Chapter 17: Environmental Taxes

Transcription

1 10/12/03 Chaper 17: Environmenal Taxes [I] makes perfec sense o ax good hings less heavily and bad hings heavily we ough o reduce axes on work, invesmen, and enrepreneurship, and increase hem on polluion, wase, and greenhouse gas emissions --Jeff Hamond and Brian Dunkiel ( The Logic of Environmenal Tax Reform in he Unied Saes, he ecological economics bullein, 3 (3), 1998) [E]nvironmenal axes ypically exacerbae, raher han alleviae, pre-exising ax disorions --Lans Bovenberg and Ruud de Mooij ( Environmenal Levies and Disorionary Taxaion, American Economic Review, 84 (4), pp1085-9, 1994) 171: Inroducion This chaper is a brief survey of a fronier area of policy analysis how environmenal axes work when here are oher axes The analysis has implicaions for oher forms of regulaion such as markeable allowances and command-and-conrol Organizaion Secion 171 reviews our earlier analysis of environmenal axes as correcive Pigovian axes (and olls) The secion exends he inquiry o compare environmenal axes wih ordinary axes and consider he use of he ax revenue Secion 172 considers he possibiliy of a double dividend hypohesis, where environmenal axes work oward wo social goals a he same ime reducing he environmenal harm and offse oher (disorionary) axes Secion 173 sudies he ineracion of environmenal axes wih oher axes and he problem ha increasing he use of environmenal axes may increase he disorionary coss of exising axes Secion 174 finds non-disorionary properies of environmenal axes These properies make environmenal axes unusually efficien as a revenue source, bu hey can also lead o some problems of equiy or fairness Secion 175 idenifies he policy problem as one of balancing efficiency and fairness goals

2 Par II: Valuaion -2- In his chaper we sudy wha happens o environmenal axes when here are oher axes I ll divide he sudy ino four sages: 1 A long early sage from abou 1910 o 1990 when economiss focused heir aenion on he correcive propery of environmenal axes, wih lile aenion o he effecs of oher axes 2 A brief sage from abou 1990 o 1994 when economiss urned heir aenion o he possible benefis of environmenal ax reform and a double dividend 3 A recen sage from abou 1994 o he presen wriing when economiss found problems wih he double dividend and emphasized he disorionary coss of environmenal axes 4 An overlapping recen sage where economiss found unusual non-disorionary properies of environmenal axes, along wih a radeoff of efficiency and equiy The sakes are high Some of he analysis emphasizes he disorionary coss of environmenal axes and has led o policy recommendaions wih subsanially more environmenal harm han he correced Pigovian levels we have been sudying Oher analysis finds unusual non-disorionary properies of environmenal axes and suggess he reverse These differences are no limied o recommendaions abou environmenal axes, bu spill over o affec recommendaions abou command-and-conrol, markeable allowances and oher forms of regulaion The differences make i worhwhile o sudy a difficul and complicaed policy area Moreover, if environmenal axes are o be used more, hey could generae large revenues, in he $100 s of billions annually, in his counry alone The environmenal axes we will sudy in his chaper are really axes on exernaliies The exernaliies we will focus on are caused by producers for example, by facories emiing smoke in he process of producing seel, or commuers causing congesion while driving cars and producing rips o and from work The axes we will sudy in his chaper are per uni (or proporional) axes A 7% sales ax, for example, is a per uni ax You pay 7 cens for he firs dollar of your purchase, and you pay 7 cens for nex dollar you spend, and so on Per uni axes are easy o work wih, because he ax revenue is jus he ax (or more precisely he ax rae) imes he number of unis of he hing being axed 171: Firs Sage The Correcive Propery of Environmenal Taxes 1711: Correcive Pigovian Taxes We are familiar wih he firs sage, because his has been he perspecive of he earlier chapers In he highway congesion model we sudied a bridge oll, in he fisheries model we sudied a landing ax, and in he smoke model we sudied an

3 Chaper 17: Environmenal Taxes -3- emissions ax In hese hree environmenal problems of congesion, depleion, and polluion he oll or ax is se equal o is Pigovian level, he sum of he marginal environmenal damages 1 The Pigovian ax mirrors he marginal cos a driver, fisherman, or polluer imposes on ohers back ono himself The idea is o creae incenives for he producer of he exernaliy o avoid he ax by reducing he excessive levels of environmenal harm o heir efficien levels This reducion is ofen called correcive The environmenal ax revenue can be used o finance governmen producion of goods and services like highways, schools, naional defense, mainenance of naional parks, and research on vaccines, o decrease oher axes, o compensae hose who bear he coss of polluion and oher environmenal harms, or i could be divided up and reurned o everyone, as we did in he compuer simulaion of Chapers 8 and 9 Bu o focus on how environmenal axes correspond o wage raes and oher facor paymens (like ren for use of land), le s make an unrealisic assumpion We will assume, jus for his secion, ha here are no governmen produced goods and services and no oher axes, so we don have o worry abou ax ineracion effecs Once we see he parallel beween an environmenal ax and a wage rae, we will drop his unrealisic assumpion In laer secions we will ake ino accoun he role of governmen in producing goods and services and he resuling need for he governmen o finance hem wih axes In his secion we ask: How do correcive Pigovian axes correspond o wage raes (and oher facor paymens)? The shor answer is ha he correcive Pigovian ax corresponds very closely o a wage rae (or a paymen for a facor of producion) Then, when in he following secions we ake ino accoun he more realisic complicaion of he governmen s raising of ax revenue o finance publicly produced goods and services, we can explore how his correspondence changes, if a all 1 Recall ha an environmenal or exernaliy ax is a ax per uni of an environmenal or exernal harm; a Pigovian ax is an environmenal ax se equal o a special level he sum of he marginal environmenal damages

4 Par II: Valuaion -4- Figure 171 The "Correcive" Pigovian Tax and Is Correspondence o he Wage Rae ( i ) The labor marke The NSB is maximized wih wage wand labor employed L 0 The prediced NSB is he shaded riangle ( ii) The smoke "half-marke" Wih no regulaion, he prediced smoke emission is S u and prediced NSB is area A - area B ( iii ) The smoke "half-marke" correced wih he Pigovian ax The prediced smoke emission is S 0, and prediced NSB is he shaded area w demand for labor MB L NSB a supply of labor MC L demand for emissions MB S A B marginal damage MD S c demand for emissions MB S NSB d marginal damage MD S b L 0 labor S0 Su smoke S 0 smoke Figure 171 makes he comparison for he example of he seel indusry, which produces seel by using labor and emiing smoke Panel (i) shows he labor marke for he indusry As in Chaper 6, he producers demand curve for labor MB L is he horizonal sum of each individual producer s marginal benefi curve (from labor), and he labor supply curve MC L is he horizonal sum of each individual laborer s marginal cos curve Here s a quick summary of he hree marke forces we sudied in ha chaper, applied o he labor marke

5 Chaper 17: Environmenal Taxes -5- Box 1: Three Marke Forces in a Well-Funcioning Marke for Labor Producers equalizaion On he demand side of he marke, producers have an incenive o hire or lay off labor unil he marginal benefi MB L equals he wage rae w, which is he price producers have o pay for a uni of labor Laborers equalizaion On he supply side of he marke, laborers have an incenive o accep or rejec job offers unil he marginal cos MC L equals he wage rae w, which is he laborers rae of compensaion for supplying a uni of labor Marke clearing The wage rae adjuss unil supply and demand pressures are saisfied for he same amoun of labor employed in he indusry In he model of Figure 171(i) he hree marke forces are in equilibrium a a, for he wage w and employmen level L 0 As you can see in he diagram, he ne social benefi (NSB) aribuable o he labor marke is maximized for he amoun of labor L 0 prediced in he model Panel (ii) shows he producers demand for smoke emissions Smoke conribues o he producion process, and if smoke is axed or oherwise regulaed, he producers will have o build expensive baghouses or underake oher expensive abaemen or cu producion of seel The producers demand for smoke emissions, MB S, is he horizonal sum of each producer s marginal benefi from smoke On he demand side, producers have an incenive o emi smoke up o he poin where he marginal benefi MB S equals he price he producers have o pay for a uni of emissions In he unregulaed siuaion, his price is zero, shown in panel (ii) a b This par of he marke is working in a corresponding way wih he demand for labor in he labor marke By working I mean ha he producers are equalizing heir marginal benefis from smoke emissions o he price hey pay for he emissions, corresponding o he producers equalizaion in he labor marke The marke incenive for he producers equalizaion is working, bu he zero price of emissions is inefficienly oo low In he unregulaed siuaion he model predics ha he producers will, facing a zero price, emi smoke a he level S u Bu he marke is only half a marke As in Chaper 7, he curve of marginal damages MD S is he verical sum of he individual smoke recipiens marginal damage curves (recall ha he sum is a verical sum because smoke is a public bad and harms many people a once) Because smoke is an exernaliy, when here is neiher compensaion nor regulaion as in panel (ii) he smoke recipiens involunarily live wih he smoke ha is emied The recipiens may have cosly individual defensive acions, for example moving o a less smoky locaion or buying air filers, and you can hink of

6 Par II: Valuaion -6- he underlying individual marginal damage curves as he ne damage cos including he cos of personal abaemen acions The model predics ha wihou compensaion or regulaion (and wih Coasian bargaining impracical), producers will emi S u a b and recipiens marginal MD S will be a c (panel (ii)) Wih only half a marke, here are insufficien marke incenives o make b and c coincide Because smoke is an exernaliy, here isn a recipiens equalizaion corresponding o he laborers equalizaion in he labor marke In panel (ii), area A represens he social benefis aribuable o he smoke emissions and B represens he social coss, wih he NSB = A B Bu NSB are maximized wih smoke emissions S 0, and he prediced equilibrium is inefficien, a marke failure In panel (iii) he Pigovian ax fills in for he gap in effecive incenives for he smoke recipiens The Pigovian ax ˆ, colleced from he producers, raises he price of emissions for he producers and creaes an incenive for producers o adjus heir emissions o S 0 This half of he marke works as i did before, bu wih a differen price for he producers As before, he oher side of he half-marke coninues o lack equilibraing incenives Bu wih he governmen seing he environmenal ax rae a ˆ (pronounced ha ), he recipiens MD S equals he producers MB S a d wih he prediced emissions S 0 in panel (iii) Wih emissions a S 0, he NSB aribuable o he smoke half-marke is maximized and he exernaliy is correced, as we saw in Chaper 7

7 Chaper 17: Environmenal Taxes -7- Figure 172 Correspondence beween Wage Compensaion and Pigovian Compensaion ( ii) Environmen harm recipiens' oal compensaion, oal damage, and oal ne benefi w demand for labor MB L A B supply of labor MC L demand for emissions MB S labor's oal compensaion is wl 0, which is he wage imes he oal labor employed, areas A + B, he "wage bill" C D sum of marginal damage MD S he harm recipiens' oal compensaion is S 0, which is he sum of marginal damage imes he amoun of smoke emied, areas C + D, he "Pigovian revenue" L 0 labor S 0 smoke w E F L i individual i' s supply of labor MC L 0 i Laborer i's compensaion is he wage w imes he amoun iis employed Li The compensaion is wli, he recangle wih area equal o E + F Area F is i's oal cos and E is i's ne benefi labor i i's Pigovian compensaion is i's marginal damage i imes he amoun of smoke emied S0 This is i S0, he recangle wih area equal o G + H Area H is i's oal damage and G is i's ne benefi G H S 0 i's individual marginal damage MD i smoke ( iv) Environmen harm recipien i's individual compensaion, damage, and ne benefi Nex we consider he correspondence beween compensaion o laborers in he labor marke and compensaion o harm recipiens in he smoke half-marke In Figure 172(i), he laborers oal compensaion is wl 0, he wage rae imes he amoun of employmen, shown in panel (i) as he area A + B This compensaion, someimes called

8 Par II: Valuaion -8- he wage bill, happens auomaically in he marke and goes direcly o he workers In corresponding siuaion wih smoke correced o is Pigovian level S 0, he amoun of revenue generaed is he Pigovian level of he environmenal ax, which is he sum of he marginal damages or ˆ imes he amoun of smoke S 0, and his is ˆS0 This amoun equals he area C + D, he area of he recangle wih heigh ˆ and lengh S 0, in panel (ii) The governmen has o decide wha o do wih his revenue, which we call he Pigovian ax revenue, or Pigovian revenue for shor The case where he Pigovian ax corresponds mos closely o he wage rae is where he governmen decides o use he Pigovian revenue o compensae he smoke recipiens In his case he Pigovian ax is like a wage rae, wih he Pigovian revenue compensaing he people who bear he coss of smoke, corresponding o he wage bill, which compensaes he workers who bear he ime and rouble of heir labor 2 Compensaing he smoke recipiens makes sense in anoher way as well In his early sage of analysis, here is no need for revenue-raising axes In he case we are (briefly) considering here are no governmen produced goods and services Nex we explore he correspondence beween he Pigovian ax and he wage a he individual level Panel (iii) of Figure 172 shows he curve of individual marginal cos of labor for individual i (his marginal cos is his ime and rouble for an exra, small uni of labor) When he works L i hours a day, his oal cos of working is area F His oal compensaion a he marke wage rae is his wage w imes his hours L i, in oher words wl i, he whole recangle E + F His ne benefi from working is E Panel (iv) shows he curve of individual marginal damage for individual i breahing smoke (his marginal damage is his healh cos from breahing for an exra uni of smoke) His oal damage from exposure o S 0 unis of smoke is area H In he diagram, he is compensaed a he rae of his individual marginal damage ˆ i His oal compensaion is ˆS i 0, which is he recangle wih area G + H His ne benefi from exposure o he exernaliy and being compensaed for i is H This corresponds o he labor marke in which laborer i s compensaion E + F more han covers her oal cos from labor F In he environmenal (exernaliy) case, as cours pu i, he (Pigovian) compensaion makes he harm recipien whole Of course, when someone dies from an environmenal harm, as wih black lung disease 3, or an exernaliy as in he World Trade 2 Bu if people are compensaed for environmenal harms, will hey have incenives o avoid he harm? Will here be oo many people living oo close o airpors? This is he problem of coming o he nuisance we addressed in Chaper 16 3 Is black lung disease an exernaliy? The disease, which is imposed by he work condiions in coal mining, fis our definiion of an imposed harm ha canno be cosly avoided In a well-funcioning marke, his exernaliy is in principle inernalized by he bargaining process Bu when laborers are no well informed of he risks and process of

9 Chaper 17: Environmenal Taxes -9- Cener bombing, one can be made whole If you are lucky, your family will be compensaed a a rae roughly equal o he saisical cos of a life (somewhere beween $1 o $3 million (as appears likely he case of he World Trade Cener, bu such compensaion is unusual) In principle, he correspondence beween he Pigovian ax and he marke wage is very close 4 I say in principle because, even hough some compensaion is acually paid o people hur by polluion and oher environmenal harms, i usually isn Even if he governmen waned o pay harm recipiens Pigovian compensaion, as a maer of fairness or righ, i is adminisraively impracical o compensae all he harm recipiens a he raes equal o heir individual marginal damages 5 In conras, in a well funcioning labor marke, he hree marke forces lead ( as by an invisible hand ) he rae of compensaion (he wage rae) o equal o he laborers marginal coss of labor (per uni of labor ime), as shown in panel (iii) We will address he problem of adminisraive feasibiliy for he environmenal case oward he end of he chaper In summary, when he Pigovian ax is used o correc an environmenal harm and he Pigovian revenue is used o compensae he harm recipiens, on he basis of heir individual marginal damages, he Pigovian ax corresponds direcly o he wage rae (or oher facor paymens) An imporan difference beween he Pigovian ax ˆ and he marke wage w is ha while he wage rae adjuss auomaically o marke forces, he Pigovian ax does no auomaically adjus o he marke bu is se by he governmen As a reminder of his difference I pu a lile ha over he Pigovian ax In he 1950 s and 60 s when economiss direced heir aenion o he correcive properies of he Pigovian ax, hey ofen called i a user fee or a charge because i funcions more like a wage han a ax (especially when he Pigovian revenue is used as compensaion) Possibly a lo of confusion could be avoided if i were called a Pigovian fee or even a Pigovian wage Bu Pigovian ax is he common erm now, and we will sick wih ha he disease, or have lile labor mobiliy, he healh coss are unlikely o be fully inernalized in he employmen bargaining process 4 There remains he difference, hough, ha labor is a privae good and he labor supply curve comes from adding he individual supply curves horizonally, while smoke is an exernaliy where many people can be hur a once and he MD S comes from adding up he individual marginal damage curves verically This difference beween horizonal and verical adding explains he difference beween panels (iii) and (iv) In panel (iii), L i is less han L 0 and, in panel (iv), ˆ i is less han ˆ 5 I is oo hard o esimae all he individual raes individually I is easier o esimae he sum of he marginal damages ˆ (wih some error) The sum of marginal damages is ofen esimaed in environmenal damage assessmens

10 Par II: Valuaion : A Brief Inroducion o Ordinary Taxes (We ll Need I Laer) I is ofen said ha he only cerainies in life are deah and axes Now i is ime o ake ino accoun publicly produced goods and services, and he need for revenueraising axes o finance hem Ordinary axes are no correcive bu disorionary For example, a ax on labor does no correc he amoun of labor In a compeiive marke, he level of labor was correc (efficien) before he ax on labor is imposed Insead he labor ax drives a wedge beween how much a worker values his or her labor and how much an employer values i Figure 173 Ordinary Disorionary Taxes--An Example wih he Labor Tax ( i ) Tax colleced from he ( ii) Tax colleced from he ( iii ) Taxes colleced from laborers producers boh producers and laborers MB L MB L MB L disorionary disorionary disorionary cos cos cos A A A a _ w c _ e w + v w + v B MC L B MC L B MC ax revenue D D w D ax revenue ax revenue L w - _ v b w w - _ v C d f C C E E E L 1 L 0 labor L 1 L 0 labor L 1 L 0 labor Figure 173(i) shows an ordinary xxx labor ax v colleced from he laborers (his happens when laborers have o pay a payroll ax, or when laborers pay an income ax which we approximae by a ax per uni of work) Wih he ax, laborers rae of compensaion is heir afer-ax price of labor, w v, he marke wage minus he ax hey have o pay Laborers have he incenive o seek or refuse employmen up o he poin where heir afer-ax rae of compensaion equals heir marginal cos MC L Because in panel (i) he ax is no colleced from he producers, heir afer-ax price of labor is jus he wage rae w As before producers have he incenive o hire or lay off labor up o he poin where heir afer-ax price of labor equals heir marginal benefi from labor MB L (producers equalizaion) As before, he wage adjuss unil he amoun of labor demanded by he producers is equalized o he amoun supplied by he

11 Chaper 17: Environmenal Taxes -11- laborers (laborers equalizaion) And in he supply-and-demand model, he wage rae adjuss unil hese equalizaions happen, wih labor employmen a L 1 (marke clearing) In panel (i), producers equalize heir marginal benefis o heir afer-ax price of labor a a, and he laborers equalize heir marginal coss o heir afer-ax rae of compensaion a b, for he same L 1 The effecs of he hree marke forces described in Box 1 are shown by he corners of he recangle B in panel (i) Geomerically he recangle has is op righ corner a a on he demand curve (producers equalizaion), is boom righ corner a b on he supply curve (laborers equalizaion), and a is verically above b (marke clearing) The area of he recangle also has a meaning Because is heigh is v and is lengh is L 1, he area is v L 1 This is he ax revenue he governmen collecs, he ax rae imes he amoun of labor employed The area of he lile riangle o he righ of he recangle has a meaning oo The area is he ne benefis ha could be obained if he governmen didn need o impose a ax on labor o ge he ax revenue o finance he publicly produced goods and services This loss of ne benefi is called he disorionary cos of he ax To raise ax revenue, a ax is needed Bu he ax leads o less labor employed (employmen wih he ax L 1 is less han employmen L 0 wihou he ax) Wih he ax, he whole area A + B + C + D is no longer he NSB aribuable o labor employmen This is because he ax revenue B is used o finance public goods and services, or o reduce oher disorionary axes The ne benefis of hese uses are likely o be higher han he amoun of he ax revenue oherwise i would no be worhwhile imposing he ax and creaing he disorionary cos D The area A, hough, is he ne benefi o he producers of employing L 1 labor, when here is he ax v, and he wage shifs because of he ax And area C is he ne benefi o he laborers of supplying L 1 labor, when here is he ax v colleced from he laborers (and he wage shifs because of he ax) Think of he imes you gone o a resauran, looked over he menu and he prices, made your choice, enjoyed he meal, and hen, when he bill came, saw he prices lised on he menu for your choices and jus below an exra amoun for he sales ax The resauran is collecing he ax from you o pass along o he governmen The idea may have come o you, Suppose he ax was colleced from he resauran raher han from me The resauran would mark up he prices o cover he ax and i would come o he same hing This inuiion is percepive, and panel (ii) of Figure 173 shows he same idea when he same amoun of labor ax is imposed as in panel (i), excep i is colleced from he producers raher han from he laborers In panel (ii) I wroe he ax v o remind us ha i is colleced from he producers raher han from he laborers

12 Par II: Valuaion -12- The producers equalize heir marginal benefis o w + v, heir afer-ax price of labor a poin c The laborers equalize heir marginal coss o heir afer-ax rae of compensaion w a poin d The wage rae adjuss unil he amoun of labor demanded by he producers equals he amoun supplied by he laborers, a L 1 And he above hree marke condiions are me when he op righ corner of he recangle in Panel (ii) is a c and he boom righ corner is a d Is his L 1 in panel (ii) he he same amoun of labor employed as he L 1 in panel (i)? I drew he MB L and MC L curves o be he same in he wo panels The amouns of he wo axes v and v are he same (bu one is colleced from laborers and he oher producers), and so in boh cases he heigh of he recangle is he same This means ha he lenghs of he wo recangles are he same make an accurae drawing wih he supply and demand curves he same as in panel (i) and he heigh of he recangle equal o v (and also v ) and you will find here is only one way o ge he corners on he supply and demand curves Thus he lengh of he recangle is he same L 1 unis long in boh panels Wih he same heigh and lengh, he recangles areas are he same (so he ax revenues are he same) Wih he same geomery, he producers ne benefis are he same in he wo panels The laborers ne benefis are he same The disorionary coss are he same Moreover, afer he wage has adjused in he wo siuaions, he afer-ax compensaion for labor w v in panel (i) is he same as he afer-ax compensaion for labor w in panel (ii) This means ha he afer-ax labor compensaion is he same in he wo panels Panel (iii) shows wha happens when axes are colleced from boh producers and laborers, and he wo axes add up o he same oal ax as in panels (i) and (ii) We ge a differen wage adjusmen, bu he same recangle, and he same A, B, C, and D as before Moreover, labor s compensaion, which is he afer-ax wage imes he labor employmen and equals he area C + E, is he same in all hree panels This equivalence propery applies o oher ordinary axes, besides labor axes Because his propery will be useful laer o disinguish a key difference beween ordinary and environmenal axes, I ll highligh i here

13 Chaper 17: Environmenal Taxes -13- Box 2 : Equivalence Propery for Ordinary Per Uni Taxes on Non-Exernaliies If one ax v is imposed on he buyer and anoher ax v on he seller, he wo axes can be replaced wih a single ax v = v + v, which could be imposed on eiher he buyer or he seller wih he same equilibrium oal amouns of he ransacion, disorionary cos, ax revenue, buyers ne benefis, and sellers ne benefis 172: Second Sage The Double Dividend Environmenal axes are mainly on hings ha sociey wans o discourage, like polluion, congesion, and depleion, while ordinary axes are mainly on hings sociey wans o encourage, like income 6 Is i possible for environmenal axes o raise revenue for publicly produced goods and services (schools, roads, naional defense) and a he same ime discourage environmenal harms? In Figure 172(ii) he Pigovian revenue was used o compensae environmenal harm recipiens, raher han o become a source of governmen revenue This is he case where he Pigovian ax funcions like a wage rae, bu as economiss have poined ou, i is impracical o compensae each harmed individual on he basis of his or her individual marginal damage Wha would happen if he governmen kep some or all of he Pigovian revenue o finance publicly produced goods and services, or lower oher axes? This would be easier adminisraively I would sacrifice compensaion o he harm recipiens, bu i would be a source of governmen revenue In he early 1990 s David Pearce and oher environmenal economiss proposed a green ax reform The idea was o shif he ax base from ordinary axes on hings we wan oward environmenal axes on hings we don wan Ordinary axes have a single benefi hey raise governmen revenues Bu hey come wih a major cos hey creae disorionary coss Environmenal axes have wo benefis hey raise governmen revenues and a he same ime correc environmenal harms A double dividend if you will To ake advanage of he double dividend, he idea goes, he ax base should be shifed oward environmenal axes There should be more environmenal axes han here are now, fewer ordinary axes, more revenue generaed by environmenal axes and less by ordinary axes The shif does no need o be complee, bu here is room for a subsanial shif As far back as 1975, he Swedish economis Agnar Sandmo found a sriking example of a double dividend When governmen s revenue need equals he Pigovian 6 This is no a complee difference because some ordinary axes are sin axes, like axes on cigarees or alcohol, hings ha mos people wan o discourage

14 Par II: Valuaion -14- revenue, he governmen s enire revenue need can be me by appropriaing all he Pigovian revenue All he ordinary (and disorionary) axes can be se a zero wih no disorionary cos o he ax sysem 7 In his way he environmenal ax correcs he environmenal harm and raises revenue a he same ime Policy makers found he idea of a double dividend appealing In Europe and Japan he ax on gasoline is much higher han i is in he Unied Saes An original moivaion for high gasoline axes was o raise revenue, and his revenue is a subsanial fracion of he oal ax revenue raised in Europe and Japan High axes are no popular, bu when governmens poined ou ha he gasoline ax helped he environmen, his ax became a less unpopular The environmenal effecs of he gasoline ax were soon highlighed by he growing concern abou climae change Gasoline consumpion releases large quaniies of carbon dioxide, one of he main greenhouse gases Oher developed counries began o wonder when he Unied Saes would ake he problem of global warming seriously and ake he iniial sep of raising gasoline axes The pain of an increase in he gasoline ax is lessened because i would raise ax revenue and oher axes could be lowered (bu many people direcly feel an increase in he gas ax while no believing or noicing offseing ax reducions elsewhere) European counries and especially Scandinavian ones began o explain energy axes as beneficial o he environmen and o make modes shifs in heir ax sysems oward environmenal axes 173: Third Sage Disorionary Coss of Environmenal Taxes 1731: The Tax Ineracion Effec Public finance economiss, who sudy how he ax sysem works, became ineresed in environmenal axes They agreed wih Sandmo s finding, bu noed ha almos always he governmen s revenue need is greaer han he Pigovian revenue source, in which case here will be oher axes besides environmenal axes While he public finance economiss agreed ha environmenal axes work srikingly well when here are no oher axes, hey found a problem when here are oher axes To see he problem, consider again he example of he seel indusry, which uses labor and emis smoke Figure 174(i) shows he seel indusry s labor marke, when here is a ax v on labor (eg colleced from he producers, as a wihholding ax) and iniially smoke is unregulaed As before he producers demand for labor is MB L, and he laborers supply MC L, and he disorionary cos of he labor ax is he shaded riangle, wih equilibrium 7 Agnar Sandmo noed his case in 1975 (Agnar Sandmo, Opimal Taxaion in he Presence of Exernaliies, Swedish Journal of Economics, pp 86-98, 1975), bu his observaion did no receive much aenion a he ime

15 Chaper 17: Environmenal Taxes -15- labor employmen L 1 Now consider wha happens o he labor marke when an environmenal ax is used o reduce he smoke emissions (The environmenal ax could be se a is correcive Pigovian level, or some oher level) Figure 174 The Tax Ineracion Effec ( ii) Labor ax disorion compounded by he environmenal ax _ w + v w demand for labor MB L labor ax revenue disorionary cos of he labor ax supply of labor MC L demand for labor MB L _ w + v smaller labor ax revenue w ineracion effec supply of labor MC L demand for labor MB L ' wih env ax L 1 labor L 2 L 0 L 1 L 0 labor Panel (ii) shows he effec in he labor marke o regulaing smoke by he environmenal ax 8 In response o he increased price of smoke, seel producers reduce heir smoke emissions They do his by reallocaing some labor from direc seel producion o building and mainaining bag houses and oher means of smoke abaemen The producers may also reduce heir seel producion, and hereby smoke emissions wih he reducion These acions lead o social benefis of cleaner air, bu hey reduce he privae benefis o he indusry from making and markeing seel Wih lower privae benefis, and ypically lower privae marginal benefis, he producers demand curve for labor is pushed downward o MB L ' as shown by he dashed line in Figure 174(ii) Exercise (1) Draw diagrams o show wha happens when (a) he ax v on labor ges smaller (b) he ax on labor is zero (c) here is a ax v on labor, colleced direcly from he laborers 8 Panel (ii) is similar o a diagram by Goulder (p 402 in Environmenal Policy Making in a Second-Bes Seing, in Economics of he Environmen, (ed Rober Savins, 4 h ediion), WW Noron & Company: New York, 2000)

16 Par II: Valuaion -16- In Figure 164(ii), wih he demand curve pushed down he wage adjuss downward a lile and labor employmen is furher disored from L 1 o L 2 Moreover, he disorionary cos in he labor marke increases by he amoun shown by he shaded recangle This increase in disorionary coss is wha public economiss mean when hey say ha environmenal axes exacerbae or compound he disorionary coss of preexising axes The increase in disorionary coss represened by he recangle is called he ax ineracion effec If environmenal axes exacerbae he disorionary coss of pre-exising axes, and his effec is subsanial, hen environmenal axes and environmenal ax reform are likely o lose some of heir appeal Furher, i appears ha he same ineracion effec applies o oher forms of regulaion such as command-and-conrol and markeable allowances If hese forms of regulaion are used, polluers are likely o respond by shifing labor ino abaemen This leads o declines in he marginal privae benefis o he polluers wih a similar shif of he labor demand curve downward, as in Figure 174(ii) Wih he labor demand curve shifed downward by hese oher forms of regulaion, here will be an increased disorion in labor employmen and an increase in he disorionary cos of he labor ax No only is he oal disorionary cos higher wih he environmenal ax (and possibly oher environmenal regulaion) in panel (ii) han wihou i in panel (i), bu also you can see ha wih he environmenal ax, he labor ax revenue is smaller when here is an environmenal ax han when here isn So he argumen goes Once hese effecs of environmenal axes and oher forms of environmenal regulaion on pre-exising axes are aken ino accoun i seems ha his will lower he appeal of environmenal regulaion generally, leading o lower levels of environmenal proecion generally How imporan is he ineracion effec compared wih he correcive benefis of environmenal axes and heir revenue-raising opporuniies? To answer his quesion, public finance economiss used an approach similar o he one we used in sudying exernaliies 1732: The Second-Bes Problem To find he mos efficien 9 highway oll, we maximized he NSB, aking ino accoun he naural endency of o swich beween he congesed bridge and uncongesed highway unil he ravel coss, he bridge oll for he bridge drivers, are 9 Recall our second definiion of efficiency: efficiency = uncerainy, we use prediced NSB raher han acual NSB acual NSB maximum possible NSB If here is

17 Chaper 17: Environmenal Taxes -17- equalized beween he wo roues (This is he idea of a Nash equilibrium and wha Pigou called he naural endency ) To find he mos efficien combinaion of environmenal and ordinary axes, public economiss do a similar maximizaion, bu wih more axes and more consrains Here s he approach: Box 3: The Second-Bes Problem (1) find axes ha maximize he Ne Social Benefi (NSB) where he NSB is he --benefis of marke produced goods and services, plus --benefis of he publicly financed or produced goods and services, minus --disorionary coss of he ax sysem, and minus --coss of he environmenal (exernaliy) harms subjec o --consrains of he marke equilibrium condiions, and --consrains on he axes; and hen (2) recommend hese maximizing axes as second-bes efficien axes The recommended maximizing axes are called second-bes because of he consrains Wih fewer consrains i ypically is possible o find a higher NSB Consrains of marke equilibrium condiions include he producers equalizaion, he laborers equalizaion, and marke clearing The idea is ha he governmen ses he axes on a marke economy, and he marke equilibrium condiions arise from he incenives in he marke process, if here are no uncorreced exernaliies or oher sources of marke failure (like monopoly pricing) When here are axes, he hree marke consrains lead o he ax wedge in Figure 173 The ax wedge is he recangle in he diagram, creaing boh he ax revenue and he disorionary cos for ordinary axes Why should policy makers pu consrains on he axes? Someimes he axes are consrained so ha he oal revenue hey raise is fixed This reflecs wha legislaors and presidens mean when hey say no new axes ( no ne increase in ax revenues ) If policy makers did no consrain heir choice of axes, second-bes analysis would rely on some simple non-disorionary axes In doing so hey could increase he NSB over wha can be achieved by using ordinary disorionary axes like income axes, labor axes, and sales axes Here s an example of hese simple axes Everyone over 20 years old mus pay an annual ax of $5000, no maer if he or she is rich or poor, healhy

18 Par II: Valuaion -18- or sick No one can change heir behavior o avoid or lessen he ax (for he example we assume ha he governmen keeps careful records of everyone s birh cerificae, so no one can fraudulenly claim a younger age) Wih no one able o modify heir behavior o avoid hese axes, he axes do no disor behavior and have no disorionary coss So his argumen goes Taxes ha you canno avoid by changing your behavior are called lump-sum axes If he lump-sum axes are sufficien o mee he revenue need, hey can replace all oher axes and he ax sysem will have no disorionary coss a all The NSB will be higher han wih ordinary disoring axes and he oucome is called firs-bes efficien Sandmo s example of he double dividend, where he Pigovian revenue replaced all oher axes, leading o no disorionary cos o he ax sysem, is anoher example of firs-bes efficiency When we focused on he correcive properies of environmenal axes, and emporarily assumed ha here were no governmen revenue needs and no axes, we had anoher example of firs-bes efficiency In diagrams of his chaper, he lile 0 in L 0 and S 0 is for firs-bes (opimal) efficiency If here are no consrains in he second-bes analysis on lump-sum axes, secondbes analysis recommends increasing hem o he poin where hey finance he enire revenue need If some lump-sum axes are allowed, bu no enough o mee he revenue need, here will be some ordinary axes o cover he shorfall in governmen revenue need Wih hese ordinary axes here will be disorionary coss, and hus some disorionary coss o he ax sysem as a whole Bu wih more lump sum axes and fewer ordinary axes, he disorionary coss of he ax sysem as a whole will be lower, he NSB higher, and wih higher NSB here will be a higher second-bes efficiency Bu here is an obvious problem wih hese lump-sum axes If you are poor, a $5000 annual ax will be very burdensome If you are very rich, a $5000 ax will be hardly noiceable And wha happens if a poor 20 year old can pay he $5000 ax? Does he or she go o debors prison? Policy makers can avoid some of hese adverse disribuional consequences by seing lower axes o poorer aduls and higher axes o richer aduls Bu hen someone on he boundary beween he lower and higher ax could modify his behavior, by working a lile less o ge ino he lower ax caegory and he ax would become disorionary, like an ordinary ax (and hey wouldn be lump-sum, unavoidable axes anymore) Given he choice beween using lump-sum axes wih heir adverse disribuional consequences and no using lump-sum axes wih heir higher NSB and efficiency, policy makers almos always choose no o use lump-sum axes Mos economiss agree wih his choice, and second-bes analysis almos always includes he consrain no lump sum axes

19 Chaper 17: Environmenal Taxes -19- We have seen his idea before In making decisions wih sreams of benefis and coss over generaional ime, we considered wo policy goals: inergeneraional efficiency (achieved by maximizing he presen value of he ne benefi sream over generaional ime) and inergeneraional equiy (achieved by choosing a fair disribuion of benefis and coss over generaional ime) We considered balancing hese wo goals by maximizing he presen value of he ne benefi sream, subjec o a consrain of susainabiliy Similarly, he second-bes approach balances he goals of efficiency and equiy (here equiy is he disribuional fairness of he ax burden) by maximizing a NSB subjec o a consrain on he choice of axes ( no lump-sum axes ) Clearly, in he policy debae much depends on he choice of he consrains chosen by he policy maker Wih his idea of consrained maximizaion in mind, we can now undersand how he public finance economiss esimaed second-bes environmenal and ordinary axes They maximized he NSB over differen possible choices of environmenal and ordinary axes wih he consrains of he marke equilibrium condiions and he consrain of no lump-sum axes They maximized he NSB (subjec o hese consrains) over all he markes and in his way ook ino accoun ineracions across markes and heir ax ineracion effecs Wha hey found was surprising Typically hey found ha he second-bes environmenal ax is less han is correcive Pigovian level Ofen i is abou 35% less, someimes more han ha and someimes less han ha, bu rarely as high as he Pigovian level

20 Economiss found ha he second-bes ax 1 is ypically lower han is Pigovian level and he second-bes amoun of harm S1 is ypically higher han he Pigovian level S0 of environmenal harm They found ha increasing he second-bes environmenal ax 1 a lile bi decreases he disorionary cos A bu his is offse by ax ineracion effecs Par II: Valuaion -20- Figure 175 The Second-Bes Environmenal Tax and he Second-Bes Amoun of Harm 1 demand for emissions MB S A marginal damage MD S S 0 S1 smoke Figure 175 shows a second-bes ax 1 on smoke abou 35% less han is correcive Pigovian level ˆ Wih he lower environmenal ax, he second-bes level of smoke S 1 is subsanially higher han is firs-bes level S 0 Area A shows he disorionary cos from he increased level of environmenal harm (i comes because he marginal environmenal damages of smoke are greaer han he marginal benefis, when smoke increases above S 0 ) Bu, in he finance economiss analysis, his disorionary cos is made up for by reducions in he coss of ax ineracion effecs in oher pars of he economy A heme in much of he recen lieraure is ha environmenal axes exacerbae pre-exising ax disorions The idea is ha wih lower environmenal axes (and more environmenal harms), here is less disorion of oher axes 174: Fourh Sage Non-Disorionary Properies of Environmenal Taxes 1741: Symmery beween Environmenal Taxes and he Labor Tax I seems srange ha environmenal axes can be so non-disorionary in Sandmo s example, and so disorionary when here are oher axes Graned ha wih he presence of oher axes here are ax ineracion effecs, bu can here be non-disorionary

21 Chaper 17: Environmenal Taxes -21- properies of environmenal axes even when here are oher axes? There sill seems o be a puzzle Le s ake anoher look a Figure 171 and recall he siuaion when an environmenal ax is se a is correcive Pigovian level ˆ, he Pigovian revenue is used as compensaion for he smoke recipiens, and here are no oher axes In his case here was a symmery beween he environmenal ax and he wage rae Now le s add he complicaion of oher axes Is here sill a symmery? Figure 176 Symmery beween he Environmenal Surax and he Labor Tax ( i ) Labor marke Tax colleced from he producers ( ii) Smoke half-marke Taxes colleced from he boh producer MB L MB S _ w + v w A B ax revenue C E disorionary cos c d D MC L + _ F G ax revenue H J disorionary cos e f I MD S L 1 L 0 labor S 1 S 0 smoke There is a symmery, in fac wo symmeries One symmery is beween he wage and he Pigovian ax par of he environmenal ax, and he oher symmery is beween he labor ax and he remaining par of he environmenal ax Figure 176 shows he siuaion In panel (ii) he environmenal ax is divided ino wo pars: he Pigovian ax ˆ which is colleced from he producers of smoke and used as compensaion for he smoke recipiens, and an environmenal surax, which is also colleced from he producers bu used as ordinary ax revenue o finance publicly produced goods and services or subsiue for oher axes In panel (i) he wage w is paid by he producers and used as compensaion o he laborers The labor ax v is colleced from he producers and becomes a governmen source of ax revenue Thus in he diagram he wage w corresponds o he Pigovian ax ˆ

22 Par II: Valuaion -22- and he labor ax v corresponds o he environmenal surax In he diagram here are he wo symmeries, bu how do we know he diagram is drawn correcly? Panel (i) of Figure 176 is he same as panel (ii) of Figure 173 The idea here was ha producers hire and layoff unil heir afer-ax price of labor ( w + v ) equals heir marginal benefi from labor, a c, he laborers seek and qui jobs unil heir afer-ax price of labor (he wage rae w) equals heir marginal cos of supplying labor a d, and he wage adjuss unil he marke clears wih he same employmen supplied as demanded (L 1 ) This much is sandard economic analysis In panel (ii) of Figure 176 he smoke half-marke of smoke producers emi smoke unil heir afer-ax price of smoke ( ˆ + v ) equals heir marginal benefi from smoke a e and emissions level S 1 In he half of he marke ha is no working properly because of he exernaliy, he smoke recipiens live wih he amoun of smoke emied A his emissions level S 1 he sum of he marginal damages a f, jus he Pigovian level of ˆ This is no a surprise because he governmen ses he Pigovian par of he ax o equal he sum of he marginal damages (for he emissions level S 1 he smoke recipiens are exposed o) So he lower righ corner of he recangle in panel (ii) is on he recipiens marginal damage curve a f and he diagram is drawn correcly For convenience, I have drawn he producers demand curve for labor MB L in panel (i) o look like he producers demand curve for smoke emissions MB S in panel (ii), he laborers supply curve MC L o look like he recipiens marginal damage curve MD S, and he amoun of he labor ax v o be he same amoun as he surax Wih he symmery, his makes area A he same as area F, and so on In paricular, he labor ax revenue (area B) equals he surax revenue (area G), and he labor compensaion (areas C + E) equals he smoke recipiens compensaion (areas H + J) When he supply, demand, and damage curves differ, or he labor ax differ from he surax, he wo panels will look differen, bu he symmery remains beween wage w and he Pigovian ax, and beween he labor ax v and he surax The symmery means ha when here are ordinary as well as environmenal axes and when he Pigovian revenue is earmarked for compensaion o he smoke recipiens, he surax behaves symmerically like ordinary axes in second-bes analysis 10 When here are boh environmenal and ordinary axes in he economy, second-bes ordinary axes, like labor axes, sales axes, and income axes are ypically posiive Because of 10 You can really ell his from he diagrams and he inuiive discussion, bu a graduae suden Qinghua Zhang and I were able o derive he symmery analyically in secondbes analysis when here are muliple axes (Page and Zhang, Economics Deparmen Working Paper 2000-&&)

23 Chaper 17: Environmenal Taxes -23- he symmery, second-bes environmenal suraxes are also ypically posiive (when he Pigovian revenue is used as compensaion o he smoke recipiens) Panel (ii) of Figure 176 was no drawn for an opimized second-bes surax, bu i shows wha happens when he second-bes surax is posiive The posiive surax means ha he producers afer-ax price is higher han he Pigovian level and he second-bes level of smoke is lower han he Pigovian correcive level, shown by S 0 in he diagram This is good news for many environmenaliss, who like o see less polluion, raher han more Wha abou he ineracion effec? Analysis of he symmery case reveals many ax ineracions Jus as increasing he environmenal ax compounds he disorionary cos of he labor ax, increasing he labor ax by iself compounds he disorionary cos of he smoke surax The ax ineracion effecs are reciprocal and even someimes compleely offseing Bu why hen did economiss find ha he second-bes environmenal ax was ypically less han is Pigovian level (as in Figure 175)? The answer is ha hey were analyzing he asymmeric case where he Pigovian revenue is used as general revenue raher han for compensaing he harm recipiens Thus we find ha a basic policy quesion is Are here reasons for consraining second-bes maximizaion o require he Pigovian revenue be used as compensaion? If he consrain is added, second-bes analysis ypically recommends a posiive surax and less environmenal harm han is Pigovian correced level If he consrain is no added, second-bes analysis ypically recommends a negaive surax and more environmenal harm han is Pigovian level Moreover, his difference affecs policy choice for oher forms of regulaion, like command-and-conrol The difference could be subsanial As a rough guess here migh be 50% or even 100% more smoke (environmenal harms) when he consrain is no added compared wih he siuaion when i is added (assuming ha policy makers follow he recommendaions of second-bes analysis)

24 Par II: Valuaion -24- Figure 177 The Second-Bes Environmenal Tax wih and wihou he Consrain of Pigovian Compensaion The shape of he producers' demand curve MBS reflecs declining marginal benefis of smoke emissions and magnifies he difference in he recommended levels of smoke wih he consrain of Pigovian compensaion wihou he consrain of Pigovian compensaion 2 1 demand for emissions MB S marginal damage MD S wih he consrain S 2 S 0 S1 smoke wihou he consrain Figure 177 shows where his guess comes from, aking ino accoun ha he marginal benefis of smoke emissions are ypically declining Wihou he consrain ha he Pigovian revenue is used as compensaion o he harm recipiens, economiss found he second-bes level of he environmenal ax 1 ofen o be abou 35% less han is Pigovian level ˆ as shown in he diagram Wih his ax, we predic S 1 emissions of smoke When he Pigovian revenue is consrained o be used as compensaion o he harm recipiens, we are in he symmery case In his case, we are likely o ge a second-bes surax posiive As a rough guess i migh be abou 10% of he Pigovian level In his case he whole environmenal ax 2 would be abou 10% more han he Pigovian ax, as in he diagram, and prediced smoke emissions would be S 2 as illusraed in he diagram In he diagram smoke wihou he consrain (which requires he Pigovian revenue o be used as compensaion o he recipiens of he environmenal harm) S 1 and his amoun is is abou 70% more han he smoke emissions S 2 wih he consrain There are reasons for and agains adding his consrain Environmenal legislaion includes he disribuional goal of an adequae margin of safey o proec he mos vulnerable (his is saed in he Clean Air Ac, for example) Requiring he