2021 marked the beginning of the energy crisis. Following economic disruptions caused by the COVID-19 pandemic and the beginning of the Russian invasion of Ukraine, consumer prices surged worldwide whilst output growth slowed. In response to this energy price crisis, European governments introduced policies to contain the cost of energy and limit undesired impacts on households. Not all policies were designed in the same way. Support ranged from subsidies to businesses, transfers to vulnerable household groups and reduced taxes on energy. In addition, countries debated the possibility of taxing “windfall” energy companies’ profits to support these policies.
In a recent paper for Energy Economics entitled “How should governments respond to energy price crises? A horse-race between fiscal policies” we look at the impact of five fiscal policies that aimed at reducing the cost of energy inspired by measures adopted in Europe. We also evaluate the impact of windfall taxation on energy companies’ profits to finance such policies.
We use a computable general equilibrium (CGE) model of Germany and the rest of the EU to simulate the impact of a sudden increase in the cost of imported energy. The model is used as a test bed for the impact of five fiscal policies: firms tax reduction, energy price subsidies targeted to all households, lower-income households and both households and firms and income subsidies targeted to lower-income households. Each policy is compared to a situation where no policy is implemented. We calculate welfare effects for each of the policies by assuming that the government finances these policies by increasing (and later repaying) public debt only or by using a combination of debt and additional taxes on energy companies’ profits.
Chart: Long run welfare under energy policies and financing mechanisms
TR= firm tax reduction, UPS= energy price subsidies targeted to all households, TPS= energy price subsidies targeted to lower-income households, GPS= energy price subsidies targeted to all households and firms, TIS= income subsidies targeted to lower-income households
We show that targeted demand-side policies such as targeted at lower-income households price and income subsidies reduce energy prices most effectively and increase welfare compared to a situation where no policies are implemented. Supply-side policies such as production tax reductions provide the best short-run output recovery but do little to address inequality. We find that the introduction of windfall taxation is welfare-enhancing if households care about the provision of public goods sufficiently.
What does this research mean for policymakers?
What is the optimal policy mix?
The results of our study suggest that there is a trade-off between the ability of these fiscal policies to reduce the cost of living for households and to sustain output. Subsidies directed to households better reduce the cost of living. This is especially true when these are directed to lower-income households which typically consume a greater share of their income on energy. Subsidizing firms sustains economic output but does little to alleviate the cost of living. An optimal policy mix would depend on the specific policy goal. If governments care about distribution, then demand-side policies are better especially if targeted. But if the priority is sustaining output, supply-side policies are preferred. Of course, a mix of the two policies could be implemented.
Taxes on energy companies’ profits (windfall taxation) have redistributive powers and reduce the amount of future debt governments will pay. This type of taxation is a particularly attractive policy if governments face a high degree of sovereign default risk or if energy firm profits are held by foreign investors. In such cases, windfall taxation may be welfare-enhancing even if households do not care about the provision of public goods.
What is generalisable?
In our research, we compare the effectiveness of energy policies using the special case of Germany. The results of our study are generalisable to countries with a structure and energy import dependence similar to Germany. Understanding how a country’s structural characteristics and energy import dependence affect the ranking of the policies evaluated will be an important extension of the research we published.
How important is household behaviour?
Based on our findings, marginal propensities to consume out-of-income subsidies are crucial in determining the welfare impacts of such policies. In other words, the policies targeted at households work if households use the subsidies to pay their energy bills. If marginal propensities to consume are close to one, then subsidies to lower-income households are the optimal policy to counteract inflationary pressure and to increase long-run welfare. However, if households have lower marginal propensities to consume, income subsidies become relatively ineffective and targeted at lower-income households energy price subsidies should be preferred. Therefore, a key input in the analysis of income subsidies during energy crises is the marginal propensity to consume out-of-income subsidies.
What about the environment?
In the paper, we do not consider the environmental effects of the policies. Short-run energy policies may have large environmental effects likely closely related to the output recoveries associated with the policies. We therefore expect that the supply-side policies lead to larger emissions impacts. Future research should aim to validate this belief as countries’ supply channels may indirectly influence the embodied emissions linked to the policies.
For more in-depth discussion on the policies discussed in the article, please read the article available at:
Geoffroy Duparc-Portier acknowledges funding from the UK Economics and Social Research Council (ESRC), [project number 2277374], Scottish Graduate School in Social Science, [grant number ES/P000681/1]. Gioele Figus and Geoffroy Duparc-Portier acknowledge funding from the ESRC, Centre for Inclusive Trade Policy, [grant number ES/W002434/1].
 We expect lower-income households in high-income countries to have higher marginal propensities to consume out-of-income subsidies based on evidence from Agarwal et al. (2007) and Parker et al. (2013).