Market-Based Enviromnental-Policy Instruments.
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 misleading. The fact
that the optimal pollution tax falls short of environmental quality in
the presence of pre-existing taxes suggests that environmental quality
also falls. In a recent paper, I show that this is not necessarily true.
[4] I argue that in second-best analysis, one must distinguish between
issues of "price" -- the optimal tax rate -- and
"quantity" -- the optimal level of environmental quality.
Using a simple analytical general-equilibrium model, I show that an
increase in required government revenue, financed through distortionary
taxation, can lead to both a reduction in the optimal tax on pollution
and an increase in environmental quality. Although the particular
finding is specific to the model in that paper, the more general finding
is that one cannot infer the impact of increased revenue requirements on
optimal environmental quality simply by looking at changes in optimal
tax rates.
Revenue is central to the double-dividend hypothesis, and the role
of environmental revenue-raising in a second-best world has been an
important area of research. Two papers suggest the complexity of that
relationship. Goulder and his coauthors make the important point that
revenue raising per se is not sufficient to ensure an efficiency
improvement in a world with preexisting taxes. [5] If the
environmental-tax revenues are returned to consumers in a lump sum, then
there is no scope for reduction of other pre-existing distortionary
taxes. An environmental tax on pollution with a lump sum rebate of
proceeds has the same economic impact as a cap-and-trade system under
which the tradable permits are given to economic agents at no cost. That
policy was adopted as part of the sulfur dioxide trading system under
the Clean Air Act Amendments of 1990. When environmental-tax proceeds
are returned in a lump sum, there is no guarantee that the adoption of
an environmental tax will enhance welfare.[6] Don Fullerton and I have
shown that raising revenues in order to lower other distorting taxes is
not necessary to achieve a welfare gain.[7] For example, imposing a
small tax on a polluting input used in production and using the revenue
to lower a pre-existing labor tax is equivalent to subsidizing clean
inputs used in production through an increase in a pre-existing labor
tax. In fact, for small taxes, there is a continuum of policies that
might raise revenue lose revenue, or involve no revenue at all, with
identical impact on welfare. Because the focus on revenue can be
misleading, we propose an alternative interpretation that associates the
exacerbation of pre-existing tax distortions with policies that generate
privately retained scarcity rents. The rents interpretation can be seen
most easily in a cap-and-trade program such as the sulfur dioxide
trading program just described. Gaps on sulfur dioxide emissions serve
as an entry barrier for electricity producers. The rents accruing from
barriers to entry into this industry are capitalized into the price of
tradable permits. If the permits go to the electric utility industry,
then the scarcity rents remain in private hands. If, on the other hand,
the government were to sell the permits to electric utilities (or to
anyone else for that matter), the rents would accrue to government, and
there would be no distortionary impact of a new, small environmental
tax.[8] While the disposition of economic rents typically is viewed
simply as a distributional matter, in a second-best world the
disposition of economic rents has an impact on efficiency as well as on
distribution. If the rents are left in private hands, the efficiency
consequences can be large enough to cause a particular environmental
policy to be welfare reducing; if the rents were appropriated by
government, that same environmental policy would be welfare enhancing.
This research assumes that environmental policy instruments can be
targeted precisely. In the real world, however, most environmental taxes
are taxes on proxies for pollution. [9] Goulder examines the
institutional barriers to precise environmental taxation and analyzes
them using a partial-equilibrium model.[10] Fullerton, Inkee Hong, and I
also use a general-equilibrium model with other pre-existing tax
distortions to analyze the welfare losses from mistargeted instruments.
[11] Within plausible parameters, we find that the welfare gain from an
output tax designed to discourage pollution is less that half the gain
from an emissions tax. Although our model is highly stylized, the
welfare losses from mistargeting suggest that the ability to measure and
tax emissions directly produces efficiency gains and thus improvements.
Distribution
Environmental and energy taxes typically are viewed as highly
regressive. This perception has served as an important impediment to the
use of market-based instruments in lieu of command-and-control
regulation. But relatively recent work has questioned the regressive
nature of those taxes. In a number of papers, James M. Poterba argues
that consumption taxes are less regressive when measured over the
lifetime rather than in terms of annual income. His point is certainly
germane to gasoline taxes, which are passed forward to consumers in the
form of higher gasoline prices. [12] In more recent work, I emphasize
that although an environmental tax might be regressive (even on a
lifetime basis), environmental-tax reform easily could be progressive.
[13] What matters for distributional considerations is what tax the
environmental tax replaces. So long as the original tax is more
regressive than the environmental tax, the reform will be progressive.
Finally, it is noteworthy that distributional considerations may ar ise
in other contexts as well. For example, Europeans have long been
concerned with unemployment, and recent research on environmental-tax
policy focuses on the impact of environmental taxes on unemployment.[14]
Bovenberg and Goulder analyze the impact of various carbon dioxide abatement policies on industry equity values. [15] They note that if a
cap-and-trade system with tradable permits in carbon emissions were
adopted, the cost of permits would be borne primarily by consumers, who
would pay higher product prices. Thus, if government wished to hold
corporate shareholders harmless should a cap-and-trade system be
introduced, it would need only grandfather a small fraction of the
permits. Stated differently, the grandfathering of sulfur dioxide
emissions under the Clean Air Act Amendments of 1990 probably
overcompensated electric utilities. However, measuring the degree of
overcompensation is complicated by the fact that electric utilities had
been subject to state regulation up until enactment of the law.
Other Environmental Issues
This report focuses primarily on market-based environmental
instruments, but I'll briefly mention a number of other areas of
active environmental research. Many of the papers I describe here were
outgrowths of a joint NBER-Fondazione Eni Enrico Mattei (FEEM)
conference on environmental policy. Carlo Carraro from FEEM and I
organized that conference. [16] One area of NBER research focuses on the
costs of complying with environmental regulations. To understand how
changes in regulations affect firm behavior and costs, we consider
variations in state pollution regulations, as well as the applicability
of federal regulations (which depends on the overall quality of the
environment in the area). [17] A number of NBER researchers have
investigated the links between economic growth and pollution. [18] A
more recent literature has begun to investigate how pollution problems
(and their solutions) differ between developing versus developed
countries. Policymakers must be very careful about exporting policy
prescription s designed for developed countries to developing countries.
[19] Finally, there is an emerging literature on the role of
information, both in voluntary environmental initiatives and in the
design of research and development programs for pollution abatement.
[20]
Conclusion
General-equilibrium modeling has provided a number of important
insights about the interplay between environmental-tax policy and the
pre-existing tax system. However, much remains to be done to improve our
understanding of market-based environmental policies.
The following is an incomplete research agenda:
* The use of analytical and computable general-equilibrium models
has been beneficial and has served to focus attention on key parameters.
We need more empirical work with microdata to estimate those parameters.
For example, one key parameter for measuring the welfare gains from
better targeting of environmental instruments is the elasticity of
substitution between pollution and other inputs in production. This
elasticity potentially can be estimated from pollution abatement curves
if there are sufficient microdata.
* Environmental policy aimed at combating global warming must take
into account both international factor flows and the possibility of
carbon leakage if international agreements do not include all major
greenhouse-gas emitters. International trade models have considered many
important trade-related issues that arise from such international
agreements as the Kyoto Protocol. But more work at integrating tax and
trade models would yield a large payoff.
* Carbon (and other greenhouse gas) emissions can persist in the
atmosphere for many generations. Given that pollutants may be highly
persistent over time, intergenerational considerations in climate policy
also merit our attention.
* Optimal policy design cannot ignore political-economy
considerations. We have only begun to study how to design environmental
policies that take political constraints into consideration. The
complexity of international climate negotiations, for example, implies
the critical importance of this task.
(*.) Metcalf is a Research Associate in the NBER's'
Program on Public Economics and a professor of economics at Tufts
University.
(1.) D. Fullerton and G. E. Metcalf, "Environmental Taxes and
the Double-Dividend Hypothesis: Did You Really Expect Something for
Nothing?" NBER Working Paper No. 6199, September 1997, and
Chicago-Kent Law Review, 73 (1998), pp. 221-56.
(2.) A. L. Bovenherg and R. de Mooij, "Environmental Levies
and Distortionary Taxation, "American Economic Review, 94(1994),
pp. 1085-9; and I. W. H. Parry, "Pollution Taxes and Revenue
Recycling," Journal of Environmental Economics and Management,
29(1995), pp. S64-S77.
(3.) A. L. Boven berg and I. H. Goulder, "Optimal
Environmental Taxation in the Presence of Other Taxes: General
Equilibrium Analyses, "NBER Working Paper No. 4897, October 1994,
and American Economic Review, 86(1996), pp. 985-1000.
(4.) G. E. Metcalf "Environmental Levies and Distortionary
Taxation: Pigou, Taxation, and Pollution, "NBER Working Paper No.
7917, September 2000, forthcoming in the Journal of Public Economics.
(5.) L. H. Goulder, I. W. H. Parry, and D. Burtraw,
"Revenue-Raising vs. Other Approaches to Environmental Protection:
The Critical Significance of Pre-Existing Tax Distortions," NBER
Working Paper No. 5641, June 1996, and RAND Journal of Economics,
28(1997), pp. 708-31.
(6.) D. Fullerton and G. E. Metcalf "Environmental Controls,
Scarcity Rents, and Pre-Existing Distortions, "NBER Working Paper
No. 6091, July 1997, and Journal of Public Economics, 80(2001), pp.
249-67; and A. L. Bovenberg and L. H. Goulder, "Optimal
Environmental Taxation in the Presence of Other Taxes: General
Equilibrium Analyses."
(7.) D. Fullerton and G. E. Metcalf "Environmental Controls,
Scarcity Rents, and Pre-Existing Distortions."
(8.) This result holds under perfect competition. If the producer
is a monopolist, the distortion persists with complete government
appropriation of the scarcity rents from the environmental policy. See
D. Fullerton and G. E. Metcalf "Environmental Controls, Scarcity
Rents, and Pre-Existing Distortions;" and D. Fullerton and G.E.
Metcalf "Cap and Trade Policies in the Presence of Monopoly and
Distortionary Taxation," forthcoming as an NBER Working Paper.
(9.) For a description of the major environmental taxes in effect
in the United States, see D. Fullerton, "Why Have Separate
Environmental Taxes?" in Tax Policy and the Economy, vol. 10, J. M.
Poterba, ed. Cambridge: MIT Press, 1996.
(10.) A Schmutzler and L. H. Goulder, "The Choice between
Emission Taxes and Output Taxes under Imperfect Monitoring, "
Journal of Environmental Economics and Management, 32(1997), pp. 51-64.
(11.) D. Fullerton, I. Hong, and G.E. Metcalf, "A Taxon Output
of the Polluting Industry Is Not a Tax on Pollution: The Importance of
Hitting the Target," NBER Working Paper No. 7259, July 1999, and in
Behavioral and Distributional Effects of Environmental Policy, C.
Carraro and G. E. Metcalf eds. Chicago: University of Chicago Press,
2001.
(12.) J. M. Poterba, "Lifetime Incidence and the
Distributional Burden of Excise Taxes," NBER Working Paper No.
2833, July 1989, and American Economic Review, 79 (1989), pp. 325-30; J.
M. Poterba, "Is the Gasoline Tax Regressive?" NBER Working
Paper No. 3578, January 1991, and in Tax Policy and the Economy, vol. 5,
J. M. Poterba, ed. Cambridge: MIT Press 1991; and N. Bull, K. A.
Hassett, and G. E. Metcalf "Who Pays Broad-Based Energy Taxes?
Computing Lifetime and Regional Incidence, "Energy Journal, 15
(1994), pp. 145-64.
(13.) G. E. Metcalf "A Distributional Analysis of Green Tax
Reforms, " NBER Working Paper No. 6546, May1998, and National Tax
Journal, 52 (1999), pp. 655-81.
(14.) M. Rauscher "Factor Movements Environmental Policy, and
Double Dividends, " in Behavioral and Distributional Effects of
Environmental Policy, C. Carraro and G. E. Metcalf eds. Chicago:
University of Chicago Press, 2001.
(15.) A. L. Boven berg and L. Goulder, "Neutralizing the
Adverse Industry Impacts of CO2 Abatement Policies: What Does It
Cost?" NBER Working Paper No. 7654, April 2000, and in
Distributional and Behavioral Effects of Environmental Policy, C.
Carraro and G. E. Metcalf, eds. Chicago: University of Chicago Press,
2001.
(16.) C. Carraro and G. E. Metcalf eds., Distributional and
Behavioral Effects of Environmental Policy. Chicago: University of
Chicago Press, 2001.
(17.) R. A. Becker and J. V. Henderson, "Costs of Air Quality
Regulation," NBER Working Paper No. 7308, August 1999, and in
Behavioral and Distributional Effects of Environmental Policy; and A.
Levinson, "An Industry-Adjusted Index of State Environmental
Compliance Costs," NBER Working Paper No. 7297, August 1999, and in
Behavioral and Distributional Effects of Environmental Policy.
(18.) G. Grossman and A. Krueger, "Economic Growth and the
Environment," NBER Working Paper No. 4634, February 1994, and in
Quarterly Journal of Economics, 110 (1995), pp. 353-77; and J. Andreoni
and A. Levinson, "The Simple Analytics of the Environmental Kuznets
Curve," NBER Working Paper No. 6739, September 1998, and in Journal
of Public Economics, 80(2001), pp. 269-86; and D. F. Bradford, R.
Schlieckert, and S. H. Shore, "The Environment Kuznets Curve:
Exploring a Fresh Specification, "NBER Working Paper No. 8001,
November 2000.
(19.) R. Jha and J. Whalley, "The Environmental Regime in
Developing Countries," NBER Working Paper No. 7305, August 1999,
and in Behavioral and Distributional Effects of Environmental Policy.
(20.) Y. Katsoulacos, A. Ulph, and D. Ulph, "The Effects of
Environmental Policy on the Performance of Environmental Research Joint
Ventures," in Behavioral and Distributional Effects of
Environmental Policy; and D. Siniscalco, S. Borghini, M. Fantini, and F.
Ranghieri, "Environmental Information and Company Behavior,"
in Behavioral and Distributional Effects of Environmental Policy.