Revenue-Raising versus Other Approaches to Environmental Protection: The Critical Significance of Preexisting Tax Distortions

Using analytical and numerical general equilibrium models, we show that preexisting factor taxes produce a "tax-interaction effect" that increases the costs of pollution taxes and quotas. Under policies that raise revenue and recycle it through cuts in marginal factor tax rates, this effect is partially offset by a "revenue-recycling effect." Grandfathered pollution quotas, such as those used under the 1990 Clean Air Act Amendments to regulate electric utilities' SO2 emissions, do not benefit from this offset. Preexisting taxes raise this regulation's cost by over 70%. More than half of this additional cost could be avoided by auctioning quotas and exploiting the revenue-recycling effect.