Today’s environmental challenges demand the concerted efforts of citizens, firms and governments to encourage less pollution and environmental degradation and change existing patterns of demand and supply.

The world is facing a host of environmental challenges. Some are confined to local areas and may be the result of a few polluters, such as mercury emissions to air or sewage discharges in watercourses; others occur at the global level and are brought about by millions of different actors, such as with the emissions of greenhouse gases. While these environmental issues can be thought of as negative side-effects of countries’ economic development, it is important to consider as well that as countries grow richer, more dense, and more technically advanced, the desire and ability to confront these challenges grows as well.

This chapter introduces why an unregulated market provides too much pollution and too little innovation, the combination of which makes environmentally related innovation doubly undersupplied. It outlines that such innovation is critical for achieving environmental targets cost-effectively. There is discussion of the process of innovation, its drivers and the role of governments and industry. The chapter finishes with a discussion about the role of taxation in correcting these two market failures.

This chapter outlines the usage of environmentally related taxation in OECD countries. It begins by exploring the revenues derived from such taxes, their trends and the role that these taxes play in governments’ overall budgets. It goes on to analyse trends in the rates of taxes across countries and how countries are continuing to implement them. The chapter finishes with a discussion on the extent and impact of exemptions and rate reductions within environmentally related taxes.

This chapter analyses the effectiveness of environmentally related taxation to bring about innovation. It begins by discussing the challenges to measure innovation empirically and outlines potential metrics. The chapter then delves into a number of case studies to look for potential linkages, finding mixed evidence. It highlights the different types of innovation that environmentally related taxation does (and does not) induce. Constraints to the effectiveness of taxation to induce innovation are also investigated.

This chapter considers how the design of environmentally related taxes – the level of the tax, the extent of the tax base and the predictability of the rate – influences the ability to induce innovation. It also explores the effect of measures to address political economy considerations. Attention is then turned to other potential tax-based measures, such as accelerated depreciation allowances and R&D tax credits, to address the environmental and innovation challenges. The chapter concludes with a discussion of potential instrument combinations to achieve an optimal outcome.

This chapter provides a broad overview to policy makers about the considerations surrounding environmentally related taxation. Taxes are assessed against other potential policy instruments before turning to fundamental tax design considerations. The chapter also delves into the use of revenues derived from such taxes and the political economy considerations present during implementation. It finishes with a discussion about why taxes should be central to countries’ environmental policy approaches but that taxes alone may not be enough to fully and cost-effectively address the environmental challenges.