A Framework to Compare Environmental Policies.

• Author: Fullerton, Don
• Position: Statistical Data Included

Don Fullerton [*]

This paper builds a single model that can be used to show efficiency and distributional effects of eight different types of environmental policies (including taxes, subsidies, regulations, permits, and legal liability). All eight approaches can be designed to have the same efficiency effects, even while they have different distributional effects. For further evaluation of these policies, the paper discusses other criteria outside the simple model (including administrative efficiency, enforcement capabilities, and political feasibility). The paper ends with a discussion of likely trade-offs among these often-competing objectives of environmental policy.

1. Introduction

   To analyze environmental policy proposals, it is important to determine the conditions under which some policies might work better than others. When will a pollution tax work better than the sale of permits or some other alternative? Which is easier to administer or to enforce? Does one policy apply better to some kinds of pollutants than to others? Which policy has a greater chance of getting enacted? This paper provides a framework to compare alternative policies. For each pollutant, in each context, one policy may be more efficient while others better account for competing objectives like administrative efficiency, political feasibility, and fairness.

   Using this framework, the paper will analyze and compare eight types of policies. Clearly no single policy instrument will work best in all cases. Under some circumstances, command and control (CAC) instruments might be necessary, in either of two forms: (i) emission restrictions, sometimes called "performance standards," or (ii) technology restrictions that might be called "design standards." If emissions are difficult or impossible to measure, for example, then the authorities can at least enforce rules that require the proper installation of the required pollution control equipment such as a flue-gas desulfurization unit (scrubber) on every electric power plant, or a catalytic converter on every automobile.

   In other cases that are important to identify, these CAC instruments can be replaced by incentive instruments such as taxes, subsidies, or permits. As suggested by Pigou (1932), the pollution problem could be addressed by (i) taxes on the pollution, or (ii) subsidies to abatement. A Pigouvian tax applies to the pollutant itself, rather than to output, at a rate equal to the pollutant's marginal environmental damages (MED). The term "incentive instruments" includes both the Pigouvian tax and the subsidy to abatement, and it includes two other policies that involve permits such as those traded by electric utilities under the Clean Air Act Amendments of 1990. Those permits could be (i) "grandfathered," or handed out to existing firms in proportion to past emissions, or (ii) sold at auction by the government. A simple analytical model is used below to demonstrate conditions under which the Pigouvian tax is equivalent to a government sale of permits.

   Much of the environmental economics literature finds that the use of incentives is more "cost-effective" than CAC restrictions. [1] With imperfect information, the regulatory authorities may or may not know what is the cheapest form of abatement technology. Thus CAC regulations may require technology that is more expensive than necessary. With a tax or a price per unit of emissions, however, each firm has incentives to find and to undertake any form of abatement that is cheaper than buying a permit. Since only the cheapest forms of abatement are undertaken, these incentive policies can minimize the total cost of achieving any given level of pollution protection. So far, this cost-effectiveness argument does not distinguish between taxes, subsidies, permits that are handed out, or permits sold at auction.

   Yet the handout of permits does not raise any revenue. Thus a new literature in environmental economics concentrates on a distinction between policies that raise revenue (like a tax on pollution or the sale of permits) as opposed to polices that do not raise revenue (like the handout of permits, or a CAC restriction on emissions).2 The model below will be used to reflect on this distinction as well.

   So far, I have listed two CAC policies, two Pigouvian solutions, and two versions of a permit policy. Yet in some cases with well-defined property rights, even with pollution, Coase (1960) shows how the private market can still achieve economic efficiency on its own. Government does not need to intervene at all, except perhaps to help enforce property rights through a court system. Such a Coase solution could specify either that (i) the "victim" owns the "right" to be free of this pollutant, so the firm must buy those rights, or that (ii) the "polluter" owns the rights to pollute, so the victim must pay the firm. The surprising result of the Coase theorem is that efficiency is achieved either way. When contemplating another unit of pollution, the firm faces the same incentives whether it has to pay damages to the victim or instead forgoes a payment from the victim.

   When the conditions of the Coase theorem break down, then the government can improve welfare by a pollution tax or regulation. Each of these policies has been described and analyzed before, many times, but the purpose of this paper is to integrate all of them into a single model that can be used to show when they are equivalent, when they differ, and how they differ.

   The starting point for my analysis is a simple but standard model with no administrative cost, no enforcement problems, competitive firms, and perfect certainty. Under these conditions, I show the equivalence between emission taxes and sale of permits. Both have the same effects on pollution, and the same collection of revenue. For all eight types of policies, the same model is used to show effects on profits, on consumers, and on those who gain from environmental protection. The paper will then consider more complicated circumstances, to help policymakers choose among these policies. With uncertainty, for example, taxes and permits are no longer equivalent (Weitzman 1974).

   For each different pollutant, a different policy may be more feasible to enact, less costly to administer, or easier to enforce. For sulfur dioxide, authorities have been successful with the continuous emissions monitoring necessary to enforce the permit requirements, because electric utilities are large point sources whose emissions can be monitored economically. For other types of emissions, however, measurement may be difficult or impossible. In general, the paper will evaluate these polices with respect to criteria such as (i) economic efficiency; (ii) administrative efficiency; (iii) monitoring and enforcement capability; (iv) information requirements and the effects of uncertainty; (v) political and ethical considerations; (vi) effects on prices that might shift the distribution of burdens between high- and low-income groups, between age groups, or between regions of the country; (vii) other distortions such as taxes, imperfect competition, or trade barriers; and (viii) flexibility in the regulations to deal with transitions and dynamic adjustments.

2. Analytical Model

   To abstract from distributional issues, initially, this section develops a simple model with N identical individuals who have time and other resources they can sell in the market to earn income that can be used to buy goods. These individuals each maximize utility defined over various clean goods, dirty goods, leisure, environmental quality, and a government-provided public good. I will show the initial equilibrium with an uncorrected externality, and I will show the "social optimum" equilibrium. In the simplest model, several different kinds of policies will shift the economy to the same socially optimum allocation of resources.

   A dirty good in this model might be one that creates externalities through consumption of the good, like cigarettes or gasoline, or it might be one that creates externalities during production of the good, like electricity or steel. In other words, the good might be associated with a fixed amount of pollution per unit, or it might have variable emissions per unit of output.

   A general production function for the dirty industry might be written with both the output Y and the waste by-product Z on the left-hand side, where both are produced using inputs like however, I simply rearrange the equation to solve for output in terms of the other variables:

   Y = F(L, K, R, Z). (1)

   In other words, I view emissions as an input with its own downward-sloping marginal product curve (since additional units of emissions are successively less crucial to production). Therefore, in our model, the "dirty" output is produced using labor, capital, other resources, and "emissions." These emissions Z may include gaseous, liquid, or solid wastes. These wastes themselves entail some private marginal cost (PMC) to the firm for removal and disposal.

   This static model considers only one time period, with no saving decision. I assume perfect certainty, no transactions costs, perfect competition, and constant returns to scale production. [3] Thus the variables above can be measured in amounts per capita, but overall environmental quality is determined by total emissions:

   E = E(NZ). (2)

   Each individual gets utility from per-capita amounts of each nonpolluting good (X), polluting good (Y), a good produced at home (H), the total amount of a nonrival public good (G) provided by government using tax dollars, and from environmental quality (E):

   U = U(X, Y, H, G, E). (3)

   The individual maximizes this utility subject to a budget. Each has endowments of time and other resources, and each decides how much of these endowments to sell on the market for wage and rental income to buy X and Y. Remaining time and resources are used to produce the home good, H (child care...