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Taxes and Trading versus Intensity Standards: Second-Best Environmental Policies with Incomplete Regulation (Leakage) or Market Power

  • Stephen P. Holland

This paper investigates whether an emissions tax (equivalent to an emissions cap) maximizes social welfare (defined as the sum of consumer and producer surplus) in the presence of incomplete regulation (leakage) or market power by analyzing an intensity standard regulating emissions per unit of output. With no other market failures, an intensity standard indeed yields lower welfare, although combining it with a consumption tax eliminates this discrepancy. For incomplete regulation, I show that under certain conditions an intensity standard can yield higher welfare than any emissions tax (including the optimal emissions tax). This result persists even with the addition of a consumption tax, which ameliorates output distortions and can sometimes help the intensity standard attain the first best (when an emissions tax/consumption tax combination cannot). Comparing intensity standards to output-based updating shows that the latter yields higher welfare because of its additional flexibility. Finally, I show that with market power an intensity standard can yield higher welfare than the optimal emissions tax. The intuition of these results is relatively straightforward. The weakness of an intensity standard is that it relies more on substitution effects than output effects to reduce emissions. With incomplete regulation or market power, this disadvantage may be helpful since leakage may offset gains from reducing output and since market power already inefficiently reduces output.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15262.

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Date of creation: Aug 2009
Date of revision:
Publication status: published as “Taxes and Trading versus Intensity Standards: Second - Best Environmental Policies with Incomplete Regulation (Leakage) or Market Power” Journal of Environmental Economics and Management (2012) 63 (3): 375 – 387 .
Handle: RePEc:nbr:nberwo:15262
Note: EEE PE
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  1. Fischer, Carolyn, 2001. "Rebating Environmental Policy Revenues: Output-Based Allocations and Tradable Performance Standards," Discussion Papers dp-01-22, Resources For the Future.
  2. James B. Bushnell & Yihsu Chen, 2009. "Regulation, Allocation, and Leakage in Cap-and-Trade Markets for CO2," NBER Working Papers 15495, National Bureau of Economic Research, Inc.
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  9. Fischer, Carolyn, 2003. "Output-Based Allocation of Environmental Policy Revenues and Imperfect Competition," Discussion Papers dp-02-60, Resources For the Future.
  10. Erin T. Mansur, 2007. "Prices vs. Quantities: Environmental Regulation and Imperfect Competition," NBER Working Papers 13510, National Bureau of Economic Research, Inc.
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  13. Helfand, Gloria E, 1991. "Standards versus Standards: The Effects of Different Pollution Restrictions," American Economic Review, American Economic Association, vol. 81(3), pages 622-34, June.
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  16. Bovenberg, A.L. & Goulder, L.H. & Jacobson, M.R., 2006. "Costs of Alternative Environmental Policy Instruments in the Presence of Industry Compensation Requirements," Discussion Paper 2006-127, Tilburg University, Center for Economic Research.
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