Innovation under taxes versus permits: how a commonly made assumption leads to misleading policy recommendations

The literature on the impact of economic instruments (typically taxes and tradable permits) on the level of innovation is usually based on the assumption that innovation reduces the slope of the marginal abatement cost curve. This assumption, which usually leads to the conclusion that taxes induce higher levels of innovation than tradable permits, is however never motivated. In this short article, we analyse the assumption by introducing innovation in the production function of a polluting firm and by showing how it affects the corresponding marginal abatement cost curve. We show that the slope of the marginal abatement cost curve does not necessarily decrease with the level of innovation. As a consequence, previous analyses lead to misleading policy recommendations.