Grantee Research Project Results
1998 Progress 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 Period Covered by this Report: October 1, 1997 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 is 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. Since 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 motivates 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 forgo the potential benefit from recycling environmental tax revenues. In this research we focus 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 has two parts. The first part focuses on the regulation of a single pollutant in the presence of preexisting taxes in factor markets. We use analytical models to advance the understanding of the interactions between environmental policy and the tax system. We complement the theoretical models with numerical models to deal with some more complex interconnections that cannot be examined analytically. The numerical models consider the costs of existing and potential policies for reducing air emissions of particular pollutants such as CO2, SO2 and NOX in the U.S. economy. The first part of the research is funded through grants form EPA and NSF.
The second part of the research extends the analysis of preexisting distortions in factor markets to consider in fuller detail the preexisting regulations that govern regulations of pollutants in the U.S., especially within the electricity industry. These extensions consider 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 involves funding from EPA only.
In addition to these two anticipated areas of focus, a third focus has emerged over the course of the project. This focus includes several extensions to the project not anticipated in the original proposal. These extensions include 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.
Progress Summary:
In the first annual report under this project we identified several manuscripts that had been completed in the first year of project activity, and provided a description of those manuscripts. In this section we briefly list those manuscripts again for completeness, and indicate where they have ultimately appeared as publications. In the second year additional work continued that modified some previous manuscripts. We describe these extensions and new work conducted in the second year of the project in greater detail.
Year One Accomplishments:
1. Goulder, Lawrence H., Ian Parry and Dallas Burtraw. 1997. "Revenue-Raising vs. Other Approaches to Environmental Protection: The Critical Significance of Pre- Existing Tax Distortions." RAND Journal of Economics, 28: 708-31.
2. "When Can Carbon Abatement Policies Increase Welfare? The Fundamental Role of Distorted Factor Markets." 1998. Goulder, Lawrence H., Ian Parry and Roberton C. Williams, Journal of Environmental Economics and Management, forthcoming.
3. Parry, Ian, and Roberton C. Williams. 1998. "A Second-Best Evaluation of Eight Policy Instruments to Reduce Carbon Emissions." Resource and Energy Economics, forthcoming.
Year Two Accomplishments-Primary Research:
4. Goulder, Lawrence H., Ian Parry, Roberton C. Williams and Dallas Burtraw. 1998. "The Cost-Effectiveness of Alternative Instruments for Environmental Protection in a Second-Best Setting." Journal of Public Economics, forthcoming.
This paper employs analytical and numerical general equilibrium models to examine the costs of achieving pollution reductions under a range of environmental policy instruments in a second-best setting with pre-existing factor taxes. We compare the costs and overall efficiency impacts of emissions taxes, emissions quotas, fuels taxes, performance standards, and mandated technologies, and explore how costs change with the magnitude of pre-existing taxes and the extent of pollution abatement.
We find 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 pre-existing tax rates. For plausible values of pre-existing tax rates and other parameters, the cost increase for all policies is substantial (35 percent or more). The impact of pre-existing taxes is particularly large for non-auctioned emissions quotas (tradable permits). Here the cost increase can be several hundred percent. Earlier work on instrument choice has emphasized the potential reduction in compliance cost achievable by converting fixed emissions quotas into tradable emissions permits. Our results 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.
5. Parry, Ian. 1998. "Agricultural Policies in the Presence of Distorting Taxes." American Journal of Agricultural Economics, forthcoming.
This paper analyzes how distortionary factor taxes affect the welfare impacts of production subsidies, production quotas, acreage controls, subsidies for acreage reductions and cash transfers to farmers. Pre-existing taxes substantially raise the costs of all these policies. These additional costs reflect the welfare losses from financing certain policies by distortionary taxes. They also reflect interactions with factor markets caused by changes in the costs of producing agricultural output. Previous studies ignore the latter types of effect. Consequently they significantly overstate the costs of production subsidies and understate the costs of production quotas, acreage controls and subsidies for acreage reductions.
6. Williams, Roberton. 1998. "The Impact of Pre-Existing Taxes on the Benefits of Regulations Affecting Health or Productivity," Unpublished manuscript, Stanford University Economics Department. Status: In review at RAND Journal of Economics.
Most recent studies have made restrictive assumptions regarding individual preferences and have ignored key links between regulation, human health, and labor productivity. Together, these assumptions imply that the benefits of regulation do not affect labor supply.
This paper develops an analytically tractable general equilibrium model that allows regulation to provide benefits through several different channels, including improved health or productivity. 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.
The paper concentrates on environmental regulation, but the concepts considered here apply equally to other policies affecting productivity or health, such as research subsidies or occupational safety regulations.
7. Bento, Antonio Miguel, and Ian Parry. 1998. "Tax Deductible Spending, Environmental Policies, and the `Double Dividend' Hypothesis." Discussion Paper, Resources for the Future, Washington, DC.
This paper extends the prior literature on shifting tax burden toward environmental issues by allowing for consumption goods that are deductible from labor taxes. These "goods" represent medical insurance, other less tangible fringe benefits, mortgage interest, and so on. The initial tax system effectively subsidizes tax-favored consumption relative to other consumption, in addition to distorting the labor market.
We find 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. The second dividend arises because the welfare gain from using environmental tax revenues to cut labor taxes is much larger when labor taxes also distort the choice among consumption goods. Indeed (ignoring environmental benefits) the overall costs of a revenue-neutral pollution tax are negative in our benchmark simulations, at least for pollution reductions up to 17 percent, and possibly up to 42 percent. In addition, we show that the presence of tax-favored consumption may dramatically increase the efficiency gain from using (revenue-neutral) emissions taxes (or auctioned emissions permits) over grandfathered emissions permits.
Year Two Accomplishments-Review Articles and Public Outreach
The following manuscripts are additional products that have resulted from this project and reflect an explicit effort to synthesize the research and make the results available to general audiences. Each of these are sizable contributions on their own, but they do not offer original research. They are intended to address the public outreach component of this research project. Not listed are numerous seminars and conference presentations that also contribute to the public outreach component.
8. Bovenberg, A. Lans and Lawrence H. Goulder. "Environmental Taxation," in A. Auerbach and M. Feldstein, eds., Handbook of Public Economics (second edition). Amsterdam: North-Holland, (forthcoming).
9. Goulder, Lawrence H. "Tax Interactions, Revenue Recycling, and the Efficiency Impacts of Pollution-Abatement Policies," in P. Portney and R. Schwab, eds., Essays in Honor of Wallace E. Oates, Edward Elgar Publishing, (forthcoming).
10. Parry, Ian. 1997. "Reducing Carbon Emissions: Interactions with the Tax System Raise the Cost." Resources, 128, 9 - 12.
11. Parry, Ian. 1997. "Revenue Recycling and the Costs of Reducing Carbon Emissions." Climate Issues Brief No.2, Resources for the Future, Washington, DC.
12. Parry, Ian and Wallace E. Oates. 1998. "Policy Analysis in a Second-Best World." Discussion paper N0. 98-48, Resources for the Future: Washington, DC, 1998.
13. Williams, Roberton. 1998. "The Double Dividend When Environmental Quality Affects Health or Productivity," Unpublished manuscript, Stanford University Economics Department.
3. Year Three and Future Activities
Ongoing activities include efforts to focus on heterogeneity in abatement and production costs, and its influence on the relative cost-effectiveness of alternative instruments for environmental regulation. To address this we are exploring heterogeneity between sectors of the economy and within the electric utility industry. Also, ongoing research will address the importance of preexisting environmental regulation in the evaluation of the cost-effectiveness of new policies.
Several conceptual issues that have emerged as potentially important include the complementarity of leisure and environmental amenities, the complementarity of economic productivity and environmental quality, and the role of preexisting underemployment in the economy. We hope to continue research along these and other avenues of inquiry under subsequent projects.
Journal Articles on this Report : 4 Displayed | Download in RIS Format
Other project views: | All 60 publications | 12 publications in selected types | All 7 journal articles |
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Type | Citation | ||
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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) |
Exit Exit |
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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) |
Exit |
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Parry IWH. Agricultural policies in the presence of distorting taxes. American Journal of Agricultural Economics 1999;81:212-230. |
R825313 (1997) R825313 (1998) |
Exit |
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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) |
Exit |
Supplemental Keywords:
RFA, Economic, Social, & Behavioral Science Research Program, Scientific Discipline, climate change, Economics, decision-making, Social Science, Economics & Decision Making, 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, regulationsProgress 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.