Market-Based Enviromnental-Policy Instruments.

• Author: Metcalf, Gilbert E.

Gilbert E. Metcalf [*]

The Glean Air Act Amendments of 1990 ushered in a new era in environmental policy, constructing a market in tradable permits for sulfur dioxide emissions at electric utilities in the United States. This law was a watershed in many ways because it was the first large-scale initiative in the United States to use a market-based instrument to manage pollution. Prior to 1990, discussion and analysis of market-based instruments (for example, cap-and-trade systems, environmental taxes, and subsidies to clean production) had been theoretical for the most part because the United States, and most other developed countries, relied primarily on command-and-control regulation to reduce pollution. Interest in market-based instruments has been heightened by concerns about global warming and the role of carbon emissions. The Kyoto Protocol calls for substantial reductions in carbon emissions , and carbon taxes have been seen as a possible instrument for achieving those targets.

My work over the past five years or so has been concerned with two aspects of market-based environmental instruments: design considerations for market-based instruments in the presence of pre-existing tax distortions and distributional implications of environmental-tax reforms.

Instrument Design in a Second-Best World

The increasing focus in the 1990s on the possibility of market-based instruments along with ongoing concerns about the magnitude of distortionary taxation both in the United States and in Europe, suggested the possibility of using environmental taxes to replace existing factor and commodity taxes. A conjecture dubbed the "Double-Dividend Hypothesis" made the valid point that environmental taxes have two benefits: they discourage environmental degradation and they raise revenue that could offset other distortionary taxes. While the conjecture as stated is certainly correct, its policy implications are not so clear-cut. [1] For example, what are its implications for optimal environmental-tax rates? In a world with no pre-existing taxes, the optimal tax rate on pollution is equal to marginal environmental damages. Because Pigou is credited with this result, the term Pigouvian tax rate is often used to characterize environmental taxes set equal to marginal environmental damages. According to one view, the double- dividend hypothesis implies that the optimal tax rate on pollution should exceed the Pigouvian tax rate. This was "proved" in partial-equilibrium models, so long as the environmental-tax revenue elasticity at the optimal rate was positive. In other words, these models suggested that a pollution tax should be higher than marginal environmental damages if that higher tax rate would raise revenue so that other distorting taxes could be lowered. Lans Bovenberg and Ruud de Mooij constructed a simple general-equilibrium model to show that this result was incorrect. [2] They note that an environmental tax, although beneficial from an environmental point of view, is still distortionary and could exacerbate pre-existing tax distortions. Imagine, for example, that the only other tax in effect is on wage income, thus causing the supply of labor to fall short of the efficient level. An environmental tax will raise product prices (or reduce factor incomes) so that the real wage falls, thus causing labor supply to fall fur ther. More simply put, an increase in an environmental tax is analogous to an increase in the tax rate on wage income. Since there is already a deadweight loss in the labor market, any increase in taxes has a first-order effect on welfare. Lawrence H. Goulder, who quantifies this in a number of papers using a computable general equilibrium (CGE) model of the U.S. economy, finds, for example, that the optimal carbon tax, the proceeds of which are used to reduce personal income taxes, falls short of marginal environmental damages by 27 to 65 percent, depending on the magnitude of those damages. [3]

This focus on second-best tax rates is important for policy setting, but for purposes of considering the impact of pre-existing tax distortions on environmental quality, it can be...