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A Tax on Output of the Polluting Industry Is Not a Tax on Pollution

A Tax on Output of the Polluting Industry Is Not a Tax on Pollution

The Importance of Hitting the Target

Chapter:
(p.13) 1 A Tax on Output of the Polluting Industry Is Not a Tax on Pollution
Source:
Behavioral and Distributional Effects of Environmental Policy
Author(s):
Don FullertonInkee HongGilbert E. Metcalf
Publisher:
University of Chicago Press
DOI:10.7208/chicago/9780226094809.003.0002

A tax per unit of pollution can induce all the cheapest and most efficient forms of pollution abatement. To reduce its tax liability, the firm can switch to a less-polluting fuel, add a scrubber, change disposal methods, or otherwise adjust its production process. These methods of substitution in production reduce the pollution per unit of output. In addition, the tax raises the overall cost of production, so the higher equilibrium output price chokes off demand for the output. Thus the tax has a substitution effect that reduces pollution per unit, and an output effect that reduces the number of units. Yet few actual taxes are targeted directly on pollution. This chapter examines the welfare effect of improperly targeted instruments using a simple analytical general equilibrium model with substitution in production and demand by consumers. It derives second-best optimal tax rates on emissions or on output that are based on preference parameters, technological parameters, and preexisting tax rates. It also reviews actual environmental taxes around the world and describes the extent to which they miss the target.

Keywords:   pollution abatement, environmental taxes, welfare effect, substitution, production, emissions, targeted instruments, tax rates, output effect

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