Efficiency Costs of Meeting Industry-Distributional Constraints Under Environmental Permits and Taxes

Many pollution-related industries wield strong political influence and can effectively veto policy initiatives that would harm their profits. A politically realistic approach to environmental policy therefore seems to require the alleviation of significant profitlosses to these industries. The regulatory authority can do this by freely allocating some emissions permits or by exempting some inframarginal emissions from a pollution tax. However, such policies compel the government to forego an efficient potential revenue source and to rely more heavily on ordinary distortionary taxes. As a result, achieving distributional objectives comes at a cost in terms of efficiency. Using analytically and numerically solved equilibrium models, we analyze the efficiency costs implied by the distributional constraint that adverse impacts on profits in particular industries must be avoided. Both models indicate that the efficiency cost implied by this constraint dwarfs the other efficiency costs when the required amount of abatement is very small. When the abatement requirement becomes more extensive, however, the cost of this constraint diminishes relative to the other efficiency costs of pollution-control. We also calculate the compensation ratio: the share of potential policy revenue that the government must forego to protect the industries in question. We show how this ratio is affected by the extent of abatement, supply and demand elasticities, and the potential for end-of-pipe treatment. One definition of this ratio corresponds to the share of pollution permits that must be freely allocated to prevent profit-losses in the targeted industries. Numerical simulations of sulfur dioxide pollution-control suggest that the Bush Administration's Clear Skies Initiative would exceed this ratio, freely allocating more permits than necessary to preserve profits. Our models also highlight significant differences between gross and net policy revenues: when abatement is extensive, a large fraction of the revenue collected from emissions permits or taxes is offset by the revenue-loss from erosion of the base of existing factor taxes