Financing catastrophes through taxes

Published on Monday, 15 April 2019

Published by Arup Kumar Chatterjee on Monday, 15 April 2019

Taxation can help developing countries pay for post-disaster reconstruction.
Taxation can help developing countries pay for post-disaster reconstruction.

Destruction and disruption by natural calamities lead to financial hardships for households and businesses. With disasters in Asia and the Pacific, becoming more frequent and costlier, governments need to rethink their response beyond rescuing lives, providing relief, and restoring income generation opportunities for households and businesses.

Since disaster relief is also about raising additional revenues to finance such efforts, governments should consider tapping into taxation.

There are some good examples from developed countries. The United States tax code offers both longstanding tax breaks and temporary tax relief for specific disasters. After the 2011 earthquake, Japan introduced a 2.1% temporary surtax on income for 25 years (2013–2037) to finance reconstruction. Likewise, the Australian government responded to the 2011 Queensland floods by levying a one-year, a one-off national flood reconstruction income tax to rebuild infrastructure.

Developing countries are also exploring the potential of taxes to finance disaster relief. Ecuador paid for a 2016 earthquake by increasing the value-added tax rate from 12% to 14% for one year, and imposing one-off taxes of 0.9% on people with wealth over $1 million and 3% on business profits. India is now considering tweaking the nationwide goods and services tax to mobilize revenue for post-disaster rebuilding, and in 2015 the state of Maharashtra temporarily raised taxes on tobacco and spirits by 5% to help farmers recover from drought.

  Developing countries exploring potential of taxes to fund disaster relief

Value-added tax has great potential to finance disaster resilience via taxation. Unlike contributions through progressively higher rates on income tax, which are widely perceived as a "tax on honesty" due to widespread evasion, a value-added tax is broad-based and falls uniformly on the rich and the poor. Being built into the price, the value-added tax cannot be evaded, and taxpayers do not feel the pinch as much because the amounts are small. 

This type of tax can generate substantial revenue when imposed on essential goods and services, and is considered equitable when levied on luxury or harmful items. Since the taxpayer is unaware of paying this tax, building public awareness about natural calamities and incentivizing risk mitigation would both be detrimental.

Although revenue from additional taxation guarantees can help ex-post relief, it may however reward bad behavior by governments. Compared to households, which risk being wiped out by a disaster, governments usually only have to deal with damage to a fraction of the economy.

At the national level, governments normally smoothen expenditure on disaster relief from current income and therefore tend to spend less on prevention relative to relief. A localized shock at a provincial level is likely to have little impact on the revenue of the national government compared to that of the provincial government.

  Using VAT to pay for post-disaster recovery has pros and cons

Given that the occurrence of the shock is uncertain, the level of ex-ante spending on loss prevention or risk financing is viewed as costly. If a future bailout through additional taxation is seen as cost-neutral, governments are more willing to forego prevention and spend only when a disaster occurs.

While imposing new taxes to finance disaster recovery is less than ideal, they can certainly be used to fund preventive spending. Governments looking to maximizing their revenue while simultaneously focusing on social welfare can make people better off by spending more on disaster mitigation, and by putting in place ex-ante risk financing mechanisms to lessen the impact of potential shocks.

If they truly desire to improve preparedness and manage the impacts of residual risks, governments should actively consider setting up dedicated catastrophe insurance pools for ring-fencing additional revenues mobilized via taxation. Embedding insurance—together with an integrated approach to disaster and climate risk management—will enhance the quality of risk financing decisions.

Such a pool can help optimize risk retention by covering less severe but more frequent losses with low return periods, and transferring less frequent but more severe losses through reinsurance and alternative risk transfer solutions, which are recognized for making rapid and predictable payouts transparently. If losses are lower than expected, the surplus can accrue to the fund, and if there is a deficit it justifies the need to raise more revenue.

  NZ national disaster fund shows the way on managing disaster risk

A good example is New Zealand's Earthquake Commission established in 1945 a National Disaster Fund, which had over $6.1 billion in accumulated funds before the 2010 Christchurch and Kaikoura earthquakes, financed by levies paid by citizens as part of their home and contents insurance policies and investment returns. The EQC purchases reinsurance to meet first loss claims in the event of a major natural disaster, allowing all the money to be used if necessary. The Commission can also receive additional financial support from the government to meet all outstanding claims if the fund is fully spent. Until the 2010 events , this option known as the Crown Guarantee was never used.

The predictability of upfront payment of insurance premiums—coupled with proportionate contributions from local governments, businesses and households that reflect their actual risk exposure—can help offer cost-effective and sustainable insurance coverage.  Transparency in risk pricing likewise contributes to improving the risk landscape by spending more on loss mitigation, and structuring a portfolio of diversified risks across geography, portfolio, and time.

Advance planning for a financial response instead of relying on post-disaster fundraising is a welcome effort by any government. Targeted taxation can have a real impact when linked to risk reduction and risk transfer activities that private households and firms take. A favorable tax treatment can encourage people to purchase insurance, expand the size of the insurance market and enhance the ability to pool risk, resulting in lower premiums and less government expenditure after a catastrophe.

Promoting insurance coverage for individuals and firms through direct taxation by integrating it with insurance purchase, and combining it with incremental funds mobilized through indirect taxation can help people get back on their feet. The advantage of insurance is that this does not directly reduce economic activity today, but rather spreads the cost of rebuilding over many decades into the future.