REGULATION: UNCERTAINTY AND OTHER ISSUES

Transcription

1 RGULATION: UNCRTAINTY AND OTHR ISSUS I Taxes and permis wih uncerainy We saw in he previous noes ha axes and radeable permis are idenical, excep ha he governmen may allocae he iniial permis and herefore no collec any revenue. Of course, ax revenue can always be rebaed o he same individuals who would have been designaed o ge he permis. We will see ha when he regulaor is uncerain abou firm marginal coss, price (ax) and quaniy (permi) regulaion give differen allocaions. Typically, he polluer will claim reducing emissions is very expensive, while he environmenal lobby will claim emissions can be reduced wihou cos. For example, prior o creaion of he SO 2 radeable permi marke, indusry claimed emissions reducion would cos $300 per on, while he environmenal lobby claimed he coss would be zero. How is he regulaor o se he ax or quaniy of permis under such uncerainy? A Taxes and uncerainy Suppose a firm may have eiher high (MC H ) or low (MC L ) marginal coss of reducing emissions, wih he average being MC. Suppose he regulaor ses he ax so ha marginal damages equal average marginal coss: = ( ) = MC ( ) (52) MC L MC MC H 0,L Ē 0 0,H Figure 36: Tax regulaion when marginal coss are uncerain. 56

2 Now he acual marginal coss will be eiher higher or lower han he average. The firm reduces emissions unil he price (he ax) equals marginal coss: = MC H ( H ), (53) if marginal coss are high and = MC L ( L ), (54) if marginal coss are low. Thus he ax will be eiher oo high or oo low, creaing welfare losses: H Welfare loss: MC H L MC L MC MC H L L H H 0 Welfare loss: MC L Figure 37: Welfare losses from ax regulaion when marginal coss are uncerain. If marginal coss are low, he firm will reduce emissions a lo as i is cheaper han paying he ax. So we see oo much emissions reducion, and marginal coss are above marginal damages. Conversely if marginal coss are high, he firm does oo lile emissions reducion as i pays he low ax raher han reducing emissions. Marginal damages are above marginal coss. The average welfare loss is average of he area of he wo riangles. 57

3 B Permis and uncerainy Suppose we now impose a radeable permi sysem in which we se he number of permis so ha marginal damages equal average marginal coss: MC ( ) = ( ) (55) Now if marginal coss urn ou o be high, demand for permis will increase, raising he price of permis o p H in Figure 38. Marginal coss will be above marginal damages, creaing welfare loss. Conversely, if he marginal coss are low, lile demand for permis resuls, pushing he price down. Marginal coss are below marginal damages. P P H Welfare loss: MC H P P L MC H MC L MC L H 0 Welfare loss: MC L Figure 38: Welfare losses from permi regulaion when marginal coss are uncerain. The average welfare loss is again he average of he areas of he riangles. Noice ha axes and permis are no equivalen. Wih axes, he ax says consan bu emissions vary. Wih permis, he emissions are consan, bu he permi price varies. When marginal coss are high, emissions are oo high under he ax, and oo low under he permi sysem. Bu mos imporanly, he size of he riangles are differen. 58

4 C Minimizing welfare loss We would like o choose he regulaion sysem ha has he smalles average welfare loss. Consider wo examples: 1 Marginal damages are sensiive o emissions Suppose a small increase in emissions causes huge increases in marginal damages. An example would be a runaway greenhouse effec. A a cerain level of CO 2, emperaures rise unconrollably which fries he plane. In his case, marginal damages are nearly verical. Price and permi welfare losses are: 59

5 P P H Welfare loss: MC H P P L MC H MC L MC L H 0 Welfare loss: MC L H Welfare loss: MC H L MC H MC L MC L H 0 L H Welfare loss: MC L Figure 39: Welfare losses from ax and permi regulaion when marginal damages are verical. The welfare losses from he ax are huge, bu he permi sysem has lile welfare loss. Because emissions vary wih he ax, we will have oo much or oo lile emissions, causing welfare losses. Conversely, he permi sysem can ensure emissions are a he efficien level. 60

6 2 Marginal coss are sensiive o emissions Suppose now ha few good subsiues for a polluan exis. The marginal cos of reducing emissions migh be very seep. In his case, given permi regulaion, if marginal coss are high, he permi price would rise subsanially, and firms would pay very high coss of emissions reducion or very high coss of buying permis, perhaps bankruping he indusry. Conversely, wihheaxfirmscanalwaysjus payheaxaamodes cos. Soaxregulaion is beer. 61

7 P P H MC L Welfare loss: MC H P MC H P L L H MC Welfare loss: MC L MC H MC L MC H Welfare loss: MC H L L H Welfare loss: MC L Figure 40: Welfare losses from ax and permi regulaion when marginal coss are nearly verical. 62

8 3 General Condiion THORM 4 Weizman s heorem: If marginal damages are more seeply sloped han marginal coss, emissions permis have lower welfare losses han axes. If marginal damages are less seeply sloped han marginal coss, axes have lower welfare losses han emissions permis. When are marginal damages seeply sloped? Consider a poison ha has a modes effec below a hreshold and causes deah above a hreshold. The slope of he marginal damages increases near he hreshold. Mos researchers believe marginal damages for climae change are fla: small changes in emissions have lile effec on he aggregae concenraions, and herefore cause small changes in emperaure. Thus mos economiss advocae carbon axes over cap and rade. On he oher hand, marginal coss may be seeply sloped when few good subsiues for he polluan exis. D Safey valves and oher hybrids Hybrid policies combine ax and permi regulaions. For example a SAFTY VALV increases he number of permis issued when he permi price his a hreshold so ha he permi price remains consan. Since he price is consan bu he quaniy varies, when he permi price rises, we have ax regulaion. Suppose marginal damages are iniially seep (favoring permis) and hen fla (favoring axes): 63

9 P MC H P H MC MC L Welfare loss: MC H P P L Welfare loss: MC L MC L Welfare loss: MC H H MC MC H L Welfare loss: MC_L L H Figure 41: Tax and permi regulaion wih S shaped marginal damages. Permis are beer if marginal coss urn ou o be low because in ha case he curve is seep. Conversely, if marginal coss urn ou o be high, we are on a fla par of he curve, in which case axes are beer. Now compare o a hybrid policy. Tha is, use permis, bu issues more permis when he prices rise o, say, H on he ax graph of 64

10 Figure 41. In fac, he governmen issues enough permis so ha he price remains consan a H, bu emissions rise o = H. We hen have a ax for MC H and permis for MC L : P MC H MC MC L Welfare loss: MC H H = P H P P L H Welfare loss: MC L Figure 42: Permi regulaion wih a safey valve. In Figure 42, he safey valve does beer han eiher a pure ax or permi regulaion since he slope of he marginal damages varies. A permi sysem is beer if marginal coss are low, and a ax is beer if marginal coss are high. The safey valve allows he regulaion ype o effecively swich. Can we design a sysem which eliminaes welfare losses? Consider a ax-subsidy hybrid ha encourages emissions reducion when coss are low and vice versa. Specifically, suppose we have a ax, which is paid when polluion is above and a subsidy, s, which is paid when polluion is below. Toal paymens are: s( ) < oal paymens = (56) ( ) > Noice ha paymens are negaive when < because we have a subsidy. Now suppose marginal coss are high. From Figure 43, he firm cerainly will reduce polluion o H as i is cheaper han paying he ax. I will no reduce polluion below since he cos of emissions reducion is well above he subsidy. Similarly, if marginal coss are low, he firm will cerainly reduce below o avoid paying he ax. The firm will coninue reducing polluion, as he subsidy is greaer han he marginal cos of reducing emissions, unil H 65

11 is reached. Opporuniy cos of emiing s MC L MC MC H L H Figure 43: Hybrid ax-subsidy policy. We herefore have no welfare loss under he hybrid sysem as emissions is a he opimal level regardless of how marginal coss urn ou. By adding flexibiliy, we reduce welfare losses. This is he advanage of hybrid policies. Issues: 1. Hybrids ge progressively more complicaed as uncerainy increases. If marginal coss are no high or low, bu insead have n possible oucomes, he regulaor would need n ses of axes and subsidies. 2. RATCHT FFCT: If firms know hey are he low marginal cos ypes, and reduce emissions o ge he subsidy, hey reveal o he regulaor ha coss are low. The regulaor hen has an incenive o swich o single ax = s. Knowing his, firms may emi more o falsely signal ha emissions reducion is cosly. II Monioring We now consider he case where firm emissions canno be perfecly observed. There are many possibiliies: 66

12 1. Toal emissions are observable, bu individual firm emissions are no. 2. missions are no observable, bu some polluion reducing aciviies, such as buying a scrubber, are. 3. missions areno observable, bu hefirmcanbeaudied asome cos ohe regulaor, revealing acual emissions. ach case is slighly differen and here are many oher cases as well. We will consider (1) and (3). A Monioring oal emissions Consider a case similar o previous cases where wo firms emi, bu now suppose he regulaor can monior only oal emissions. For example, suppose runoff from wo farms ends up in a river. The PA moniors oal river polluion downsream. We know ha he ideal regulaion is ax (or permi) sysem in which each firm pays per uni of polluion where: = ( ) = MC 1 (1) = MC 2 (2) (57) Bu his supposes he firm can monior individual firm emissions o assign he ax paymens. Suppose we insead charge a ax based on oal emissions. Specifically, le: Tax 1 = Tax 2 = (58) = (59) RUL: Regulaion mus be condiional only on wha he regulaor observes. Here he regulaor observes bu no 1 or 2, and so he regulaion is based on. Now consider firm 1 in Figure 44. I faces he ax/subsidy rule (58). A 0,1, he firm can reduce emissions a low marginal cos. Now if he firm does no reduce emissions by one from 0,1 oal emissions rise and boh firms will end up paying an addiional axes. Since > MC a 0,1, he firm reduces emissions. Coninuing his logic, firm one reduces o 1 and firm wo reduces o 2. We herefore have he efficien emissions: 67

13 MC 2 ( 2 ) MC( ) MC 1 ( 1 ) 2 1 0,1 0 Figure 44: Pigouvian ax on oal emissions. The inuiion is ha he ax makes boh firms pay for each firm s emissions. Firm 1 herefore pays axes on his own emissions. However, firm 1 canno conrol firm 2 s emissions, so he fac ha firm 1 also pays axes on firm 2 s emissions is irrelevan. The only issue here concerns when he number of polluers increases significanly. In ha case: 1. One firm s conribuion o he oal emissions migh be so small as o be no measurable. In his case, he firm can increase emissions wihou increasing ax paymens. 2. I migh be infeasible o make one firm pay axes on all firm s emissions because he oal ax paymens migh exceed he firm s revenues. B Audiing Suppose he regulaor can observe firm emissions only via a random audi. The regulaor ses he probabiliy of he audi, π and he fine f, per uni of emissions. So he cos o he firm is: f wih probabiliy π oal paymens = 0 oherwise (60) 68

14 Average paymen is hus: Ave[ paymens ] = πf +(1 π)0 (61) We would like a ax per uni of emissions equal o he marginal damage: = ( ) (62) Looking a equaion (61), seing πf = works. For each uni of emissions, he firm on average pays πf. So he firm will reduce emissions unil πf = MC. So we se: πf = MC ( ) = ( ) (63) Suppose for example ha, due o limied funds, he PA can monior only on average every oher period. Then he PA need only double he fine/ax o provide enough incenives o reduce emissions. Furher audiing issues: 1. The regulaor may reduce audi coss by monioring violaors more frequenly han non-violaors. Non-violaors will have increased incenives o remain ha way. A violaion now resuls in he firm being moved o he group which is audied more frequenly. Because he non-violaors have incenives o remain ha way, hey can be moniored less frequenly. 2. Sudies show PAs in developing counries monior more closely when hey ge o keep he fine. III Allocaing Iniial Permis The allocaion of iniial permis does no maer for efficiency. However, his resul depends on perfec compeiion. In he absence of perfec compeiion, firms may use he iniial allocaion o hur compeiors. Three cases are imporan o consider: 1. The poliical process. Compeiive firms are small and herefore canno affec he poliical process. A large firm can. By lobbying, large firms can ry o block environmenal regulaion. By allocaing he iniial permis o large firms, heir incenives o engage in lobbying are reduced and he environmenal regulaion is more likely o go hrough. 69

15 2. New enrans are ypically no allocaed permis. Thus, large firms can use he permi regulaion o resric compeiion from new enrans and hus increase heir prices. 3. Large firms can manipulae he price of permis. We will look closely a he hird issue. Suppose we have a single large firm and a group of small compeiive firms, which we will call he compeiive fringe. This indusry srucure is very common. Now for simpliciy allocae all he permis o he large firm. The large firm mus herefore decide how much o emi and how many permis o sell o he fringe. The number of permis is fixed a, so we have: L + F =. Forhelargefirm,hemarginalcosofreducingemissionsisMC L ( L ) = MC L ( F ). By reducing emissions by one, helargefirm gesonemore permi o sell. Saringfrom 0,L, reducing he firs uni of emissions is cheap, and becomes more cosly he more emissions are reduced. Thus supplying permis becomes more and more expensive. For he fringe, he demand or marginal willingness o pay for a permi is equal o he marginal cos of reducing emissions MC F ( F ). A Perfec Compeiion If he large firm aced in a compeiive manner, we would have: P MC( F ) P Demand=MC F ( F ) F F Figure 45: missions by he compeiive firm when he large firm is allocaed he permis and behaves compeiively. 70

16 Noice ha he efficien oucome resuls. The large firm is allocaed he permis. However, if i behaves compeiively, i sells some of he righs o he fringe unil he marginal coss are equalized a F. This is he Coase heorem in acion. We have: MC L ( L ) = MC F ( F ) = MC( ) = ( ) (64) B Imperfec Compeiion Suppose now he large firm acs like a monopolis. I could sell F permis o he fringe, bu if i keeps more permis, he monopolis can drive up he price and make more revenues from he permi sales. Furher, by keeping some permis, he monopolis has o do less emissions reducion. So insead he large firm reduces emissions and sells permis unil he marginal coss equal he marginal revenue: P P m Deadweigh loss MC( F ) P Demand=MC F ( F ) MR m F F Figure 46: Welfare loss from allocaing iniial permis o monopolis. A m < F, he monopolis has driven he price up o p m and increased revenues. The large firm keeps he exra permis, and so does less emissions reducion. Therefore, we have: MC L (L m ) < MC F (F m ) (65) Alhough he efficien oal emissions sill resuls, oo lile emissions reducion is done by he large firm. Welfare loss is given by he riangle ha represens he difference beween 71

17 he acual cos of reducing emissions and he efficien cos. C Opimal iniial allocaion under imperfec compeiion We saw above ha allocaing he permis o he large firm does no work, as he large firm wihholds some permis from he marke, causing he permi price o increase, which raises profis for he large firm. Since he large firm has oo many permis, oo lile emissions reducion is done by he large firm, and oo much by he small firm. Suppose we insead iniially allocaed all he permis o he fringe. Then we would have he reverse problem. The large firm would demand oo lile permis o keep he price of permis down. The large firm ends up wih oo few permis, and hus oo much emissions reducion, relaive o he fringe. Wha if we allocae F o he fringe and he res o he large firm? A price P = MC F (F) = MC L (L), he fringe does no wan o sell any permis since i would ge only P for selling he permis and have o pay MC F > P o reduce emissions below F. The fringe does no wan o buy any permis a P, since for emissions greaer han L we have P > MC F. The same is rue for he large firm. Thus if we perfecly allocae he iniial permis, we can acheive efficiency. However, his imposes a lo of required knowledge on he par of governmen: hey mus know all firms coss. The advanage of he permi sysem is ha he governmen can rely on he marke o deermine where emissions reducion is cheapes. In oher words, we migh as well have a sandard which varies across firms. Finally, noe ha he same problem applies o aucioned iniial permis. For example, he large firm can simply bid zero or no paricipae in he aucion. All permis hen go o he fringe, which he large firm can buy a a low price. IV Double Dividend Governmens need o raise revenue o fund public goods. However, any ax causes welfare losses. If we ax wages or income, hen people work less. People are no happy because hey are working less han hey wan o, so as o avoid he ax. The governmen ges no revenue from people no working. veryone loses. Suppose we insead ax bads. Now if people creae less bads because hey are axed, we have a welfare gain, no a loss. Definiion 22 The DOUBL DIVIDND HYPOTHSIS saes ha replacing axes on goods wih axes on bads creaes a welfare gain. 72

18 Noe ha he double dividend applies only o axes and aucioned permis. Oher forms of environmenal regulaion do no raise revenue. Consider a labor marke wih a ax per hour worked paid by he firm. We have a welfare loss because people work less han is opimal, jus o avoid paying he ax. The governmen revenues are RV = r = H H, (66) which is he recangle in Figure 47. The welfare loss is he riangle. w ax rev welfare loss S L w + w D L H H D L,ax H Figure 47: Welfare loss from a ax on hours. A Pigouvian ffec Now consider a good wih a polluion exernaliy. The opimal ax generaes revenues given by he recangle in Figure

19 $ ax revenue Welfare gain MC+ Q MC P Q + Q P Q Demand Q* Q Q Figure 48: Pigouvian ax on emissions. Noe ha we have a welfare gain because we are now equaing marginal social coss and willingness o pay. We call he welfare gain from lower polluion he PIGOUVIAN FFCT (P). The welfare gain is he riangle in Figure 48. B Revenue Recycling ffec Now le us recycle he revenues by reducing he labor ax rae so as o keep overall revenues consan. We now have: HH = r Q Q (67) Definiion 23 The RVNU RCYCLING FFCT (RR) is he welfare gain from replacing he labor ax wih he environmenal ax. The RR is he difference beween he wo riangles in Figure 49 (he darker, blue area): 74

20 w Revenue Recycling ffec S L w+ w D L H H H D L, D L, H Figure 49: The revenue recycling effec. So far, we have wo welfare gains (a double dividend). If hese were he only wo consideraions, we could increase he ax on he good wih an exernaliy above he Pigouvian level and sill increase welfare. C Tax Ineracion ffec However, he increase in he price of Q affecs our demand for leisure. In general, we would expec demand for leisure o increase. Working is less aracive because our wages buy less goods. We subsiue owards leisure. So he supply of labor shifs o he lef. This is a problem because we lose ax revenues, which mus be made up by increasing he labor ax rae, and herefore he welfare loss. Le H denoe he labor supply a he ax rae H. Then we have: HH = r Q Q (68) Since H < H, he ax rae has o be greaer, han and he welfare loss larger. Definiion 24 The TAX-INTRACTION FFCT (TI) says ha Pigouvian axes decrease he supply of labor, necessiaing higher axes o keep revenues consan. 75

21 w Original Loss Final welfare loss smaller S L S L 3 1 Disorionary labor ax 2 Revenue Recycling 3 Tax ineracion D L, D L, D L H H H H Figure 50: The ax ineracion effec. In Figure 50, he ax ineracion effec is he difference beween he green and red riangles. I represens he welfare loss from changing axes from o, so as o keep revenues consan. If he change in labor supply is large, he green riangle, which represens oal welfare loss, can be greaer han he blue riangle. In his case, i is opimal o se he environmenal ax below he Pigouvian level. Thus a double dividend may or may no resul. Ian Parry (1995) indicaes no: he opimal polluion ax in he U.S. should be only The ax ineracion effec exceeds he revenue recycling effec. One hing is cerain. In he absence of a revenue recycling effec (for example a sandard or a permi sysem in which he permis are given away), he opimal polluion ax mus be less han he marginal damage, when he ax ineracion effec is accouned for. Noes: 1. We are assuming he governmen ses oher axes incorrecly, bu axes polluion correcly. For example, i is beer o ax consumpion han wages. I is unlikely ha a governmen can be very good a polluion axes and very bad a seing labor axes. 2. The wage ax ends o reduce consumpion of he polluing good, perhaps all he way o he opimal level. 76

22 3. The revenue recycling effec makes a srong case for aucioning permis (raher han giving hem away) and using he revenues o reduce oher kinds of axes. Wihou he aucion, we lose he welfare gain of he revenue recycling effec. 77