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India Insurance Report - Series II 75

2. Sovereign Risk Financing

Given the uncertainty of the occurrence of a shock, governments normally smooth expenditure on
disaster relief from current income. 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. A localized, provincial
shock is likely to have little impact on the revenue of the national government compared to that of the
provincial government. Although revenue from taxation may not guarantee ex-post relief, even if it does,
it may reward bad behaviour by governments. 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.
The level of ex-ante spending on loss prevention or risk financing is viewed as costly, and therefore, they
tend to spend less on prevention relative to relief.

Further, the increasing frequency and severity of natural hazards and extreme weather events have
raised the economic costs associated with these events. Government finances are vulnerable on two
fronts. First, economic activity may contract in the short term, lowering revenue collection. Second,
post-disaster relief and reconstruction efforts may increase government expenditure and crowd out other
priority spending, with potentially long-lasting effects on human capital accumulation and an economy’s
potential growth rate.
Both physical and transition risks impair asset values and the credit quality of loans and investments
from banks, financial institutions, insurers, and capital markets. In the absence of appropriate
countercyclical financing mechanisms, like income-smoothing social safety nets and public insurance
schemes, this can create sizeable implicit contingent liabilities for governments.

Yet, governments have been slow to integrate climate risk and its threat to financial systems into
their decision-making and strategies. Governments looking to maximize 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.

3. Additional Taxation

Since disaster relief is also about raising additional revenues to finance such efforts, governments
can consider additional taxation. Developed countries provide some good examples. 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, one-off national flood reconstruction income tax to rebuild infrastructure.

A few 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’s GST
Council has been in discussion for 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.