Dynamics of Environmental Regulation and Voters' Biased Beliefs: A Political Economy Approach

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Since the beginning of the environmental movement during the sixties, environmental regulation has experienced a major evolution in OECD countries. Until the end of the 1980s, the use of command and control instruments massively characterized environmental policies, whereas economic theory has given strong support in favor of market-based, incentive instruments. (1) During the 1990s, the use of environmental taxes, as well as permit markets, grew extensively both in Europe and in the United States. Positive political economy literature of environmental regulation has mainly focused on the predominance of command and control instruments and has devoted little effort to explain the emergence of market-based instruments.

Some works focus on a single instrument, such as taxes or tradable permits. In a context of a small open economy, Fredriksson (1997) studies the effect of competition between an industrial and an environmentalist group on the level of a pollution tax. He shows the level of taxation depends on the proportion of the two types of agents in the population and on the elasticity of pollution compared to emissions prices. Aidt (1998) also focuses on the internalization of a negative externality with a tax. He shows that in a context of lobbying, the regulator implements the more efficient instrument to make transfers toward private interests, namely a tax on the use of the polluting input. Nevertheless, the political result is suboptimal because the chosen level of pollution diverges from the pigouvian level. Hanoteau (2004) is interested in tradable permits and shows the way permits are allocated is not neutral. In a context of lobbying, selling permits or giving them freely affects their price and quantity equilibrium because it gives industry shareholders incentives to lobby for or against emissions reductions.

Other contributors have analyzed and compared different instruments. This is the case of Buchanan and Tullock (1975), who seek to explain the predominance of direct regulation over tax. In their model, firms can reduce pollution exclusively by reducing production. Direct regulations create barriers to entry for new firms and generate a scarcity rent for old firms. Conversely, taxes increase firms' compliance costs. This analysis evaluates interest group preferences without modeling lobbying. Dijkstra (1998) analyzes interest group influence on two environmental policies. First, it is related to the choice between a direct regulation and a tax. The author suggests that the political acceptability of different instruments depends on the timing decision of the regulator. The latter first might decide which instrument to use, and then, how to distribute revenue (timing IR). But he might decide the contrary (timing RI). Dijkstra shows that when two industry groups compete for rent at each stage, the probability that the tax is implemented is higher with timing RI than IR. (2) These models of rent competition have explained why direct regulation is implemented where taxes are available (Dijkstra 1998); others have focused on permits (Hanoteau 2004).

Aidt and Dutta (2004) is the only contribution which provides an explanation for the evolution from direct regulation toward market based instruments (such as taxes or permits). Such evolution toward the use of market based instruments is the result of more ambitious environmental targets. Indeed, for lax environmental targets, consumers, as well as the lobby groups representing the polluting industry, support direct regulation [S]. The industry lobby supports [S] because of the price effect that increases total industry profits, and consumers support [S] because actual environmental damage is lower than with the other instruments. As the target becomes more stringent, a conflict of interest between consumers and the industry lobby emerges that has to be solved by the elected politician. The industry lobby gradually becomes more interested in cost-efficiency and shifts its support to permits [P]. …