For many decades, economists have argued the case for taxes on pollution. From an economic perspective, such taxes (or effluent charges, as they are often called) serve to correct a serious source of market failure: the absence of a "price" needed to prevent the careless and excessive use of scarce environmental resources. However, the economist's case has not found a receptive audience in the policy arena. Instead, legislators and regulators have ignored this policy approach in favor of the more traditional command-and-control measures under which environmental agencies specify emissions limitations and control technology polluter by polluter. Many studies have documented the unnecessarily high costs and other wastes associated with these programs, but with a few exceptions, these studies have not had much effect on the design of environmental policy.
During the past year, a new interest in taxes on pollution has emerged. In the desperate search for new revenue sources to reduce the deficit in the federal budget, legislators both in the House and Senate have begun to give more serious consideration to such taxes. This interest has led to the introduction by Congressman Judd Gregg of New Hampshire of a bill entitled "The Sulfur and Nitrogen Emissions Tax Act of 1987" (H.R. 2497). Hearings on the bill were held by the House Ways and Means Committee in September 1987. Not surprisingly, the hearings brought forth strong opposition from representatives of the coal industry and various public utilities, which appears, for the moment, to have stalled progress on the bill. More generally, however, the Congress continues to be interested in the idea of taxes on pollution as a source of federal revenues.
In principle, taxes on pollution offer not only an effective policy approach to protection of the environment, but also a very appealing addition to the revenue system. While most taxes have harmful side effects on the economy by distorting economic choices, taxes on pollution have socially beneficial side effects such that they cost society less than the revenues they produce.
The economic rationale
The economic case for pollution taxes is really just a straightforward corollary of the logic underlying a market system. The proper functioning of a system of free markets depends on the emergence of a set of prices that accurately reflect the cost to society of the resources used in the production of goods and services. Prices are the basic signals in a market system that direct the flow of resources to their most productive use. For most goods and services, the market forces of supply and demand generate the proper price.
Under certain circumstances, however, such prices may not reflect true social cost—and pollution is a classic case of such a circumstance. The basic point is straightforward: the absence of an appropriate price for certain of our scarce environmental resources (such as clean air and water) has led to their overuse, resulting in what the textbooks call a case of "market failure." A producer, for example, whose factory spews smoke on a neighboring residential area is using up a scarce resource—clean air; put slightly differently, the producer is imposing a real cost on those who must live with the dirty air. But the firm need not bear this cost in the same way that it pays for other resources—labor and raw materials—that it employs. While the price of labor and materials encourages the firm to economize on their use, there is no such incentive for the firm to control its smoke emissions. Whenever a scarce resource is made available free of charge (as is the case where individuals have free access to our limited stocks of clean air and water), it is bound to be used to excess. Producers and consumers alike must be made to bear the costs that their activities impose on others if they are to be expected to adjust these activities in light of the costs.
From this perspective, the basic cause of excessive environmental degradation is the absence of an appropriate price for scarce environmental resources. Once accepted, this proposition has a direct policy implication: the need for government to intervene and, in the absence of the interplay of supply and demand, to impose an artificial price, a tax (or effluent fee), on damaging waste emissions. It is easy to show in terms of microeconomic analysis that if this tax is set equal to the value of the damages from an additional unit of emissions, sources will have the proper incentive for controlling their discharges of pollutants. Economic analysis thus suggests the need for taxation of pollution to correct for a serious "failure" in a competitive market system.
"We are paying far more than is necessary to clean up the environment."
Traditional command-and-control programs, by contrast, are much less efficient policy instruments, because it is virtually impossible for the environmental authority that must prescribe control measures to know what the most effective and least costly control technology will be for each polluter. These programs often result in across-the-board requirements for control measures that fail to take account of the particular circumstances of individual polluters. There is now a large body of empirical work that describes the enormous waste associated with these programs. Existing studies of U.S. programs for the management of air and water quality find that control costs to polluters range from double to (in some instances) more than ten times the least-cost outcome! In short, we are paying far more than is necessary to clean up the environment.
Probably even more important than this distortion in the choice among existing control technologies is the lack of compelling incentives for research and development in abatement technology. Over the longer haul, the success of our environmental programs will depend critically upon our capacity to discover and employ more effective and less costly methods of pollution control. The command-and-control approach not only fails to provide these incentives, but may actually discourage such pursuits: a firm that finds a new and better way to control its waste discharges may be "rewarded" by the environmental agency with a tougher set of abatement directives.
In contrast, pollution taxes provide a powerful set of incentives that encourage both the selection of the proper control technology among existing options and the search for new and more effective abatement procedures. Such activities would be directly profitable to polluters, since they would reduce costs. For example, a firm that discovers a less expensive way to control its waste discharges could employ this new technique to reduce its discharges yet further. It would realize savings both on its control activities and on its tax bill as a result of lowering the level of waste emissions. And society benefits from the cleaner environment that results in turn. A system of pollution taxes would effectively harness the powerful market force of competition on behalf of environmental protection.
The revenue rationale
If the basic economic rationale for instituting pollution taxes is to correct a malfunctioning in the market system—the case set out above—then the level of tax rates should be determined by our environmental objectives, not by revenue considerations. Tax rates should be set such that waste discharges are cut back to levels consistent with our targets for air and water quality. Nevertheless, such taxes would naturally produce revenues for the public sector.
Taxes on pollution would constitute a very appealing component of our overall revenue system. Any system of taxation creates a myriad of incentives for individuals and firms, incentives that lead to a variety of adjustments in economic behavior. What is troubling is that the vast majority of these adjustments are harmful: they introduce distortions into the functioning of the economy, with resulting losses in social welfare. A tax on wage or salary income, for example, not only raises revenues but also creates disincentives to work. If 50 or 60 cents of an extra dollar of income is drained off in additional taxes, people have a compelling incentive to cut back on work effort and to substitute untaxed leisure pursuits for income-producing activities.
"Pollution taxes would effectively harness the powerful market force of competition on behalf of environmental protection."
Moreover, there is now a large body of empirical work suggesting that the welfare losses to society from the distortions caused by our tax system are quite substantial. In a recent survey of this work, Edgar Browning of Texas A&M finds that although there remains great uncertainty concerning the magnitude of the distortion associated with taxes on labor earnings, it is potentially quite large, with estimates ranging from a low of about 8 cents lost per dollar of tax revenues to an upper bound in excess of $1.00. The true costs to society of the taxes we pay are larger (probably much larger) than the amounts of revenue actually collected. Taxes on pollution thus have a major attraction: not only can they provide needed protection for the environment, but they can substitute for other revenue sources that damage the economy.
Admittedly, the revenue potential of pollution taxes, while not trivial, appears modest. David Terkla of Boston University has made a detailed study of the potential revenues from the taxation of sulfur and particulate-matter emissions from stationary sources in the United States. Terkla calculates that annual revenues in 1982 dollars would range from a lower bound of about $1.8 billion to a high of $8.7 billion. The great bulk of these revenues, he estimates, would come from the tax on sulfur discharges. Revenue estimates for this tax alone range from a minimum of $1.7 billion to an upper bound of $8.5 billion. Another recent estimate, this one prepared by the staffs of the Joint Committee on Taxation and the House Committee on Ways and Means, assumes a tax of 45 cents per pound on sulfur and nitrogen dioxide emissions from boilers and furnaces, and puts annual revenues from the tax at about $6.3 billion.
These revenue estimates are not large when compared to the overall revenue needs of the public sector. Pollution taxes obviously could not completely replace major taxes, such as income and sales taxes, in our revenue system. Nevertheless, they have a potential role to play. A broad set of pollution taxes encompassing most of the major air and water pollutants—and perhaps other wastes, including those that find their way into landfills—would obviously produce more tax receipts. These monies could relieve pressures for injurious increases (or perhaps permit decreases) in rates of the major forms of taxation.
Revenues from pollution taxes could thus substitute to some extent for revenues from "harmful" taxes. Terkla, in his aforementioned study, also explored the potential "efficiency gains" from the use of pollution taxes. These gains result from removing distortions to the economy caused by income and other taxes. Terkla finds the gains to be of measurable significance. He calculates that if his estimated revenues from the taxes on sulfur and particulate matter were substituted for tax receipts from labor income, there would be a savings to society ranging from $0.6 billion to $3.1 billion. If these revenues were substituted for corporate income taxes, the efficiency gains, would be even larger—ranging from $1 billion to $4.9 billion. Such results suggest that the gains from a more efficient economy might offset as much as one half of the revenues themselves.
Implications for legislation
As the general support for pollution taxes becomes embodied in actual legislation, it is essential to scrutinize carefully the particular provisions of proposed bills to ensure that the essential properties of this approach are not compromised in the legislative process. Certain issues are central to an effective piece of legislation—and the Gregg bill, H.R. 2497, is instructive in this regard.
First, the tax base must be defined correctly. The tax must be levied on the level of waste emissions—that is, it must be a tax per unit of actual waste discharges (for example, a levy of 25 cents per pound of sulfur emitted into the atmosphere). The tax must provide a direct Incentive to polluters to cut back on their waste emissions; thus, a tax on the sales or profits of polluting industries will not do—the tax must be directly on emissions. The Gregg bill, incidentally, has the right tax base: it provides for a tax on emissions of sulfur and nitrogen oxides.
Second, legislation should ensure that the revenues from the tax are directed to reducing the federal deficit, and later to decreasing levels of other, more harmful, taxes. There is a strong temptation to direct revenues from a pollution tax into some kind of environmental trust fund. In the case of the Gregg bill, for example, a provision is made for the creation of a Sulfur and Nitrogen Emissions Trust Fund from which monies would be made available to assist polluters in their control efforts. This particular measure was designed, in part, to soften opposition from those subject to the tax. However, as the hearings on the bill made clear, that strategy was not successful and should be strongly resisted. The revenues from pollution taxes should become part of general revenues.
Third, it is desirable to retain some flexibility over the tax rate—unlike the Gregg bill, which prescribes a fixed set of rates. It might well turn out, for example, that the rate prescribed in the bill is insufficiently high to attain our targeted level of air quality. Or, alternatively, the rate could be so high as to lead to "excessive" cleanup at very high cost to society. It is important in such instances to have the capacity to adjust the tax rate to the proper level. This doesn't mean that rates need to be adjusted every month or so, but rather that we should not lock ourselves into a single rate over a long period of time; opportunities should exist to review the rate.
And fourth, for pollution taxes to be effective, they must not be accompanied by regulations on pollution control technology. The taxes themselves should provide the incentives for firms to seek out and use the least-cost methods for controlling their emissions. If the environmental agency has prescribed treatment procedures for polluters, then taxes obviously cannot perform this function. The basic rationale for pollution taxes would be compromised. This point needs special emphasis, for it is fundamental to the proposal for pollution taxes. Such taxes cannot be overlaid on a command-and-control system of regulated technologies without destroying the efficiency-enhancing properties of the effluent tax system.
A market alternative
No discussion of market incentives for pollution control would be complete without mentioning an intriguing alternative to pollution taxes: a system of transferable discharge permits. Instead of taxing sources on their emissions, the environmental authority could issue a limited number of permits that authorize the emission of a specific amount of the relevant pollutant (where the number of permits is kept sufficiently low to achieve the environmental target). Sources would then be free to buy and sell these discharge permits. In principle at least, such a system has the same cost-saving properties as a system of pollution taxes—namely, it can achieve the target level of environmental quality at the least cost to society.
"Pollution taxes must not be accompanied by technological regulations on polluters."
Permits may have some advantages over taxes; for one thing, they give the environmental agency direct control over the level of emissions through control of the number of permits (rather than indirect control through regulating the level of the tax rate on discharges). Moreover, since existing regulatory systems make use of permits, making them marketable would appear to be a less wrenching change in our approach to environmental protection than scrapping permit systems altogether fora system of pollution taxes. The Environmental Protection Agency has gone some distance toward such a system of transferable permits with its Emissions Trading Program for the control of certain air pollutants. Some states now have programs that allow sources to exchange emissions entitlements, and many of these exchanges have resulted in large cost savings.
However, taxes have their appeal as well: they present a direct price incentive to sources (without the need to organize a market in discharge permits) and raise needed tax revenues. The choice between these two market instruments for pollution control is a fascinating issue in policy analysis. As economic analysis has shown, where it is crucial to prevent levels of pollution from exceeding certain damaging threshold levels, the permit approach is especially attractive because of the direct control it provides over levels of emissions through limiting the number of permits. But where the greater danger is one of excessive costs of pollution control, taxes or fees have the advantage since sources can always avoid high costs of pollution control by maintaining emissions and paying the associated taxes. Each of these approaches has its own important place in the broader spectrum of policies for management of the environment.
Wallace Oates is professor of economics at the University of Maryland and visiting scholar in RFF's Quality of the Environment Division. This article is based on his testimony in September 1987 before the House Ways and Means Committee on H.R. 2497, the Sulfur and Nitrogen Emissions Tax Act of 1987.
A version of this article appeared in print in the May 1988 issue of Resources magazine.
