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Energy, Inflation, and Taxes by Sven R. Larson

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Energy, Inflation, and Taxes

Europe is suffering from inflation in excess of 9%, with Estonia, Latvia, Lithuania, the Netherlands, and Slovakia above 13%.

There is a great deal of uncertainty surrounding inflation: has it peaked, as the most recent numbers indicate, or will it continue to rise? As if this uncertainty was not enough, there is an unending stream of troubling, energy-related news: the new British prime minister is considering a “freeze” on energy bills; the Swedish parliament just panic-bailed out power companies; a German fertilizer company announced production halts due to exorbitant energy costs; the French president predicts of the “end of abundance.”

And now, emerging public protests link sanctions against Russia to the growing strife of everyday life.

Inflation causes economic turmoil, which causes uncertainty, and uncertainty is venomous to the economy. It is also a catalyst for political instability—something our political leadership hates.

They will do anything they think is necessary to quell instability. That, however, does not necessarily mean they will respond in such a way that the underlying problem—in this case high inflation—is solved. When politicians have their backs against the wall, when they have to react instead of proact, they always protect their short-term political survival first.

Sadly, this means that we the people may have to protect ourselves against the crippling effects of high inflation.

An essential starting point of such do-it-yourself politics is to learn as much as there is to learn about what inflation is and its origin. That way, IKEA-assembling our own anti-inflation strategy becomes a lot easier.

This essay does not provide a plug-and-play survival guide to inflation. My goal is instead to explain where you can go, and what information you can find, in order to educate yourself on inflation, specifically energy costs.

There are many statistical resources out there, but only one of high quality that cuts across all of Europe. That source is Eurostat, the statistics agency of the European Union. Their detailed and highly informative energy database breaks down the numbers in multiple ways, including by country.

One of the best features of this database is its numbers on electricity prices. Figure 1 below reports year-to-year changes in the average electricity price for the 27 member-state EU. The solid blue line represents inflation in the average price per kilowatt hour, kWh, for end users (think households). The dashed blue line represents the same price changes including taxes.

The red line is the inflation rate for electricity prices as reported under Eurostat’s Harmonized Index on Consumer Prices. The timeline on the horizontal axis is semi-annual, with “S1” representing the first half of each year and “S2” the second half.

Figure 1

Source: Eurostat

But how is it possible that the red line, in other words the HICP-based price, changes at different rates than the end-user prices?

The reason is explained in a methodological note from Eurostat. The prices they track

are defined as the prices actually paid by purchasers for products, including any taxes less subsidies on the product after the deduction of discounts from standard prices or charges

The blue-line prices, which are from the aforementioned energy database, do not take into account any subsidies.

In addition to the apparent differences depending on statistical methodology, Figure 1 has three interesting things to tell us.

First, from 2009 to 2019, end-user prices for electricity have risen faster when taxes are taken into account than when taxes are excluded. For the entire 11-year period from 2009 through 2019, the average annual increase in before-tax end-user electricity prices is 1.6%, but 2.9% when taxes are included.

This is a substantial difference, showing how governments cause inflation by raising taxes. It is also an observation that will help us explain today’s high inflation numbers.

The motive behind higher taxes is likely the official desire to “transition” the economy toward “renewable” energy sources. In reality, such vanity-laced motives are often just a shiny coating on the good old government hunt for as much tax revenue as it can get its hands on.

One indication of this is the red line in Figure 1, which again represents the HICP-based electricity price index. According to this price index, electricity price inflation for the aforementioned 11-year period was 2.9%.

This is identical to the end-user price inflation with taxes included. Since the HICP price index adjusts for both taxes and subsidies, we can conclude that subsidies had no effect on electricity prices in Europe during the period from 2009 through 2019.

If government had truly wanted an energy transition, they would have provided subsidies for those energy sources on par with taxes on “undesirable” energy sources. Figure 1 shows us that this is not the case. On the contrary, all government has done is add a tax burden that for the period in question almost doubled inflation in electricity prices.

Then comes the pandemic and its 2021 aftermath. Interestingly, energy-price inflation did not start with the Russian invasion of Ukraine. Let us take a closer look at the most recent numbers, for the years 2019-2021:

Figure 2

Source: Eurostat

In the first half of 2021, the HICP electricity price shoots up by 5.6% compared to the first half of 2020. In analyses of other consumer markets, a similar spike for 2021 is often dismissed with the point that prices fell during the artificial economic shutdown in 2020. However, as is evident in Figure 2, in the first half of 2020 electricity prices fell by 0.6%, which is barely enough to register in the data.

For two reasons, the spike in electricity prices in 2021 cannot depend primarily on the shutdown that began in 2020.

  • Capacity. There was a sharp increase in demand for electricity when the economy opened up again. However, that increase was preceded by an equally sharp drop in demand during the previous year. Prior to that drop, Europe supplied itself with electricity under a sound balance between supply and demand. When demand declined in 2020, production capacity was left idle—it was not destroyed or otherwise permanently taken out of business. Therefore, when demand increased again, the idle capacity went back to work.
  • Supply and demand. If the sharp rise in electricity prices in 2021 were driven by rapidly rising demand, then logically the preceding sharp drop in demand in 2020 should have caused a decline in prices of similar magnitude. The reason for this is in the so-called price elasticities of supply and demand. A change in demand for a product—in this case electricity—has to have the same price-and-demand effects in, so to speak, both directions. Unless very specific conditions are met, it cannot be the case that a rise in demand drives up the market price while a fall in demand does not.

In other words, looking at Europe’s electricity prices from the highest point of overview, we see inflation in those prices start already in 2021.

But where did this inflation come from?

I would suggest that taxes are to blame, but the evidence is not as apparent as for the period 2009-2019, when tax-included prices on electricity rose faster than net-tax prices.

In short, I urge caution here based on the numbers reported in Figures 1 and 2. There, we see that the spike in electricity prices in 2021 is higher when we rule out taxes than when they are included. In the first half of 2021, end-user prices, before taxes, increased by 2.7% while the tax-included price only rose by 0.6%. The difference is even bigger for the second half of that year.

Despite this, taxes could indeed be an explanation for the rise in electricity costs. To see why, let us first dissect the taxation mechanism that could be our inflation culprit.

There are two parts to this mechanism, the first of which has to do with how taxes apply to electricity bills. According to Eurostat’s energy-price database, prices are higher for consumers that use less electricity, and lower for large consumers. Since lower-income households tend to use less electricity than well-to-do households, this price bias is to the disadvantage of the former.

Figure 3 reports electricity prices without taxes, for five categories of consumers. The categories are differentiated based on how many kilowatt hours they use per year:

Figure 3

Source: Eurostat

An average household falls somewhere in the middle here. There is no suitable consensus among statistical sources as to how much electricity an average European family uses, but most estimates fall within the 4,000-8,000 kWh per annum (depending primarily on income and geographic location).

Interestingly, the tax burden is reversely distributed. Figure 4 reports the tax an electricity user has to pay on his electricity bill, per euro of electricity. For example, in the first half of 2007, the smallest consumers of electricity paid a bit over 41 cents in taxes for every €1 they paid for electricity:

Figure 4

Source: Eurostat

In addition to being redistributive, the tax burden increased steadily over the past decade. This means that when electricity consumption increases, so does the tax burden. This in itself can cause inflation, but not necessarily the kind we are witnessing right now. After all, as we saw earlier, pre-tax electricity prices rose faster in 2021 than prices including taxes.

Nevertheless, I maintain that taxes may play a role in our current electricity-price inflation, one reason being found in Europe’s widely used value-added tax, or VAT. This tax can drive inflation just by virtue of its existence.

Here is how it works. Using a purely hypothetical example, suppose you pay €3 for a gadget. Government considers the gadget to be an environmentally bad product, so they put a 5% “green tax” on it. The VAT is 19%.

If each tax is applied to the tax-free price of €3, then adding the two taxes to the original price gives us a sales price of €3.72. However, if the VAT applies to the €3 base price as well as the green tax, the total out-the-door price for you the consumer will be €3.75.

Not a difference worth arguing about, right? Well, let’s see what happens if we raise the green tax while keeping the VAT constant at 19%. A doubling of the green tax to 10% raises the total price from €3.72 to €3.87 when the VAT applies to the base price, and from €3.75 to €3.93 under the tax-on-tax model.

In terms of inflation, this is the difference between 4% and 4.8%.

And now for the grand finale: how higher taxes could drive inflation despite the curious results we saw in Figures 1 and 2. If EU member states recently raised so-called green taxes, and if those increases happened during or just after the pandemic-related economic shutdown, then as the economy opened up again, households and businesses faced rapidly rising electricity costs.

In response, they reduced their overall use of electricity. Per Figure 4, this would mean that the tax burden on their electricity bill actually falls—while prices are rising. Since the tax burden is lower for smaller users, even modest cuts in electricity consumption will alleviate some of the inflationary effects through a somewhat lighter tax burden.

Again, this explanation is general for the EU as a whole. It is also based primarily on available price data; sadly, Eurostat does not publish actual kWh usage along the same breakdowns as we see in Figures 3 and 4. If they did, we could easily determine whether or not the average electricity user has cut down kilowatt-hour consumption.

Despite the lack of complete data, as demonstrated here, we do have good reasons to ask to what extent tax hikes have contributed to electricity-price inflation in the past two years. Therefore, if our governments refrained from further tax hikes in the near future, and instead chose to alleviate the tax burden on electricity, they could do more to help struggling families and businesses than by any other means.

Sven R. Larson is a political economist and author. He received a Ph.D. in Economics from Roskilde University, Denmark. Originally from Sweden, he lives in America where for the past 16 years he has worked in politics and public policy. He has written several books, including Democracy or Socialism: The Fateful Question for America in 2024.