Today the Environmental Audit Committee published a report focusing on the implications of Budget 2011 for environmental taxes. One of the key recommendations was that in order to "... build trust and acceptance of environmental taxes", consideration should be given to "... greater use of at least partial hypothecation of revenues from environmental taxes [for environmental ends]." What does this mean, and is this a good idea?

'Hypothecation' means earmarking tax revenues for specific, identified purposes. 'Pure hypothecation' would see spending on a particular programme linked directly to the revenue raised by a particular tax or set of taxes: the licence fund used to finance the BBC is perhaps the best example of this. 'Incremental hypothecation' would see revenues raised from tax increases used to raise spending on a particular public service: net revenues from London's congestion charge, for example, are spent on public transport in London. A related concept is that of a 'tax switch', where revenues from new or increased taxes in one area are used to pay for cuts in other taxes. When the Climate Change Levy (CCL) was introduced in 2001, a 0.3 percentage point reduction in employer National Insurance Contributions (NICs) was also implemented with the idea that the overall package would on average be 'revenue neutral' for businesses.

But hypothecation has significant problems. In particular:

1. With pure hypothecation, it is highly unlikely that the optimal amount to spend on a particular programme will be the same as the optimal amount of money raised from a particular tax. The tax base may also be volatile, which would lead to inappropriately volatile spending, and (particularly for environmental taxes) may even erode away over the long term if behaviour changes. Governments should be seeking to raise revenue in the most efficient way possible and to spend that revenue in the most efficient way possible. It is highly unlikely these objectives will marry up neatly in a way that justifies pure hypothecation.

2. With incremental hypothecation, it is usually impossible to verify that the government's promises have actually led to any changes in the allocation of spending. Suppose, for example, the government took the advice of the Environmental Audit Committee to use higher fuel duties to raise spending on public transport. Without detailed plans for expenditures in the absence of the tax increase - which certainly do not exist beyond the current Spending Review period - it would be impossible to verify that this is actually how the extra receipts had been spent.

3. In the past some promises of hypothecation have turned out to be meaningless. Revenues from the Aggregates Levy, introduced in 2002, were earmarked for a 0.1 percentage point cut in employer NICs and a "Sustainability Fund" which paid for projects to reduce the local impacts of extracting aggregates. This fund, however, was abolished in the 2010 Spending Review without any commensurate cut in the Levy. Similarly the 'revenue neutral' cut in NICs following the CCL introduction has been anything but: the cost of lower NICs has significantly outweighed the receipts from the CCL. For example, in 2011-12 the CCL is forecast to raise £0.7 billion. However, increasing employer NICs by 0.3 percentage points would raise around £1.3 billion.

What about the benefits of hypothecating green taxes for environmental spending as a means to increase public support for green taxes? While winning public support is clearly an important consideration for policy makers, it should not be an excuse for poor policy making. It may well be true that there is a clear rationale both to raise green taxes and to spend more on environmental objectives. But if so the case for each should be made on its own merits rather than making one contingent on the other. It is hard to disagree with the Committee's conclusion that the Government needs to take "... a more coherent and clearly articulated approach to environmental taxes ... setting out their objectives and rationale, the basis on which rates are set and how their impact will be evaluated." Doing so could in itself help instil public support for green taxes, rather than relying on hypothecation which at best would be meaningless and therefore misleading, and at worst inefficient.