Bridging the natural catastrophe protection gap with taxes and insurance

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In a chain reaction of events, the destruction and disruption by natural calamities and disasters lead to financial hardships for households and businesses. And as governments shift their response to these hardships from rescuing lives, to providing relief, and restoring income generation opportunities for households and businesses, predictably they look to raising taxes to finance efforts.

After an earthquake in 2016, for example, Ecuador increased its value added tax (VAT) from 12% to 14% for one year and levied a one-off tax of 0.9% on people with wealth over $1 million and a one-time tax of 3% on business profits. This was in addition to access to $300 million in emergency funding from the Ministry of Finance and a contingency credit line worth more than $600 million from multilateral lenders. And after the 2011 Tohoku earthquake, Japan introduced a 2.1% temporary surtax on income for 25 years (2013–2037) to finance reconstruction.

Likewise, in 2015, the Indian government temporarily raised taxes on tobacco and spirits by 5% to finance new crops in Maharashtra State after severe drought had caused crop failure. A high-level committee is now considering tweaking the nationwide goods and services tax regime to mobilize revenue for rebuilding after natural calamities.

In many countries, including the United States, the tax code offers both long-standing tax breaks and temporary tax relief for specific disasters.

Taxation is an essential tool for social engineering in developing Asia. But for direct taxes (e.g., income tax), even though the contribution could be attained through  progressively higher taxation rates, any policy measure will be seen as a “tax on honesty” given that tax evasion is so widespread.

By contrast, indirect taxes (e.g., VAT on commodities and services) are broad-based and fall uniformly on the rich and the poor. Such taxes are collected in small amounts at the time of purchase, and taxpayers do not feel the pinch. And because they are built into the price, they cannot be evaded. When imposed on luxury items or undesirable or harmful items, they are considered equitable. They are very elastic in yield when imposed on essential goods and services that have inelastic demand, and can yield substantial revenue because people must buy these things. However, they raise prices, for rich and poor, in that businesses are likely to pass the tax on to consumers. Moreover, because hidden in the amount, the taxpayer is unaware of paying tax and therefore it does not help develop public awareness about natural calamities or incentivize disaster risk reduction. Any decision to impose such a tax regime should be accompanied by simultaneous policy measures to reduce negative externalities.

Although revenue soaked up through additional taxation is likely to guarantee aid in the form of ex-post relief, such a compensation mechanism may effectively reward bad behavior by governments who under-invest in loss prevention or allocate it to other uses. This is not to say that buildings will not be built to withstand earthquakes or there would be no spending on land-use management. Rather, it is that, at the margin, less money will be spent on preventive activities. Assuming that citizen welfare is not a substitute for government income and that disaster risk reduction is a normal good whose consumption increases with income, governments when prioritizing their spending will allocate less to disaster prevention because they are fully aware of the possibility of a bailout through additional taxation in the event of a disaster. This thus raises the overall expected impact of a natural shock.

Compared to households, who risk being wiped out by disaster, governments of large countries usually face damages to only a small fraction of the economy. At the central level, they normally smooth expenditure on disaster relief from current income and tend to spend less on prevention relative to relief. Moreover, a localized shock at the state level is likely to have little impact on central government revenue compared to that of the state government. Since the occurrence of the shock is uncertain and the level of spending is set ex-ante, loss prevention or formal insurance is viewed as costly while relief through additional taxation is seen as free. Governments are therefore more willing to forego prevention and spend only when a disaster occurs. And this ex-post revelation of under-investment in risk mitigation therefore does not apparently indicate government misjudgment.

On the other hand, if relief and prevention are complements, the inflow of assistance from the additional taxation may cause an increase in preventive spending. Governments looking to maximize their income while simultaneously focusing on social welfare can make people better off by spending more on disaster mitigation and putting in place ex-ante risk financing mechanisms, like insurance, to lessen the impact of potential shocks.

Another important point is that the definitions of disaster are unclear—and often ignored by governments. And sometimes the definitions are arbitrary or politically motivated. In the extreme case, governments could deliberately avoid financing post-disaster relief, or rehabilitation, or reconstruction. The relevant question to be posed is whether such a compensation mechanism generates a moral hazard, resulting in under-investment in disaster risk reduction. How governments define and classify calamities, and how such classification can help establish the triggers for disbursing benefits, needs to be transparent so that the use of taxes for disaster risk financing can become independent of political considerations.

As such, ringfencing the additional funds mobilized by setting up a dedicated catastrophe insurance pool for the potential reduction in losses to taxpayers after a disaster has occurred needs to be actively considered to improve preparedness to manage the impacts of residual risks. Embedding (re)insurance, together with an integrated approach to disaster and climate risk management, will enhance the quality and impact of risk financing decisions by state governments. The pool can help optimize national 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. The valuable role of risk sharing and risk transfer instruments, and their ability to make rapid and predictable payouts transparently, while effectively smoothening the fiscal impacts of shocks, is well recognized. If losses are lower than expected, the surplus can accrue to the pool, and if there is a deficit, it can justify the need to raise more funds post-disaster.

The predictability of up-front payment of insurance premiums from additional taxes, with proportionate contributions from the state governments that reflect their actual risk exposure, can help structure a portfolio of diversified risks across geography, portfolio, and time. This will enable the pool to offer cost-effective insurance coverage after negotiating the purchase of higher limits of reinsurance at a lower cost.

If integrated within a comprehensive national disaster risk financing strategy and anchored on a risk-based premium tariff it can ensure financial sustainability by offering (i) innovative insurance solutions and (ii) uniformity in coverage through standardized policy wording, and by (iii) reducing the drivers of risk, (iv) eliminating duplicate claims, and (v) incentivizing investment in financial resilience and more spending on mitigation. Without transparency in risk pricing, there can be no incentive to any government to improve the risk landscape.

A portion of the funds can also be earmarked for strengthening disaster preparedness and crisis response by promoting insurance literacy, greater institutional capacity, and accessing disaster risk data available for catastrophe modeling.

Planning for financial response options instead of relying on fundraising efforts in the aftermath of disasters by any government is a welcome. By integrating with insurance, the use of incremental funds mobilized through taxation can help better leverage capital and target benefits for citizens.

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