The Cost-Effectiveness of Alternative Instruments for Environmental Protection in a Second-Best Setting

This paper employs analytical and numerical general equilibrium models to examine the costs of achieving pollution reductions under a range of environmental policy instruments in a second-best setting with pre-existing factor taxes. We compare the costs and overall efficiency impacts of emissions taxes, emissions quotas, fuels taxes, performance standards, and mandated technologies, and explore how costs change with the magnitude of pre-existing taxes and the extent of pollution abatement. We find that the presence of distortionary taxes raises the costs of pollution abatement under each instrument relative to its costs in a first-best world. This extra cost is an increasing function of pre-existing tax rates. For plausible values of pre-existing tax rates and other parameters, the cost increase for all policies is substantial (35 percent or more). The impact of pre-existing taxes is particularly large for non-auctioned emissions quotas: here the cost increase can be several hundred percent. Earlier analyses have emphasized the potential cost-savings from converting fixed emissions quotas into tradeable emissions permits. Our results indicate that the regulator's decision whether to auction or grandfather emissions rights can have equally important cost impacts. In both first- and second-best settings, the cost differences across instruments depend importantly on the extent of pollution abatement under consideration. Total abatement costs differ markedly at low levels of abatement. Strikingly, for all instruments except the fuel tax these costs converge to the same value as abatement levels approach 100 percent