A law to tax motor vehicles has finally landed in the Riigikogu. While some changes may still be introduced, it is likely people will have to pay a tax when first registering a vehicle in Estonia plus an annual usage tax. Seldom has a law sparked more debate and vocal protest in Estonia.

It is surprising that while plans to lay down a relatively modest car tax have resulted in ferocious protests and public debate, the January VAT hike from 20 percent to 22 percent failed to provoke a similar reaction. The higher VAT rate and the new car tax are estimated to yield more or less the same amount in tax revenue. Why is the car tax such a massive problem in a situation where higher taxation of staples – such as potatoes, rye bread and milk – is not seen as a concern?

President Alar Karis has said: "Even the authors of the car tax do not seem to understand why it is needed. Here it is aimed at protecting the environment, while it's aimed at generating tax revenue elsewhere – it is confusing."

If we ask whether the car tax aims to protect the environment or whether it's simply a way to collect more money as taxes, the answer could be that it's both, as is often the case with environmental or so-called win-win taxes.

Tax theory

According to tax theory, a government looking for additional tax revenue should tax products in the case of which demand (or supply) is non-elastic, meaning that changes in price do not greatly affect quantities sold.

The logic is simple. If the government taxes a product demand for which is elastic, the tax will work to drive away consumers, which will hurt sales and through it tax receipt. Taxing products with elastic demand also impacts consumer well-being by forcing them to drop products they like in favor of those they do not.

While taxpayers are expected to pay taxes, taxes that alter behavior constitute excess tax burden.

How a tax can alter behavior and result in excess tax burden can be explained using a simple example.

Let us imagine the government is weighing whether to tax apples or bananas. If the government decides to tax apples, those who love apples will switch to bananas because apples are now hugely expensive. In the end, the government generates very little revenue and apple fans are negatively impacted by having to eat bananas, which they don't like. According to tax theory, higher taxes should hit non-elastic demand products.

This logic applies to ordinary goods, while it does not always apply in the case of products that have a negative environmental impact. Economists say that a product has a negative external effect if it affects people other than those buying and selling. If I drive my car in Tallinn, it takes up space, emits CO2 and other pollutants, which have a negative effect on Tallinners and possibly beyond.

Economic theory tells us that products with negative external effects should be taxed to motivate the polluter to dial back their harmful action. Such taxes are referred to as corrective taxes as their aim is to offset harmful external effects.

If I have to pay more to use my car, I may drive less often or sell my car and use a bike instead. Such corrective taxes are most effective when applied to products with very elastic demand. While they will not generate much in terms of revenue, pollution will fall.

I believe the attentive reader has noticed that economic theory recommends applying very different tax policy to products that do not pollute and those that do. In the first case, governments should tax non-elastic demand products, while in the second case, it should be those with elastic demand.

This leads us back to the possibility of environmental taxes serving as win-win taxes. If demand proves elastic, pollution will fall. If demand is non-elastic, the government will generate revenue without resorting to excessive tax burden.

This can be applied to the taxation of vehicles in Estonia.

If demand for cars is very elastic, the car tax will not generate much revenue, while it will lower the number of cars, which will reduce gridlock and air pollution in major cities and help lower CO2 emissions.

If demand for cars is highly non-elastic, the tax will not alter behavior and the additional tax burden cannot be considered excessive. Taxing cars also makes sense from the perspective of social structure. Statistics shows that poverty is widespread among pensioners, while many pensioners do not own a car and are therefore not affected.

The example of Denmark

Interest groups have suggested that laying down a car tax makes Estonia look like a third world country. That is clearly not the case. Almost all European countries tax vehicles, while some of them sport very high tax rates.

I come from Denmark, which is one of the wealthiest countries in Europe. In Denmark, the tax on new gasoline cars is around 100 percent of the cost of the vehicle to which a green usage fee is added, which comes to a lot of money in the case of "thirsty" gasoline cars. High taxes mean that cars tend to be much smaller in Denmark than they are in Estonia and many young people cannot afford to buy a car. Even so, most people in Denmark own a vehicle.

I believe that the taxation of cars will work similarly in Estonia. People will buy smaller cars, families may share a vehicle and some might start to drive less. Our cities will become a little more environmentally friendly and it is hoped that fewer people will be killed or maimed in traffic.

No one likes paying taxes, while those who pay the car tax can at least take solace in knowing that additional revenue is not created through even higher taxation of potatoes, bread and milk.