It’s Not a Simple Choice!

Posted by Don Fullerton on Jan 16, 2010

Filed Under (Environmental Policy)

A lot of research in environmental economics is all about the choice of environmental policy: a pollution tax, an abatement subsidy, tradable permits, or some regulatory mandate.  Economists have made two primary distinctions.  One distinction is between a price instrument (like a tax or subsidy) and a quantity instrument (like a fixed number of permits, or nontradable quota).  It’s a bit esoteric, but the choice between those two categories depends on uncertainty about the cost of abatement, and the slope of the marginal abatement cost curve.

A different key distinction is between a market based instrument (like tax OR tradable permits), as opposed to command and control regulations (like quotas or technology requirements).   This distinction is not so esoteric: having a tax or permit price per unit of pollution provides incentives to abate pollution in all the cheapest ways, and therefore minimizes the cost of abatement.  In contrast, regulators may easily require forms of abatement that are much more expensive.  Estimates suggest that command and control regulation can be six times as expensive as using market based instruments.

The point of this blog, however, is that these choices are too simple.  They do not encompass actual policy choices that are not only more complicated, but that cannot even be so categorized.   The “tax” is usually not on pollution itself, but on gasoline or on a car.  Also, virtually every “reform” is a package, and should be considered as a package!  I’ve shown in earlier research that the combination of a subsidy to abatement plus a tax on output can be functionally equivalent to the ideal tax on pollution.

Another “combination” is in the European Union, where a cap-and-trade carbon permit system applies to about half the economy, including electricity generation and major industries, but which does not cover small industries, residences, and transportation.  So they are now considering a carbon tax for the “nontrading” sector.

And anything done in the United States is likely to be a hybrid.  The Congress seems to want a cap-and trade permit system, or at least to call it a cap-and-trade permit system.  But that variable price may have a ceiling, and it may have a floor.  At the extreme, in a hybrid system as the ceiling and floor get closer to each other, the system converges to the single price of a carbon tax.  In other words, it’s not really one or the other.

Despite the complications, it may be worth our while to think about the ideal combination of policies, not the choice among distinct alternatives.