Academic journal article Atlantic Economic Journal

Efficiency-Distributional Trade-Offs in the Taxation of Environmental Pollution

Academic journal article Atlantic Economic Journal

Efficiency-Distributional Trade-Offs in the Taxation of Environmental Pollution

Article excerpt

KEITH WILLETT [*]

Internalizing the externality costs from environmental pollution with a tax has received a great deal of attention and discussion in environmental economics literature. The primary motivation for setting the size of the tax rate is usually driven by economic efficiency considerations, but distributive consequences may play an important role in the decision of whether to adopt a tax. This paper shows how these trade-offs can be addressed when environmental pollution is internalized with a tax. (JEL Q28, H23)

Introduction

It is easy to find examples of market activity that include the generation of environmental pollution. One example might be those oil companies that produce gasoline. An evaluation of such a situation can lead to the conclusion that too much gasoline is being produced at too low a price in the market because this price reflects only the marginal private costs and not marginal social cost. That is, the marginal externality cost from the environmental pollution is ignored in the market price.

Concerns about environmental pollution in cases such as this lead immediately to discussions of environmental policy. Internalizing the attendant externality costs from environmental pollution with a tax has received a great deal of attention and discussion in environmental economics literature [Baumol and Oates, 1988]. Among other things, the primary motivation for setting the magnitude of the tax rate is usually driven by economic efficiency considerations [Cropper and Oates, 1992].

Clearly, economic efficiency constitutes an important starting point for formulating environmental policy, but the distributional impacts on various groups of a policy instrument may be equally important in gaining support for that instrument. There are many arguments supporting this contention. Buchanan and Tullock [1975] put forth a public choice theory of public policy which says that the interests of those stakeholders whose decisions are most directly affected by the policy instruments must be accounted for as well as the interests of those affected by environmental pollution. Nunn [1985] argues that public policy decisions are usually made as a result of collective actions by special interest groups seeking a solution to a particular problem. In particular, she concludes that "...public policy...is collective action by more or less self-interested individuals" [p. 874]. Thus, particular policies adopted appear to be motivated to a large extent by distributional considerations. Frey and Lau [1968] also suggest that policies analyzed solely on the basis of their economic efficiency impacts have little chance of being implemented because of the failure to take into consideration their distributional consequences. In most cases, these consequences have their origins in the policy implementation process.

In a general sense, the important lesson to be learned from Nunn [1985] and Frey and Lau [1968] is that public policy decision analysis must focus on the trade-offs between economic efficiency and the possible distributional impacts identified with different policies. This paper shows how these trade-offs can be addressed when the externality cost of environmental pollution are internalized with a tax.

This paper is organized as follows. In the second section, a set of analytical models are developed which are then used to identify the efficiency and distributional impacts of a tax. The third section provides an analysis of the relevant trade-offs, and the fourth section presents a summary and conclusions.

Efficiency and Distributional Impacts of a Tax

The standard economic efficiency aspects of using a tax to internalize the externality costs of environmental pollution are certainly well known. Nevertheless, they are recounted first with the aid of Figure 1 to help focus the analysis. The underlying market structure in this analysis is assumed to be a competitive market structure. …

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