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Executive Summary

A Conceptual Framework to Compare Environmental Tax Shift Policies

By Don Fullerton, University of Texas at Austin

Using emission taxes or auctioned pollution permits to improve the environment would raise revenue that could be used to reduce existing taxes on labor and investment. To clarify the debate about such "tax shift" proposals, this paper examines the choices among various types of environmental policies in light of competing objectives like economic efficiency, political feasibility, and fairness. The paper builds a simple economic model to analyze and compare a list of eight policies with respect to a list of eight criteria.

The paper has two major parts: The first provides the analytical machinery necessary to demonstrate how the various policies work and conditions under which they have identical effects. The second defines the many goals and objectives of policymaking; that is, conditions under which the various policies differ.

Part I: Analytic Machinery

Clearly no single policy will work best in all cases.For example, the current type of command and control (CAC) instruments, such as emission or technology restrictions, might sometimes be necessary for political or administrative reasons In other cases that are important to identify, these instruments can be replaced by "incentive instruments" such as taxes, subsidies, or permits. As suggested by Arthur Pigou in 1932, the pollution problem can be addressed by (a) taxes on pollution, or (b) subsidies to abatement. The term "incentive instruments" includes both of those Pigouvian solutions, and it includes two other policies that involve permits. These could be (a) "grandfathered," or handed out to existing firms in proportion to past emissions, or (b) sold at auction by the government. The simple analytical model is used 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. Regulatory authorities may not know what is the least expensive form of abatement technology, but a tax or a price per unit of emissions gives the firm incentives to implement the cheapest methodologies, thus minimizing the total cost of achieving any given level of pollution reduction. So far, this "cost-effectiveness" argument does not distinguish among taxes, subsidies, permits that are handed out, or permits sold at auction. Yet the handout of permits does not raise any revenue. Thus recent research concentrates on a distinction between policies that raise revenue (like a tax or permit auction) as opposed to policies that do not (like the handout of permits or a CAC restriction).

For cases with well-defined property rights, Ronald Coase in 1960 showed how the private market can still achieve an efficient outcome on its own. Government does not need to intervene, except perhaps to help enforce these property rights. Such a Coase solution could specify either that (a) the "victim" owns the "right" to be free of this pollutant, so the firm must buy those rights, or that (b) 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: The firm faces the same "cost" per unit of pollution whether it has to pay damages or instead forgo a payment.

This paper integrates all eight of these solutions into a single model that shows when they are equivalent, when they differ, and how they differ. The paper also describes a new type of policy, a "two-part instrument," that combines the carrot and the stick in a way that can achieve the same effect as the tax or sale of permits. The first part of this policy is a tax on output (to reduce demand for the polluting good) and the second part is a subsidy to clean inputs such as labor, capital, and materials (to induce substitution away from emissions). If those clean inputs are already subject to income taxes, then this "subsidy" just means a reduction in the tax that would otherwise be collected. The result is analogous to a deposit refund system: The firm pays a deposit on all of its output, and receives a refund to the extent that this output was produced using clean inputs rather than dirty inputs (i.e., emissions).

Part II: The Goals and Objectives of Policymaking

The starting point for the analysis is a simple model with no administrative cost, no enforcement problems, competitive firms, and perfect certainty. Under these conditions, we show the equivalence among three of the policies: emission taxes, sale of permits, and the two-part instrument. All have the same effects on pollution and the same collection of revenue. The paper then considers more complicated circumstances, in order to help policymakers choose among these policies. With uncertainty, for example, taxes and permits are no longer equivalent. Taxes have a certain cost to the firm but uncertain effect on abatement. On the other hand, permits require a certain level of abatement but unknown level of cost. Clearly some of these policies will be more feasible to enact, less costly to administer, or easier to enforce.

The paper evaluates these polices with respect to the following criteria: (1) economic efficiency; (2) administrative efficiency; (3) monitoring and enforcement capability; (4) information requirements and the effects of uncertainty; (5) political and ethical considerations; (6) effects on prices that might shift the distribution among cohorts or demographic groups; (7) other distortions such as taxes, imperfect competition, or trade barriers; and (8) flexibility in the regulations to deal with transitions. The new policy will result in a new allocation of resources; that is, new jobs in different industries at new locations. The policy needs to be coordinated with other goals of environmental protection, antitrust enforcement, and international competitiveness. The paper suggests that environmental tax shifts can be constructed which would protect disadvantaged groups, help those who lose their jobs, help create new jobs, and even renew urban areas by promoting the development of brownfields in cities.

About the author

Don Fullerton is Addison Baker Duncan Centennial Professor of Economics at the University of Texas at Austin. Before joining the University of Texas in 1994, Mr. Fullerton taught at Carnegie Mellon University (1991-94), the University of Virginia (1984-91), and Princeton University (1978-84). From 1985 to 1987, he served in the U.S. Department of the Treasury as the Deputy Assistant Secretary for Tax Analysis. He earned his undergraduate degree at Cornell University and his Ph.D. at the University of California at Berkeley.

In the area of taxation, Mr. Fullerton is best known for studies of marginal effective tax rates, the effects of taxes on investment, and distributional effects. His recent work in environmental economics has focused on policies to affect household disposal of garbage and recycling, policies for green design, and the effects of the Superfund clean-up program. He is author or co-author of many journal articles and several books, including: The Taxation of Income from Capital: A Comparative Study of the U.S., U.K., Sweden, and West Germany, edited with M. A. King, (1984); Who Bears the Lifetime Tax Burden?, with D. L. Rogers (1993); and Footing the Bill for Superfund Cleanups: Who Pays and How?, with K. N. Probst, R. E. Litan, and P. R. Portney (1995). His current research considers cases where the ideal tax on a pollutant is infeasible, because the pollutant cannot be measured, and then investigates whether the same incentives to reduce pollution can be achieved by a combination of tax and subsidy rates on other goods.

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