6. Optimal Corrective Taxes

Transcription

1 6. Optimal Corrective Taxes 6.1 Introduction The source of inefficiency associated with any externality is the absence of pricing. The external effect is external precisely because the source agent does not pay a price for the cost they impose on others (for a negative externality) or receive a price for the benefit they bestow on others (for a positive externality). Corrective taxes on activities with associated negative externalities (or subsidies in the case of positive externalities) are designed to price the external effect and so internalize it. That is, the tax is chosen so as to implement the social optimum as a corrected private equilibrium. We will focus on negative externalities. 6.2 The Pigouvian Tax The corrective tax was first proposed by Pigou (1921). The Pigouvian tax comprises a unit tax imposed on the source of the externality such that the effective marginal private cost to the source agent becomes: MPC(t) = MPC + t The source agent still makes decisions on the basis of (effective) private costs and benefits, and so solves MPB = MPC + t Assuming MSB = MPB, the tax-induced private optimum can effectively implement the social optimum if the tax is chosen to reflect MEC. That is, set the tax such that: t = MEC(z*) Note that the tax is set equal to MEC evaluated at the social optimum, z*. The tax-induced private optimum is z ˆ( t) = z* such that 1

2 MPB(z*) = MPC(z*) + MEC(z*) Setting the tax equal to marginal external cost effectively internalizes the externality by making the source agent take account of the external cost. See Figure 6.1. In the case of pollution, the tax should be levied on emissions and set equal to marginal damage evaluated at the social optimum: t = MD(e*) The source agent chooses her private optimum to equate marginal abatement cost with the tax: MAC(e) = t That is, at the tax-corrected private optimum the source agent balances the marginal cost of abating (MAC) with the marginal cost of not abating (t). If MAC reflects the true social cost of abatement, then the corrected private optimum implements the social optimum: MAC(e*) = MD(e*) It is important to note that an optimally set tax will not necessarily reduce emissions by very much. In particular, if MAC is very steep then emissions may only fall by a small amount in response to the optimal tax. This does not mean that the tax has failed in any sense. The purpose of the tax is to internalize the environmental damage caused by the emissions, not to reduce emissions per se. If the cost of reducing emissions is very high (a steep MAC curve) then it may be efficient to tolerate a large volume of emissions even if they are very damaging. The objective is to ensure efficiency; reducing emissions is not an economic objective in itself. Note the parallel between this point and the discussion in chapter 3 on the distinction 2

3 between achieving intragenerational efficiency and achieving sustainability. 6.3 The Pigouvian Tax When There Are Many Emission Sources Recall from section 4.3 that when there are many emission sources, efficiency requires that marginal damage be equated to marginal abatement cost for each source. Figure 6.2 reproduces Figure 4.6. What taxes are needed to implement this social optimum as a corrected private optimum? The same Pigouvian rule applies; each source is levied with the same tax: t = MD(E*) where E* is the efficient level of aggregate emissions. Each source responds to the tax by setting emissions to equate its own MAC with the tax. Thus, in the corrected equilibrium, MACs are equated across sources and equated to marginal damage. That is, the tax implements the social optimum as a corrected equilibrium. It may seem surprising that the same tax is applied to both sources despite their potentially different MACs. The reason is straightforward: the tax is levied so that each source pays the appropriate price for the damage its emissions cause, and that damage is independent of MAC. Note too that each source pays a tax equal to MD evaluated at the optimal level of aggregate emissions. Why? The damage done by the emissions from one source generally depends on the level of emissions from other sources, because each source adds to aggregate emissions. Only when marginal damage is constant will the Pigouvian tax be independent of the level of aggregate emissions. 3

4 6.4 Targeting the Source of Damage The Pigouvian tax should be levied directly on the source of damage. Example: a firm emits effluent that contains mercury. Suppose a tax is levied on the volume of total effluent that a firm emits. Natural response by the firm: cut back on the volume of effluent, but not necessarily on the mercury content. The firm may simply drive some water off as steam and emit an effluent with a higher mercury concentration. The tax will have been ineffective at pricing the mercury. The tax should ideally be levied on the mercury content of the effluent, not on the effluent itself, because it is the mercury, and not the effluent per se, that causes damage. In many instances it is difficult to levy a tax on the source of the damage. Example: nitrous oxides and volatile organic compounds emissions from automobiles are not exactly correlated with gasoline consumption. Thus, a tax levied on gasoline does not address the source of the problem but taxing emissions directly in difficult. Also important to note that the same type of emissions can cause very different damage under different circumstances. For example: damage from municipal waste water discharged depends on medium. This means that the same type of emission may have to be taxed at very different rates in different geographical areas. 6.5 Pollution Abatement Subsidies In terms of creating incentives it would appear that paying an abatement subsidy is equivalent to charging a tax on pollution, since the subsidy foregone for not abating has the same opportunity cost as a tax paid for polluting. However, the long-run competitive industry responses to the subsidy and the tax will generally be very different. 4

5 Figure 6.3 illustrates the long-run effect of an emissions tax in a competitive industry (assuming a fixed emissions-output ratio). The tax raises marginal and average costs. Equilibrium price rises and some firms exit. Total industry output falls. Figure 6.4 illustrates the long-run effect of a subsidy. The subsidy raises marginal cost (since there is an opportunity cost associated with polluting) but reduces average costs. Equilibrium price falls and new firms enter. Total industry output rises. If the emissions-output ratio is fixed then the subsidy actually creates more pollution in the aggregate relative to no regulation. Key result: marginal incentives alone are not enough. Only if firms pay the total cost of their pollution will the profitability of entering or exiting an industry reflect the true social benefit of entry and exit. 6.6 The Pigouvian Tax and Incentives for Cleaner Technology Adoption We noted in chapter 2 that knowledge growth is crucial to support increasing growth in consumption given the fixed assimilative capacity of the environment. On the other hand, new technologies are costly to adopt. Does the Pigouvian tax create the correct incentives for cleaner technology adoption? Efficiency Figure 6.5 illustrates the adoption of a cleaner technology (drawn for the case of constant marginal damage and a single source). Marginal abatement cost is lower under the new technology at all levels of abatement. This means that the efficient level of emissions is lower under the new technology. 5

6 What is the social benefit of adopting the new technology? Social benefit has two parts: reduced damage = area A + area C reduced abatement cost = [area B + area D] - [area C + area D] = area B - area C Thus total social benefit = area A + area B Net social benefit = benefit - cost of adoption Adoption is worthwhile if and only if net social benefit > 0. Private incentives What are the firm s incentives when facing the Pigouvian tax? Private benefit has two parts: reduced tax payments = area A + area C reduced abatement cost = [area B + area D] - [area C + area D] = area B - area C Thus total private benefit = area A + area B Thus, private benefit = social benefit. If the firm faces the true social cost of adoption, then private net benefit = social net benefit. That is, the corrective tax implements the efficient technology adoption choice. 6

7 $ MPB MSB MSC MPC t * x * $x x Figure 6.1 7

8 $ MAC 1 MD( E) MAC 2 t e 2 * e 1 * E = e + e * * * 1 2 e 2 e 1 e Figure 6.2 8

9 $ $ MC t S t AC t AC MC S D x t x 0 x X t X 0 Figure 6.3 9

10 $ $ MC s MC AC S S s AC s D x s x 0 x X 0 X s Figure

11 $ MAC(old) MAC(new) t A MD B C D e 1 * e 0 * e E Figure