In addition, an efficient pattern of response to pollution problems might involve relocation by firms or households; White and Wittman (1982) discuss the possible contribution of pollution taxes to efficient location decisions It has been

recognised that certain types of abatement and defensive measures can complicate greatly the achievement of an optimal level of pollution abatement (Coase, 1960; Shibata and Winrich, 1983).

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(ii) Dynamic Incentives for innovation. In addition to these "static" cost-minimisation properties of emissions taxes, taxes and other environmental market mechanisms may also provide a "dynamic" incentive for the development of further cost-effective methods of pollution control. The source of these dynamic improvements is the fact that, even at the static optimum, the environmental tax continues to be paid on remaining units of emissions - thus providing an incentive to search for technological innovations that will reduce still further the optimal level of emissions (Wenders, 1975; Magat, 1978; Milliman and Prince, 1989).

Emissions taxes® will give a greater incentive for such innovations than command-and-control regulations, which merely constitute an incentive for the minimum necessary compliance. However, it is not clear whether emission taxes, alone, can be expected to secure the first-best level of innovation. Carraro and Topa (1991) show a model in which emissions taxation leads to less than the first-best level of environmental innovation.®

(Hi) Vulnerability to regulatory failure. Market instruments such as emissions taxation may be less exposed to the risk of regulatory "failure" than certain forms of quantitative regulation. One important source of regulatory failure is the asymmetry of information between regulators and their subjects (Vickers and Yarrow, 1988). Where a substantial amount of information about the circumstances or characteristics of individual firms is required to implement a particular policy, the firms may be in a strong position to control the flow of information to the regulator in such a way as to significantly affect the way the policy is applied. Although there may be little difference between a uniform rule on emissions levels (e.g. one setting an upper limit to emissions) and an emissions tax in the amount of information required for administration and enforcement, a regulatory policy which sought to take more account of the circumstances of individual firms would be much more vulnerable to regulatory failure. The efficient allocation of emissions abatement between firms depends on the marginal costs of abatement to each firm, and this information can only be obtained by the regulator from the firms themselves.

(iv) Revenues. The revenue raised from emissions taxes may be regarded as an additional benefit from their use, in that it may reduce the amount of revenue which has to be raised from existing taxes, and hence reduce the net aggregate deadweight loss from raising public revenues (Terkla, 1984). At the same time, however, as discussed in section 6, there are also issues about the burden of the tax payments on households or firms, and their distribution, to be taken into account.

(v) Monopoly. Buchanan (1969) discusses a possible limitation of environmental taxes in circumstances where polluting firms have a degree of monopoly power. Where companies have market power, they may reduce output below that which would occur in perfect competition, in order to maintain higher prices. An environmental tax raises the marginal cost of production and consequently a monopolist will reduce output even further, away from the social optimum. An

5 Tradeable permits, whether auctioned or distributed free, will also provide a similar Incentive for Innovation, since the necessary permits have a cost or opportunity cost to any source which continues polluting. However, depending on the rule for permit Issue over time, this incentive could be less than with an emissions tax (Maleug, 1989). This result arises because the firm which Innovates reduces the aggregate demand for permits, and thus reduces the value of any permits which It holds.

6 There are, of course, well-known "public good" arguments for the subsidy of R&D, especially of fundamental research.

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environmental tax set at a level that would lead to an efficient amount of pollution abatement by firms in a competitive industry will typically not be efficient if applied to a monopoly. In an empirical investigation of the significance of this argument, however, Oates and Strassmann (1984) found that the welfare costs of output restriction by monopolies were rather small and the inefficiencies in Pigouvian taxation from this source consequently unimportant.

(vi) Non-uniform damage. Where the concentration of pollution, either in particular localities or over certain time periods, is of importance, more complex forms of tax instrument will be needed than where the concentration of pollutant emissions is irrelevant.^ A straightfonward tax per unit of effluent discharge (or, more generally, pollutant emitted) would not discourage geographic or temporal concentrations of pollution, whilst at the same time it could mean that firms in areas where pollution was less damaging might be charged more than the value of the damage created. Where policy is, nonetheless, constrained to use only uniform taxes, there is then a straightfonward tradeoff between the efficiency gain from taking into account the diversity of abatement costs, and the efficiency costs of inadequately differentiating between polluters with different marginal abatement benefits (Seskin, Anderson and Reid, 1987). A number of papers have considered the use of zoned taxes or other non-linear tax systems to reflect the fact that pollution in particular localities or at certain times causes greater damage (Tietenberg, 1978; Kolstad, 1987).

One case where determination of the appropriate time profile of tax rates is particularly complex is that of a carbon tax, used to control greenhouse gas emissions. One reason for this is that the problem is one of a stock externality; the damage relates primarily to the total stock of greenhouse gases in the atmosphere rather than to the rate of emissions (Nordhaus, 1991). Also, as Sinclair (1992) observes, the choice of a tax profile is further complicated by the fact that the fuels concerned are an exhaustible resource. Policy measures to regulate the rate at which the resource is depleted will need to take account of the natural changes overtime in the pricing of the resource, reflecting its scarcity. Sinclair’s conclusion that, in steady state, the optimal carbon tax rate should decline

over time is challenged by Ulph, Ulph and Pezzey (1991), who argue that a steady state will in general not arise, and that in many cases the optimal carbon tax will rise initially, and then fall as the exhaustion constraint starts to bite,

2.2 Pollution taxes versus subsidies

In principle, subsidies can be used to provide a similar incentive to reduce pollution to that provided by a tax or charge on each unit of pollution. A subsidy, on each unit of pollution abafemenfcompared with the existing situation, would lead individual polluters to reduce pollution by the same level, and make the same choice of technology as they would if faced with a tax at the same level on each unit of pollution.

There are, however, four principal points of difference between the use of incentive mechanisms based on subsidies and mechanisms based on taxes and charges.

7 Cases where the geographical concentration of pollution Is of no concern at all are rare; the emission of 0 0 2 (and Its Impact on global warming) probably provides the only significant practical example.

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(i) Definition of the subsidy baseline. Since the equivalent subsidy has to be paid on each unit of pollution abated, rather than on each unit of pollution emitted, It Is necessary to define a baseline level of emissions against which current emissions will be compared. In principle, this requires a complex "counterfactual" assessment of what would have happened In the absence of policy. A more stralghtfonward alternative, using the emission levels at the start of the policy as the baseline may Initially be a reasonable approximation, but would become Increasingly out-of-date; In addition, as Kamlen, Schwartz and Dolbear (1966) point out It could encourage polluters to Increase pollution at the outset, to qualify for higher subsequent subsidy.

(ii) Effects on entry and exit. Whilst taxes and subsidies can provide the same Incentive at the margin, as Bramhall and Mills (1966) observe they have different effects on the level of profits earned by polluters. This may affect the evolution over time of the Industry structure, since the pollution abatement subsidy could reduce the rate of exit from the Industry. Whilst the reduction In exits (e.g. bankruptcies) may be seen as having political advantages. It has the unhappy consequence that the level of pollution from the Industry as a whole could actually rise. If policy was based on pollutlon-abatement subsidies rather than pollution taxes.®

(iii) Public expenditure. One obvious difference Is that subsidies add to public expenditure, and thus require other taxes to be raised to finance them, whilst pollution taxes raise tax revenue, and thus permit other taxes to be reduced. The potential value of the revenues from environmental taxes Is discussed In detail In section 6.

(iv) Concealed protection. One Important practical consideration which counts against the use of subsidies In environmental policy Is the risk that over time these subsidies may come to constitute a form of protection for the Industries concerned. The appropriate level of subsidy to reflect environmental objectives may be difficult to define with any precision, and the appropriate pattern of payment across firms may, as argued above, rest on a number of difficult judgements. In these circumstances, the borderline between justified and unjustified subsidy may be blurred, and It may be relatively easy for protectionist pressures to lead the subsidy to be Increased. Such Indirect or concealed protection In the guise of environmental policy has been the focus of discussions In a number of International fora. Amongst the countries of the OECD It has been a major reason for the adoption of the Polluter Pays Principle (PPP), which Is based on the most readlly-verlflable rule, a baseline of zero subsidy In environmental policy (OECD, 1974).

On the other hand, Bovenberg (1992) argues that subsidies may In some circumstances be promising Instruments for unilateral environmental policy, since they will lead to smaller changes In the pattern of trade and factor flows than environmental taxes, and will thus Involve smaller economic adjustment costs. This argument for the use of subsidies Is perhaps strongest In the context of the gradual adoption by countries of policies to control an International environmental externality. For example, the temporary Impact of the unilateral Introduction of a carbon tax on the

8 See Baumol and Oates (1988), Chapter 14, for further discussion. Pezzey (1992) discusses the conditions under which a scheme including subsidies would achieve efficient abatement and efficient entry/exit decisions.

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trade of the country which moves first may be iarge; a poiicy based instead on subsidy wouid reduce the need for trade to adapt to what the "first movers" hope is oniy a temporary situation, before other countries have adopted simiiar measures.®

2.3 Pollution taxes versus tradeable permits

US poiicy towards market instruments in environmental policy has evolved in a rather different direction to that taken in Western Europe. Little use has been made of emissions taxes in the US, but there has been considerable interest in the use of systems of tradeable pollution permits, including a much-documented river pollution application in Wisconsin (O’Neil etal, 1983), permit trading for lead in petrol, and extensive scope for emissions trading in various parts of the air pollution control systems. There has been some discussion of the reasons why US policy has evolved in this distinctive direction (Burtraw and Portney, 1991), and extensive consideration of practical lessons that can be derived from US experience (see, e.g. Tietenberg, 1990).

The principal theoretical consideration in the choice between taxes and tradeable permits relates to the impact of uncertainty. Where policy can be based on complete information about both the costs and benefits of pollution control, a chosen optimal level of pollution abatement can be attained either using quantity-based instruments (such as tradeable permits), or using price-based systems of regulation (charges or taxes). Important differences emerge, however, between quantity and price-based regulation in how the outcomes are affected by uncertainty about the costs and benefits of abatement (Weitzman, 1974).

A system of tradeable permits guarantees the quantitative reduction in pollution, but at uncertain cost, whiist a price-based mechanism such as an environmentai tax has an uncertain impact on the quantity of emissions, but fixes the marginal cost to polluters of emission controls. The choice between the two types of environmentai market mechanism, thus turns on whether policy error regarding the costs of pollution control would be more damaging than uncertainty about the quantitative reduction in pollution.

The practical experience of tradeable permits also suggests one other major problem area, which is the efficiency of the permit market. These have tended to be thin, and the supply of permits for trading, in particular, has been small, perhaps because the rules of the schemes have been too vague about the long-term rules for permit allocation, and have imposed various restrictions on permissible trades (Hahn, 1989). Permit trades will also not take place at the efficient level if polluters are large, and can affect the price at which permits are traded (Hahn, 1984; Misioiek and Elder, 1989).

On the other hand, permits have the attraction that they can be introduced without significantly increasing the average financial burden on existing polluters by a system of "grandfathering" - a free distribution of permits to existing polluters. This may, it is suggested, ease acceptance

9 Similar arguments can be made for using regulation or "grandfathered" tradeable permits Instead of taxes In these situations.

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compared with taxes and charges where there may be public scepticism about any commitment to use revenues to compensate, on average, those Industrial or social groups affected by the introduction of an environmental tax/° Issues of tax burden and compensation with environmental taxes are discussed in more detail in section 6.