Revenue-Raising vs. Other Approaches to Environmental Protection: The Critical Significance of Pre-Existing Tax Distortions

Abstract

This paper examines the choice between revenue-raising and non-revenue-raising instruments for environmental protection in a second-best setting with pre-existing factor taxes.We find that interactions with pre-existing taxes fundamentally influence the costs of regulation and seriously militate against pollution abatement policies that do not raise revenue.Indeed, if the marginal environmental benefits from pollution reductions are below a certain threshold value, then any amount of pollution abatement through non-revenue-raising (NRR) policies like emissions quotas is efficiency-reducing.Under conditions roughly approximating S02 emissions from electric power plants in the U. S,, efficiency gains vanish if marginal environmental benefits are below $109 per ton and an NRR policy is employed.Moreover, imposing the "Pigouvian" (rather than second-best optimal) level of quotas can reduce welfare, even when environmental benefits are as high as $220 per ton.These results are largely independent of the size of the regulated sector relative to the overall economy, These findings stem from two underlying effects.The tax-interaction eflect is the adverse impact in factor markets arising from reductions in after-tax returns to factors associated with the higher production costs caused by environmental regulation.This effect leads to significantly higher efficiency costs than what would apply in a first-best world with no pre-existing taxes.Revenue-raising regulations (taxes) enjoy a revenue-recycling efecf that offsets much of the taxinteraction effect, but non-revenue-raising regulations (quotas) enjoy no such offset.Consequently, for any given target level of emissions reduction, the gross efficiency costs of nonrevenue-raising policies are higher than those of revenue-raising policies.These general equilibrium results are relevant to government regulation outside the environmental area.To the extent that government regulations of international trade or agricultural production raise the costs of output and thereby reduce real factor returns, they can generate much higher social costs than would be indicated by partial equilibrium analyses.