Tax Policy towards Energy and the Environment

By Metcalf, Gilbert E. | NBER Reporter, Winter 2006 | Go to article overview

Tax Policy towards Energy and the Environment


Metcalf, Gilbert E., NBER Reporter


My research over the past several years has focused on the role of taxes and other instruments in environmental and energy policy. I have focused mainly on instrument design issues in a general equilibrium framework, as well as on the distributional implications of energy and environmental taxation.

Environmental Policy

An influential paper by Bovenberg and deMooij touched off a large research agenda on the optimal design of environmental taxes in a second-best world with pre-existing taxes. (1) It had long been understood that taxes on pollution could help to internalize pollution externalities. Beginning in the 1980s, analysts began to argue that the revenue from pollution taxes could be used to reduce other distortionary taxes, thereby generating a second "dividend" with a pollution tax. Some analysts concluded that the existence of this second dividend argued for a higher tax on pollution than the first-best Pigouvian prescription, where the tax is set equal to the social marginal damages of pollution.

Bovenberg and deMooij showed that for reasonable consumer preferences the optimal tax would, in fact, be lower than social marginal damages. Their insight was that while an environmental tax would enhance efficiency by discouraging pollution, it was still a distortionary tax and could interact with other distortionary taxes with first-best efficiency losses. Building on this initial result, researchers began to identify the gains from raising revenue via environmental policy instruments (pollution taxes or auction revenues from cap and trade systems). With Don Fullerton, I showed that the popularly held view that revenue-raising instruments were preferred to non-revenue-raising instruments focused on the wrong point. (2) What mattered was whether policies created scarcity rents and whether the government received the rents and used them to lower other distortionary taxes.

The result--that the second-best tax on pollution was below social marginal damages--was troubling to many environmentalists who were concerned that it implied that in a world with distortionary taxation more pollution should be allowed. Such a conclusion confuses price and quantity effects. That a first-best price rule ("set pollution taxes equal to social marginal damages") is modified in the presence of tax distortions ("set pollution taxes below social marginal damages") does not imply anything about changes in the optimal level of pollution. Using a simple analytic general equilibrium model, I provide a counter-example to show that having a tax below social marginal damages could be consistent with a higher level of environmental quality. (3)

The analytic general equilibrium framework constructed for the research just described was easily extended to a consideration of monopoly behavior among polluting firms and instrument design when policymakers cannot target pollution directly but rather must target some proxy for pollution. (4) The interest in second-best environmental policy design was widespread at this point and the NBER co-sponsored a conference on environmental policy with FEEM in Italy that Carlo Carraro and I co-organized. (5) One of the hotly debated topics during this period was whether tradable permits for pollution (like those for S[O.sub.2] trading under the Clean Air Act Amendments of 1990) should be given away or sold. One paper from that conference made the important point that this was not an either-or situation; rather, some of the permits could be traded and some sold. (6) The paper showed that only a small portion of permits need be given away in order to preserve the equity value of the energy industries because most of the burden of the permit price is passed forward to consumers in the form of higher prices.

I also have applied insights from the literature on second-best environmental taxation in my research on climate modeling. In particular, an empirical analysis of European energy and climate policy suggested that the benefits from auctioning permits from a European carbon cap and trade system vary substantially across countries, suggesting the need for country-specific policy guidance. …

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