Grantee Research Project Results
Final Report: Effective Environmental Policy in the Presence of Distorting Taxes
EPA Grant Number: R825313Title: Effective Environmental Policy in the Presence of Distorting Taxes
Investigators: Burtraw, Dallas , Parry, Ian , Goulder, Lawrence
Institution: Resources for the Future , Stanford University , National Bureau of Economic Research
Current Institution: Resources for the Future , National Bureau of Economic Research , Stanford University
EPA Project Officer: Chung, Serena
Project Period: October 1, 1996 through September 30, 1998
Project Amount: $200,000
RFA: Decision-Making and Valuation for Environmental Policy (1996) RFA Text | Recipients Lists
Research Category: Environmental Justice
Objective:
The purpose of this research was to investigate the economic cost of policy instruments for environmental protection in the presence of preexisting distortionary taxes. Many observers have suggested that environmental taxes or other means of raising revenue as a component of environmental policy could yield an economic dividend by providing revenue that could be used to reduce preexisting taxes in factor markets, such as labor and capital markets. Because all taxes create inefficiency, the reduction of taxes in factor markets would be expected to improve economic efficiency; however, more recent literature has identified the potentially significant indirect economic cost that an environmental tax has when there are preexisting distortionary taxes in factor markets. This cost counteracts the anticipated benefits that might follow from recycling revenue raised by an environmental tax to reduce preexisting taxes.
The insight that motivated this project is that environmental policies that do not raise revenues nonetheless are likely to impose a cost through their interactions with preexisting taxes, just as would an environmental tax; however, they forego the potential benefit from recycling environmental tax revenues. In this research, the focus was primarily on the comparison of revenue-raising and nonrevenue-raising instruments in various settings in evaluating their economic cost in achieving a stated environmental goal.
This research had two parts. The first part focused on the regulation of a single pollutant in the presence of preexisting taxes in factor markets. Analytical models were used to advance the understanding of the interactions between environmental policy and the tax system. The theoretical models were complemented with numerical models to deal with some of the more complex interconnections that could not be examined analytically. The numerical models considered the costs of existing and potential policies for reducing air emissions of particular pollutants such as CO2, SO2, and NOX in the United States economy. The first part of the research was funded through grants from EPA and NSF.
The second part of the research extended the analysis of preexisting distortions in factor markets to consider in fuller detail the preexisting regulations that govern regulations of pollutants in the United States, especially within the electricity industry. These extensions considered the combination of policies that simultaneously affect emissions, targeted policies such as mandates for abatement technologies affecting specific industries, and the role of heterogeneity in abatement costs and production costs. The second part of the research involved funding from the EPA only.
In addition to these two anticipated areas of focus, a third focus emerged over the course of the project, which included several extensions to the project not anticipated in the original proposal. These extensions included the consideration of health benefits within a general equilibrium setting for comparison with costs, an exploration of the role of tax-interaction effects in setting agricultural policy, the interaction of environmental policy with tax-deductible spending, and the role of preexisting environmental policies
Summary/Accomplishments (Outputs/Outcomes):
The first year of the project yielded three manuscripts that were published in scholarly journals. The second year of the project added to this list with four more scholarly manuscripts. Two of these have been accepted for publication and are forthcoming in scholarly journals. In addition, six manuscripts that are review articles or syntheses of the literature have been completed. Several of these were written in a format accessible to a general policy audience to address the public outreach component of this grant. Some of these are technical summaries written for a general audience of economists. In the third year, additional work continued that modified some previous manuscripts, leading to final publication of several of these manuscripts. One new effort was conducted in the third year, resulting in an additional manuscript that will be submitted for publication.
Earlier work on the choice of instruments for environmental policy emphasized the efficiency significance of the decision whether to allow trades in emissions rights by converting fixed emissions quotas into tradable emissions permits to assign abatement efforts to firms with the lowest cost of reducing emissions. A key result of this work is the finding that the regulatory decision about whether to allocate these permits without charge (for example, so-called "grandfathering" of permits to emitters based on historic emissions) versus auctioning permits to raise revenue can be equally as important in terms of economic efficiency. The cost of grandfathering may well offset the efficiency gains achieved by improving cost effectiveness in compliance activities.
In the first year of this project, this issue was examined in the context of the SO2 trading program instituted under the 1990 Clean Air Act Amendments. Using a computable general equilibrium model, it was estimated that preexisting taxes raise the cost to the economy by an additional 70 percent relative to the out-of-pocket compliance cost of the program. More than half of the additional cost reflects the failure of the program to raise revenue that could be used to reduce preexisting (labor) taxes.
Another paper in the first year examined policies to reduce carbon emissions in the United States. The tax interactions significantly raise the costs of taxes and tradable permits relative to what they would be in the absence of preexisting taxes; however, the tax interactions put the permit system at a significant efficiency disadvantage relative to the carbon tax. A third paper in the first year examined a large set of instruments and found comparable results.
In the second year of this project, previous work was extended by considering the costs and overall efficiency impacts of emissions taxes, emissions permits, fuels taxes, performance standards, and mandated technologies, and exploring how costs change with the magnitude of preexisting taxes and the extent of pollution abatement. These policies were examined within the context of costs to reduce emissions of NOX in the United States. It was found that the presence of distortionary taxes raises the costs of pollution abatement under each instrument relative to its costs in a first-best world. This extra cost is an increasing function of the magnitude of preexisting tax rates. For plausible values of preexisting tax rates and other parameters, the cost increase for all policies is substantial (35 percent or more). The impact of preexisting taxes is particularly large for nonauctioned emissions permits. The cost increase here can be several hundred percent. Earlier work on instrument choice emphasized the potential reduction in compliance cost achievable by converting fixed emissions quotas into tradable emissions permits. Results of this project indicate that the regulator's decision whether to auction or grandfather emissions rights can have equally important cost impacts. Similarly, the choice as to how to recycle revenues from environmentally motivated taxes can be as important to cost as the decision whether the tax takes the form of an emissions tax or fuel tax. This choice involves whether to return the revenues in lump-sum fashion or via cuts in marginal tax rates. This is particularly important when only modest emissions reductions are involved.
In both first- and second-best settings, the cost differences across instruments depend importantly on the extent of pollution abatement under consideration. Total abatement costs differ markedly at low levels of abatement. Strikingly, for all instruments except the fuel tax, these costs converge to the same value as abatement levels approach 100 percent.
Most recent studies ignore the benefits of regulation on labor supply and focus only on the cost side of the policy choice. An analytically tractable general equilibrium model that allows regulation to provide benefits through several different channels, including improved health or productivity was developed. The model shows that when the benefits of regulation come in the form of improved health or productivity, the benefits do affect labor supply, and therefore, create a benefit-side tax-interaction effect in addition to the familiar cost-side interaction. This effect can magnify or diminish such benefits. When the benefits of regulation boost labor productivity, the effect substantially magnifies such benefits. When regulation affects consumer health, this effect will tend to have the opposite effect, diminishing the benefits of regulation. This benefit-side interaction is potentially as large as the cost-side interactions, and thus can fundamentally affect the optimal level of regulation.
In yet another paper, the prior literature on shifting tax burden toward environmental issues by allowing for consumption goods that are deductible from labor taxes was extended. These "goods" represent medical insurance, other less tangible fringe benefits, mortgage interest, and so on. It was found that incorporating tax-favored consumption may overturn key results from earlier studies. In particular, a revenue-neutral pollution tax (or auctioned pollution permits) can produce a "double dividend" by reducing both pollution and the costs of the tax system.
Another paper analyzed how distortionary factor taxes affect the welfare impacts of production subsidies, production quotas, acreage controls, subsidies for acreage reductions, and cash transfers to farmers. Preexisting taxes substantially raise the costs of all these policies.
In the third year of the project, another paper that investigates heterogeneity in the cost of pollution abatement using a simple computable general equilibrium framework was completed. When underlying costs are heterogeneous, aggregation to a sector-level abatement cost function yields qualitatively different findings from a disaggregated representation of costs. Tradable permits that do not raise revenue (grandfathered permits) outperform command and control approaches over a wide range of emission reductions, reversing a finding in the recent literature. The results were found to be sensitive in a predictable way to the characterization of heterogeneity in the underlying data, providing guidance about the requisite level of detail for similar modeling efforts.
The conclusions from this body of research are extensive and relate in special ways to the various contexts that were investigated. The main points of conclusion include:
- Preexisting distortions away from economic efficiency raised the cost of environmental regulations to the economy in almost all contexts that were studied. Preexisting taxes are an important example of a distortion that raises the cost of environmental regulations.
- The extra cost that is identified in the context of preexisting taxes is an increasing function of the magnitude of preexisting tax rates.
- The extra cost that is identified in the context of preexisting taxes varies significantly according to the type of policy instrument used to impose environmental regulations. The key characteristic is the ability of the instrument to raise revenues that can be used to reduce other preexisting taxes.
- Regulatory design and the decision whether to raise revenue with environmental regulations can be equally as important in terms of economic efficiency as the decision to convert fixed emissions quotas into tradable emissions permits. Tax interactions put the permit system that fails to raise revenue at a significant efficiency disadvantage relative to a revenue-raising environmental tax.
- Tradable permits may be more expensive than traditional command-and-control approaches to environmental regulation over a large range of emission reduction targets.
- For all instruments except the fuel tax, the difference between regulatory costs in the presence and in the absence of preexisting taxes converge to the same value as abatement levels approach 100 percent.
- Other regulations in addition to conventional environmental regulation such as production subsidies, production quotas, acreage controls, subsidies for acreage reductions, and cash transfers to farmers also are found to interact with preexisting taxes. Preexisting taxes substantially raise the costs of all these policies.
- When underlying costs are heterogeneous, aggregation to a sector-level abatement cost function yields qualitatively different findings from a disaggregated representation of costs. Tradable permits that do not raise revenue (grandfathered permits) outperform command and control approaches over a wide range of emission reductions, reversing a finding in the recent literature.
- The choice of how to recycle revenues from environmentally motivated taxes can be as important to cost as the decision whether the tax takes the form of an emissions tax or fuel tax.
- There also exists a tax-interaction effect on the benefit side of environmental regulations. This effect can magnify or diminish such benefits.
- The benefit-side interaction is potentially as large as the cost-side interactions, and thus can fundamentally affect the optimal level of regulation.
- Incorporating tax-favored consumption into economic models may yield a "double-dividend" with negative costs associated with environmental regulation
Journal Articles on this Report : 6 Displayed | Download in RIS Format
Other project views: | All 60 publications | 12 publications in selected types | All 7 journal articles |
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Parry IWH, Bento AM. Tax deductions, environmental policy, and the "double dividend" hypothesis. Journal of Environmental Economics and Management 2000;39(1):67-96. |
R825313 (Final) |
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Goulder LH, Parry IWH, Burtraw D. Revenue-raising versus other approaches to environmental protection: the critical significance of preexisting tax distortions. RAND Journal of Economics 1997;28(4):708-731. |
R825313 (1997) R825313 (Final) |
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Parry IWH, Williams RC, Goulder LH. When can carbon abatement policies increase welfare? The fundamental role of distorted factor markets. Journal of Environmental Economics and Management 1999;37(1):52-84. |
R825313 (1997) R825313 (1998) R825313 (Final) |
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Goulder LH, Parry IWH, Williams III RC, Burtraw D. The cost-effectiveness of alternative instruments for environmental protection in a second-best setting. Journal of Public Economics 1999;72(3):329-360. |
R825313 (1997) R825313 (1998) R825313 (Final) |
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Parry IWH, Williams RC. A second-best evaluation of eight policy instruments to reduce carbon emissions. Resource and Energy Economics 1999;21(3-4):347-373. |
R825313 (1997) R825313 (1998) R825313 (Final) |
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Parry IWH, Oates WE. Policy analysis in the presence of distorting taxes. Journal of Policy Analysis and Management 2000;19(4):603-613. |
R825313 (Final) |
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Supplemental Keywords:
benefit-cost analysis, public finance, double-dividend, second-best analysis, environmental policy, carbon, sulfur dioxide, nitrogen oxides, general equilibrium analysis., RFA, Economic, Social, & Behavioral Science Research Program, Scientific Discipline, climate change, Economics, decision-making, Economics & Decision Making, Social Science, ecosystem valuation, air pollution policy, carbon sequestration, environmental tax, valuation, decision analysis, economic benefits, environmental values, emissions quotas, environmental policy, government regulatory costs, compliance costs, public policy, regulationsRelevant Websites:
http://www.rff.org/disc_papers/index.htm Exit
Progress and Final Reports:
Original AbstractThe perspectives, information and conclusions conveyed in research project abstracts, progress reports, final reports, journal abstracts and journal publications convey the viewpoints of the principal investigator and may not represent the views and policies of ORD and EPA. Conclusions drawn by the principal investigators have not been reviewed by the Agency.