PA SP MG AL SE PI RN CE MT AP RS PB GO ES SC PR DF RO PE RJ MA State Source: CONSEFAZ. Taxes can be used to smooth fluctuations in Countries, especially those with a domestic fuel prices, but such a mechanism needs to be supply of oil or refined products, are often well-designed to maintain price signals and tempted to fix fuel prices in the domestic avoid systematic revenue loss. Countries have market. Fixed fuel prices at levels well below often used fuel taxes to reduce the fluctuation of international cost are common among oil producing fuel prices faced by consumers. Fixed excise taxes countries. In Brazil, fuel prices are designated as already smooth the relative price fluctuation of regulated prices (preços administrados) and the refined products prices relative to that of crude oil. government has at times intervened via Petrobras Brazil, however, has often changed both fixed and to keep them below cost parity, most notably ad-valorem tax rates in an ad-hoc manner to offset between 2011 and 2015. From 2016 to May 2023, oil price increases. Other countries, such as Mexico Petrobras used an import parity formula to set and Chile, have an explicit, legally formulated role the refinery gate price on top of which taxes are for taxes in the stabilization of fuel prices. Brazil applied. In May 2023, Petrobras announced a new lacks a formal mechanism to ensure that taxes price fixation strategy that will focus on “client’s are balanced across oil price fluctuations, which alternative options” and the company’s “marginal results in reduced taxation during times of high oil value.” The practical implications of this change prices, but no offsetting tax increases during low cannot be evaluated at this stage due to the limited oil prices. amount of time that it has been in place and the exceptional conditions in diesel markets generated by Brazil’s purchases of Russian refined products. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 11 Prosperity Insight Figure 6: Oil price – in local currency - and retail prices in Brazil from December 2019 to February 2024 8.0 700 7.0 600 500 6.0 400 5.0 300 4.0 200 3.0 100 2.0 0 3/ 20 5/ 20 7/ 20 9/ 20 20 0 3/ 21 5/ 21 7/ 21 9/ 21 21 1/ 1 3/ 22 5/ 22 7/ 22 9/ 22 22 2 3/ 23 5/ 23 7/ 23 9/ 23 23 3 24 02 02 02 02 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 /2 /2 /2 /2 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ /1 /1 /1 /1 1/ 1/ 1/ 1/ 1/ 11 11 11 11 Gasoline price Oil price (R$, RHS) COVID-19 onset LC 194/22 MP 1163/23 ATO 27/23 Source: ANP, BCB. Going forward, taxes on fuels should remain fossil fuels efficiently, considering not only the simple, avoiding volatility, but better reflecting direct costs of fossil fuels but also their indirect the negative externalities associated with fossil negative effects on health and the environment. fuels. The ongoing indirect tax reform replaces These negative externalities are very significant the ICMS, the PIS/COFINS, and the tax on and should be reflected in the taxation of fuels. industrialized products (IPI, which does not apply By altering the relative price of fuels, well designed to fuels), with a new dual (Federal/subnational) taxes on fuels incentivize agents to adjust their VAT and an excise tax (CIDE is to remain). This short-term use of them and, over time, to invest provides an opportunity to establish a system of in more efficient technologies. To maximize this fuel taxation which is simple yet provides adequate effect, visibility, clarity, and stability in tax and and stable incentives for economic agents to use pricing policies for fuels are also crucial. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 12 Prosperity Insight 3. ESTIMATING TOTAL CARBON TAX AND RELATIVE OVER AND UNDER TAXATION OF FUELS IN BRAZIL The total carbon price (TCP) is a comprehensive TCP provides a holistic view of carbon pricing measure of the net tax burden on fuels and their signals, essential for understanding the true associated emissions, reflecting the combined impact of fiscal instruments on the incentives of effect of all fiscal instruments, compared to consumers to reduce emissions.7 Determining the taxation of other goods and services. the TCP requires a two-step process. First, it is By capturing the net impact on fuel prices, the necessary to compute the total tax burden on 7. More information on the TCP concept applied here can be found in: World Bank 2024: “Taxes, Subsidies & Energy in Latin America and the Caribbean Revisiting Fiscal Instruments with a Total Carbon Price Approach” (forthcoming). PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 13 Prosperity Insight fuels, which includes calculating all the taxes fuel consumption. Diesel, on the other hand, placed on fuels net of any subsidies or other price has frequently been subject to taxes that were interventions. Second, to arrive at the TCP, the lower than the average tax rate – hence receiving total tax burden must be compared to the taxes a subsidy as differentiated tax treatment works applied to other goods. If the net taxes applied to reduce its final consumer price relative to that on fuels are higher than those on other goods, of other goods. The ad-rem tax rates applied for this difference can be thought of as internalizing ICMS and PIS/COFINS on diesel in 2023 imply the negative externalities of fuels. This is true a tax subsidy of R$0.44 per liter. For ethanol, regardless of whether or not a formal link exists the frequent use of reduced ICMS rates and a between fuel taxes and these externalities (e.g., low PIS/COFINS ad-rem tax, also imply a tax an explicit carbon tax), as an unlinked tax (such rate that is lower than average by R$0.33 per as a conventional excise tax) has the same effect liter. The changes in fuel taxation since 2022 on relative prices. On the other hand, if the tax have significantly reduced the TCP for all fuels. burden applied to fuels is below the rate of general Converting the per liter effective taxes of 2023 into taxation, this implies an effective consumer a US$ per ton of CO2 value (the typical definition subsidy – a financial incentive that can be expected of carbon taxes) results in a carbon tax equivalent to increase the consumption of fuels. Hence, the of US$68 per ton of CO2 for gasoline and a subsidy difference in the net burden of taxation between (negative tax) of US$38 per ton of CO2 for diesel.8,9 fuels and other goods is conceptually equivalent A hypothetical new regime, applying the current to a positive or negative total carbon price (TCP) estimate of the future VAT rate (26.5 percent) resulting from the total impact (i.e., including taxes and ad-rem taxes and prices of June 2024, would and subsidies) of the fiscal system. result in significantly higher relative taxes on fuel, which is due primarily to the reduction in the In Brazil, gasoline is subject to a total net tax general tax rate on goods (which is expected to burden above general taxation – a positive TCP be lower under the new VAT than under ICMS and – which is equivalent to a positive carbon tax PIS/COFINS), but also the moderate increase in in terms of incentivizing consumers to reduce ad-rem rates in 2024. 8. Given the complex rules for tax crediting in Brazil, the negative tax estimated here assumes that lower ICMS rates on diesel are fully transferred to final users (i.e., no crediting). Partial crediting along the distribution chain would result in higher total taxes, but still negative or, at most, null. 9. Since ethanol has no direct emissions, the tax per ton of CO2 is not calculated. Ethanol production can lead to indirect emissions, however, through its impact on deforestation. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 14 Prosperity Insight Figure 7: TCP on fuels (R$/liter and US$ per ton of CO2) relative to taxes on non-emitting goods in 2021, 2023, and under the projected new regime using June 2024 prices. 1.50 150 1.00 100 0.50 US$/tCO2 R$/I 50 0.00 0 -0.50 -1.00 -50 Gasoline C Diesel Ethanol R$/I, 2021 R$/I, 2023 R$/I, 2024 $/tCO2, 2021 $/tCO2, 2023 $/tCO2, 2024 Source: World Bank calculation. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 15 Prosperity Insight 4. OPTIMAL FUEL TAXATION BASED ON ASSESSMENT OF EXTERNALITIES Insufficient taxation of liquid fuels leads to their of fossil fuels in vehicle engines leads to emissions overconsumption relative to socially optimal of CO2, increasing the concentration of greenhouse levels, consequently generating significant gases in the atmosphere and exacerbating climate externalities. Brazil’s liquid fuel use generates change. Fossil fuel combustion also releases local both country- and global-level costs that drivers pollutants with significant negative impacts on and passengers do not often consider. Combustion human health, which can be quantified in monetary PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 16 Prosperity Insight terms applying the concept of Value of Statistical For ethanol, the carbon externality would Life (VSL).10 Imposing a Pigouvian tax set at the in principle be null, given that combustion marginal value of the costs of these emissions emissions are offset during growth of the will provide incentives for motorists to alter their feedstock. However, the production of ethanol driving behavior in a way that improves societal can still result in emissions from soil and land use welfare. Beyond the direct externalities created change, especially if cultivation of ethanol crops by fuel combustion, driving creates other negative (sugarcane and maize) leads directly or indirectly impacts for society: accidents, congestion, and to deforestation. Since taxing deforestation road wear. Ideally these externalities should be emissions directly is not feasible, a carbon tax addressed directly, by, for example, applying on ethanol could be justified for this reason. road tolls that increase with traffic congestion However, estimating these emissions is not (“congestion pricing”). However, when such direct straightforward. For reference, an estimate of pricing mechanisms are not feasible, including ethanol emissions based on the upper range their costs in fuel prices is a possible “second of impact on deforestation results in a carbon best” alternative. externality of R$0.22 per liter. Figure 8a: Externalities of road fuels (R$ per liter) 5 0.05 4 1.00 0.95 3 1.29 2 2.26 0.65 1.40 1 1.51 0.16 0.75 0.86 -0 0.22 Gasoline Diesel Ethanol Carbon emissions Air pollution Accidents Congestion Road damage Source: World Bank calculation. 10. For a discussion of the VSL in the context of pollution, see: Cropper, M., E. Joiner and A. Krupnick. 2023. Revisiting the Environmental Protection Agency’s value of statistical life. Working Paper 23/30, Resources for the Future. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 17 Prosperity Insight Figure 8b: Taxation of road fuels under current and proposed new regime (R$ per liter) 4.00 3.50 1.80 3.00 2.50 2.00 0.10 0.59 1.50 1.25 0.32 1.00 2.26 1.37 0.85 0.50 1.06 0.24 0.91 0.44 0.00 0.22 Gasoline Diesel Ethanol (SP) ICMS PIS/COFINS CIDE Pigouvian Excise IVA @26.5% Source: World Bank calculation using data from Fecombustiveis and ANP. Pricing of direct externalities results in estimated at R$1.40 per liter, but is much smaller estimated efficiency maximizing excise taxes for gasoline (R$0.16 per liter), and is negligible of about R$0.91 per liter for gasoline and for ethanol. Therefore, the total Pigouvian tax for R$2.26 for diesel. The cost of carbon externalities would be R$0.91 for gasoline, R$2.26 for diesel, depends on the carbon price applied, which is and R$0.22 for ethanol. Applying the current based on an assessment of the social cost of estimate for the standard rate of the new VAT carbon. In line with recent literature, a price of (26.5 percent), and fuel prices as of June 2024, US$60 per ton of CO2 is applied here.11 This the total tax burden would come to R$2.16, implies an externality cost per liter of about R$4.06, and R$1.06 per liter for gasoline, diesel, R$0.75 for gasoline and R$0.86 for diesel. Air and ethanol, respectively.12 pollution is a significant externality for diesel, 11. This is the midpoint of a carbon price range derived in Stern, Stiglitz et al. 2017 for the period 2020 – 2030 (see also IMF, 2023). 12. As current ethanol taxes as well as final consumer prices vary greatly across states, São Paulo prices are used for ethanol in this calculation. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 18 Prosperity Insight Indirect externalities associated with driving, considered if more direct ways to address these rather than the specific fuel, are even larger, externalities, such as congestion pricing in cities though the use of corrective taxes on fuels or road tolls for heavy trucks, are not feasible. should only be considered as a second-best Vehicle taxation, as proposed under the new excise option. The social costs of accidents and tax (Imposto Seletivo), can be a complementary congestion in Brazil are very high. Using fuel taxes policy here, as another indirect way of internalizing to reduce these (via reduction in driving), would negative externalities of driving. While not directly require at least R$2 per liter in additional excises. targeting the mentioned externalities, vehicle Road damage resulting from heavy vehicles taxation can play an important role to guide running on diesel is a smaller factor. However, consumer decisions when consumers are not fully since these externalities do not derive directly from aware of the full costs of operation of a vehicle fuels, using fuel taxes is not optimal to address (which includes future fuel costs). Under these them (e.g., switching to alternative technologies conditions, tax systems that penalize the purchase such as electric cars would not significantly reduce of higher emission vehicles and favor vehicles with them). Therefore, their application should only be lower emissions can be useful. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 19 Prosperity Insight 5. DISTRIBUTIVE IMPACT OF FUEL TAXATION While most fuel is consumed by high-income typically found in the luxury segment. Therefore, households, the relative burden of fuel taxes consumption of gasoline is especially greater is tilted towards the poor. Final consumption of among the rich, with the richest 10 percent of gasoline and ethanol is usually tied to ownership households accounting for 31.3 percent of overall of cars, motorcycles, and other light vehicles, consumption, and the top 40 percent accounting which is much more common among wealthier for 72.2 percent. Nevertheless, the relative weight households. As most cars on the road in Brazil that fuels have on households’ finances is greater are flex fuel, cars and light trucks for personal among the poor. The bottom 40 percent of the use, running exclusively on gasoline or diesel, are income per capita distribution spend, on average, PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 20 Prosperity Insight 7.4 percent of their income on liquid fuels. Besides the price of gasoline and a significant increase in direct purchases of liquid fuels, disparities in the prices of diesel (ethanol does not experience consumption of other goods and services that use a price change due to unclear carbon content).13 liquid fuels as inputs, such as food and transport, This measure results in modest income losses also increase the sensitivity of poor households of 2-3 percent for the poorest Brazilians, about to fluctuations in the prices of liquid fuels. 1 percent at the median, and negligible losses for However, the poor also suffer disproportionately richer households. Adding the externalities from from fossil fuel-based transport pollution, due to local air pollution on health implies higher prices their greater likelihood to work outdoor jobs and for both gasoline and diesel, resulting in income depend on walking for daily mobility. Therefore, losses of about 6 percent for the poorest and the poor would also disproportionately benefit 2 percent for the median household. Further, from pollution abatement. adding indirect externalities (accidents, congestion, and road damage) would result in much higher Taxing fuel according to externalities would by prices still, with income losses reaching 17 percent itself reduce household incomes, especially for for the poorest, about 7 percent at the median, and the poor. Imposing a carbon tax of US$60 per tCO2 4 percent for the richest households.14 across all fuels results in a 1.7 percent decline in Figure 9a: Change in consumable income across the distribution 0% Average change in consumable income p/c -2% -4% -6% -8% -10% -12% -14% -16% 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 Disposable income centiles US$60 per tCO2 Air pollution externalities All externalities Note: Author’s own calculations using the 2017/2018 POF data. Per capita monetary income (labor and non-labor) used to define disposable income centiles. Consumable income calculated as disposable income net of consumption taxes and subsidies. Observations in the bottom and top 5% of the distribution are not displayed. 13. The global reference price of US$60 per ton of CO2 is used for illustrative purposes. Ultimately, a carbon price for Brazil would need to be tailored to national circumstances, with an emphasis on graduality and predictability of carbon pricing to maximize the economic impact of the price signal while minimizing adjustment costs. 14. Estimates are obtained from a microsimulation model using 2017/2018 POF data. Direct effects are calculated by applying the estimated price shocks on each of the fuel items observed in the survey data, while indirect effects are estimated using a Cost- Push model and a specially adapted sectoral Input/Output matrix. Simulations are static, that is, households are assumed to hold their consumption constant. Therefore, results should be interpreted as an upper bound of income losses, since households are able to mitigate losses through substitution, including by switching from gasoline to ethanol. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 21 Prosperity Insight Figure 9b: Change in consumable income across the distribution before and after revenue recycling 4% 2% Average change in consumable income p/c 0% -2% -4% -6% -8% -10% -12% -14% -16% 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 Disposable income centiles Reduced VAT Transfer to Cad. Unico HHs All externalities Note: Author’s own calculations using the 2017/2018 POF data. Per capita monetary income (labor and non-labor) used to define disposable income centiles. Consumable income calculated as disposable income net of consumption taxes and subsidies. Observations from the bottom and top 5% of the distribution are not displayed. The negative social impact of higher fuel tax can taxes could be recycled by lowering other taxes, be offset by using the revenue to support low- such as the general VAT rate. Using excise taxes income households, reduce general taxation, on goods with negative externalities to reduce the or subsidize alternative means of transport. general VAT rate is consistent with the principles Measures to mitigate the regressive impact of fuel of the current indirect tax reform, which aims to taxes can take the shape of targeted transfers be fiscally neutral, not increasing the aggregate or reduction of taxes on other consumption to tax burden of indirect taxes. This approach is less disproportionately benefit the poor. A targeted progressive, as VAT reductions also benefit the mitigation policy, offsetting losses experienced rich who consume much more in absolute terms. by the poorest 25 percent of the population Nevertheless, it would offset income losses for (households in the Cadastro Único) could be the entire income distribution, with potential for done at a low cost of only about 10 percent of households to improve their welfare by switching the revenue generated by fuel taxes, even under consumption patterns away from fossil fuels. the assumption of imperfect targeting (providing Finally, tax revenues could also be used to improve a fixed amount to all families with per capita alternative (lower carbon) modes of transport that income below half a monthly minimum wage). the poor also disproportionately rely on, such as Alternatively, the proceeds from additional fuel public transport. PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 22 Prosperity Insight 6. CONCLUSIONS AND POLICY RECOMMENDATIONS Fossil fuels in transport are a significant as effective carbon taxes have been reduced – to contributor to Brazil’s GHG emissions and negative levels in the case of diesel – in the latest tax policy has historically failed to provide round of ad-hoc fuel price changes in 2022. consistent price signals. Even though Brazil Currently, fossil fuels are undertaxed relative has been a leader in low carbon fuels thanks to their externality costs – to achieve socially to the wide-spread use of ethanol and flex fuel optimal outcomes, a significant excise tax technology, tax policy has not played a meaningful should be applied. The new excise tax, created role in reducing emissions. On the contrary, by Conditional Amendment 132, is appropriately transport emissions have continued to increase, PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION 23 Prosperity Insight directed towards goods with negative health and vans) and the fuel efficiency of engines (by delaying environmental externalities. Hence, this tax – or the decision to invest in newer trucks). Improved the existing fuel excise (CIDE) – should be used diesel taxation, combined with measures that to internalize at least the external costs to society support the adoption of cleaner trucks and buses that directly derive from, and are proportional to, could reduce transport emissions. For example, the consumption of fossil fuels, which are GHG increased taxes on diesel could be combined with emissions and local air pollution. This would imply subsidies for investment in efficient transport a significant increase in taxation, especially for equipment such as accelerated amortization, diesel. For taxation to be effective and transparent, credit subsidies for investments in more modern excise goods should not be subject to preferential and low emissions vehicles, or explicitly including treatment under the VAT – the standard rate the costs of local pollution in the criteria for should be applied on the price including excises. awarding municipal bus concessions. Implicit subsidies that reduce the pre-tax price of Ad-rem application of the VAT on fuels, as fuels below market value will also undermine the currently practiced and widely expected intended price signal of an excise tax. under the new Brazilian dual VAT, can have Despite the political difficulties, improving economic and administrative benefits, but also the price signals for diesel emissions would increases the risk of tax erosion. Fixing taxes help decouple transportation emissions from ad-rem makes for easier collection of taxes at economic growth. Diesel taxation is below choke points upstream in the supply chain, which average taxation in Brazil, which discourages the may reduce the risk of fraud. Ad-rem taxation adoption of fuel-efficient technologies and biases also provides greater smoothing of relative price transport decisions towards diesel vehicles, hence changes of refined fuels in response to oil price distorting agents’ decisions towards excessive or exchange rate movements, which would be carbon emissions and air pollution. Taxing diesel, replicated immediately by an ad valorem tax. however, is a politically loaded issue. Transport However, as underlying prices increase, effective operators have frequently successfully mobilized taxation under an ad-rem regime tends to erode, for compensatory measures when the market unless rates are periodically reset to account for price of diesel increases or to reject increases in its the change in prices. In this regard, the annual taxation. Their ability to paralyze economic activity quasi-automatic adjustment mechanism included is a concern for policymakers in many countries. in the government’s proposal for the regulation Unfortunately, this has led to an equilibrium where of the new VAT and excise tax (PLP 68/24) is an the taxation of diesel is much lower than what important and welcome feature. The tax structure its environmental effects would suggest, and using an ad valorem charge for the VAT offers below the taxation of gasoline. Low diesel taxes several options for proper pricing of externalities. provide weak incentives to rationalize the choice of The Pigouvian tax could be included in the ad-rem transport mode (as it lowers the benefits of more VAT rate or in a separate excise tax, which could efficient alternatives such as railroads), the choice be the new Imposto Seletivo or the existing CIDE of technology (e.g., adoption of electric delivery fuel tax. Prosperity Insight PROVIDING BETTER PRICE SIGNALS THROUGH FUEL TAXATION ECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT 24 D INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECON ECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT D INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECONOMICS, TRADE AND INVESTMENT | MACROECON