Roberton C. Williams

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

This paper uses analytical and numerical general equilibrium models to study 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 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 the magnitude 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 % or more). The impact of pre-existing taxes is large for non-auctioned emissions quotas, the cost increase can be several hundred percent. Earlier work on instrument choice emphasized the potential reduction in compliance cost from converting fixed emissions quotas into tradeable emissions permits. Our results show the regulators decision to auction or grandfather emissions rights can have important cost impacts. Similarly, the choice of how to recycle revenues from environmentally motivated taxes can be as important to cost as whether the tax takes the form of an emissions tax or fuel tax, particularly when modest emissions reductions are involved. In both first- and second-best settings, the cost differences across instruments depend 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.

When Can Carbon Abatement Policies Increase Welfare? The Fundamental Role of Distorted Factor Markets

Abstract This paper employs analytical and numerical models to assess the welfare effects of a revenue-neutral carbon tax and (nonauctioned) carbon emissions permits, taking into account preexisting tax distortions in factor markets. The presence of preexisting taxes significantly raises the general equilibrium costs of both policies. This cost increase is much greater under emissions permits, since this policy does not generate revenues to reduce distortionary taxes. Under our central estimates emissions permits cannot increase welfare unless environmental damages exceed about

The Substantial Bias from Ignoring General Equilibrium Effects in Estimating Excess Burden, and a Practical Solution

18 per ton of carbon. In contrast, an appropriately scaled carbon tax is welfare-improving so long as environmental damages are positive.

A second-best evaluation of eight policy instruments to reduce carbon emissions

We show that under typical conditions the simple “excess‐burden triangle” formula substantially underestimates the excess burden of commodity taxes, in some cases by a factor of 10 or more. This formula performs poorly because it ignores general equilibrium interactions—most important, interactions between the taxed commodity and the labor market. Many prior studies have shown that general equilibrium interactions affect excess burden but have not appreciated the bias associated with ignoring these interactions or the quantitative importance of this bias. We derive an implementable alternative to the simple formula. This alternative formula captures interactions that the simple formula omits; as a result it is both unbiased and usually more accurate.

The Cost of Reducing Gasoline Consumption

This paper uses a numerical general equilibrium model to compare the costs of alternative policies for reducing carbon emissions in a second-best setting with a distortionary tax on labor. We examine a carbon tax, two energy taxes, and both narrow-based and broad-based emissions permits and performance standards. The presence of pre-existing tax distortions raises the costs of all these policies, and can affect their relative cost rankings. In fact, the superiority of emissions taxes and emissions permits over other instruments can hinge on whether these policies generate revenues that are used to reduce other distortionary taxes.

Health effects and optimal environmental taxes

High nominal gas prices, new awareness of threats to national security, and growing concern about global warming have reignited discussion of ways to reduce gasoline consumption in the United States. Debate centers on changing two policies already in place: the federal gas tax and Corporate Average Fuel Economy (CAFE) standards. Two influential recent reports find that increasing the gas tax would attain a given reduction in gas consumption at lower cost than would tightening CAFE standards (National Research Council, 2002; Congressional Budget Office, 2003). The gas tax has this advantage because it encourages not just increases in fuel efficiency, but also reductions in miles driven. In contrast, CAFE standards actually encourage more driving, because increases in fuel efficiency reduce the cost of gas per mile driven. We also compare the costs of the gas tax and CAFE standard but take into account interactions with preexisting tax distortions. Many papers examine the effects of these tax interactions in other contexts, but to our knowledge none of them considers the CAFE standard (see e.g., Lars Bovenberg and Ruud de Mooij, 1994; Ian Parry, 1995; Lawrence Goulder, 1995; Bovenberg and Goulder, 1996; Parry et al., 1999; Don Fullerton and Gilbert Metcalf, 2001). These interactions reduce the cost of the gas tax but increase the cost of CAFE, thus expanding the cost advantage enjoyed by the gas tax. This difference does not arise because the gas tax raises revenue, while the CAFE standard does not. Rather, this result is similar to that in West and Williams (2004a), which showed that, since gasoline and leisure are relative complements, raising the gas tax will increase labor supply, generating additional efficiency gains. In this paper, we estimate a consumer demand system using data from the Consumer Expenditure Survey and the California Air Resources Board and find that miles driven and leisure are relative complements. Thus, the gas tax encourages labor supply by raising the cost per mile driven, producing an additional efficiency gain. Conversely, because CAFE reduces the cost per mile, it discourages labor supply and yields an additional efficiency loss. While the induced changes in labor supply are tiny relative to the labor market, they are still substantial relative to the gas market and thus have a dramatic effect on the relative costs of the two policies. Our point estimates imply that they reduce the social marginal cost of the gas tax (starting from the status quo gas tax rate and ignoring the benefits of reduced gas consumption) by almost 30 percent, while increasing the marginal cost of CAFE by nearly 60 percent. This result implies that the case for raising the gas tax rather than tightening the CAFE standard is far stronger than previous studies suggest. Indeed, it strongly suggests that any tightening at all of the CAFE standard would lower welfare unless the benefits of reduced gas consumption have been seriously underestimated.

The Choice of Discount Rate for Climate Change Policy Evaluation

Abstract The literature on environmental taxation in the presence of pre-existing distortionary taxes has shown that interactions with these distortions tend to raise the cost of an environmental tax, and thus that the optimal environmental tax is less than marginal environmental damages. A recent paper by Schwartz and Repetto (2000) challenges this finding, arguing that the health benefits from reduced pollution will also interact with pre-existing taxes, and may cause the optimal environmental tax to exceed marginal damages. Schwartz and Repetto’s analysis represented health effects implicitly in the utility function. In contrast, the present paper explicitly represents health effects in an analytically tractable general equilibrium model. This model shows that interactions with health effects from pollution actually will tend to reduce the optimal environmental tax, contradicting, Schwartz and Repetto’s conclusion. This demonstrates the usefulness of explicitly modeling health effects, and it reinforces the general notion that tax-interactions tend to raise the costs of an environmental tax.

Growing State-Federal Conflicts in Environmental Policy: The Role of Market-Based Regulation

Nearly all discussions about the appropriate consumption discount rate for climate change policy evaluation assume that a single discount rate concept applies. We argue that two distinct concepts and associated rates apply. We distinguish between a social-welfare-equivalent discount rate appropriate for determining whether a given policy would augment social welfare (according to a postulated social welfare function) and a finance-equivalent discount rate suitable for determining whether the policy would offer a potential Pareto improvement. Distinguishing between the two rates helps resolve arguments as to whether the choice of discount rate should be based on ethical considerations or empirical information (such as market interest rates), and whether the discount rate should serve a prescriptive or descriptive role. Separating out the two rates also helps clarify disputes about the appropriate stringency of climate change policy. We find that the structure of leading numerical optimization models used for climate policy analysis may have helped contribute to the blurring of the differences between the two rates. In addition, we indicate that uncertainty about underlying ethical parameters or market conditions implies that both rates should decline as the time horizon increases.

General Equilibrium Impacts of a Federal Clean Energy Standard

In recent years, cases in which state governments chose to override federal environmental regulation with tighter regulations of their own have become increasingly common, even for pollutants that have substantial spillovers across states. This paper argues that this change arose at least in part because of a shift in the type of regulation used at the federal level, from command-and-control regulation toward more incentive-based regulation. Under an incentive-based federal regulation, a state imposing a tighter regulation will bear only part of the additional cost, and thus has more incentive to tighten regulation than it does under federal command-and-control. This difference helps to explain observed patterns of regulation. In addition, it has implications for the choice of regulatory instruments. For a pollutant that causes both local and spillover damage, a federal pollution tax is likely to yield a more efficient outcome than federal command-and-control policy or a federal system of tradable permits.

The Initial Incidence of a Carbon Tax Across Income Groups

Economists have tended to view emissions pricing (e.g., cap and trade or a carbon tax) as the most cost-effective approach to reducing greenhouse gas emissions. This paper offers a different view. Employing analytical and numerically solved general equilibrium models, it provides plausible conditions under which a more conventional form of regulation—namely, the use of a clean energy standard (CES)—is more cost-effective. The models reveal that the CES distorts factor markets less because it is a smaller implicit tax on factors of production. This advantage more than offsets the disadvantages of the CES when minor emissions reductions are involved. (JEL H23, Q42, Q48, Q54, Q58)