1. Facoltà di Economia “G. Fuà” Università Politecnica delle Marche Facoltà di Economia “G. Fuà” Università Politecnica delle Marche 1 Environmental Policies: Principles and Instruments â Environmental taxes and standards - Optimal pollution level - The Pigouvian tax - Taxes vs. Standards - Other instruments â

2. 2 Environmental Policy and the optimal pollution level  Recall that: the optimal allocation of the environmental resources can be restored by assigning exclusive property rights and allowing for free transactions on them (Coase Theorem)  The achievement of this social optimum still being the objective, environmental policies are designed to efficiently pursue this objective any time voluntary negotiations and trade do not occur or become too costly or favour speculative strategic behaviour (free- riding, for instance).  We analyse now some classical environmental policy instruments that aim at restoring optimal use by affecting the voluntary behaviour of agents (mostly, of those who use the environmental goods, the “polluters”): :  Environmental taxes  E. standards  E. payments (or subsidies or incentives)  E. negotiable rights (permissions)  We discuss these instruments in terms of ability to achieve the optimal pollution level (the optimal combination between social benefits and costs) but also in terms of distributional effects (who is going to pay the costs, who is going to receive the benefits)

3. 3 The optimal pollution level: definition Let’s go back to our simple “model”: the polluter vs. the polluted; the private good (Q) vs. the public good (E). In general terms, starting from zero-pollution we can think about 3 different levels of pollution: Q0Q0 ASSIMILATION or ABSORPTION CAPACITY: Pollution level that does not imply costs (reduction of welfare) (  zero pollution) OPTIMAL NEGATIVE EXTERNALITY (POLLUTION) (Pareto irrelevant) NON-OPTIMAL NEGATIVE EXTERNALITY (POLLUTION) (Pareto relevant: regulation)

4. 4 Environmental policies: the Pigouvian tax  In the case of “polluter vs. polluted”, even when the negotiation a lá Coase does not work, it remains possible to restore the optimal pollution level (Q S ) through a direct intervention of the “State” (“Government”) that eliminates the Pareto-relevant negative externality  The solution relies on the internalization of the social cost, that is, on making social cost be part of the private (polluter) cost in producing Q. This can be achieved by introducing a tax on production of Q.  A tax on the polluting good (Q) that equalizes private costs and (relevant) social costs is also called Pigouvian tax (A.C. Pigou)  In many applications, environmental (or pollution) taxes behave as Pigouvian taxes. Let’s see, conceptually, how such tax is expected to work

5. 5 The Pigouvian tax - 1 Bm(Q) t t t* Pigouvian tax Bm(Q) t = Bm(Q) - t

6. 6 The Pigouvian tax - 2  The tax lowers Bm(Q) by t for any level of Q. Therefore the after-tax benefit of the polluter is: Bm(Q) t = Bm(Q) – t. However, as it also includes the tax revenue, the benefit of the society remains the same: (Bm(Q) t + t) = Bm(Q) – t + t = Bm(Q)  Whenever t is exactly fixed at the value of the social marginal cost in Q S, i.e. Cm(Q S ), we have the optimal Pigouvian tax (t*), as it induces the polluter to spontaneously produce the socially optimal level Q S : all the Pareto-relevant negative externality is internalized  In fact, such tax should be in principle established as follows: 1) indentify the optimal pollution level Q S ; 2) compute the respective (social) marginal cost Cm(Q S ); 3) fix and impose the tax t = Cm(Q S )  What about the Pareto-irrelevant negative externality?  The state obtains a tax revenue (t* x Q S ) that can be redistributed as compensation payments to those that still bear the Pareto-irrelevant costs.

7. 7 The Pigouvian tax - PROS  The idea behind the Pigouvian tax is straightforward and intuitive and it applies the polluter pays principle:  It achieves the social optimum (allocation problem) through a spontaneous (market) decision of the polluter  The polluter fully pays the cost he/she generates thus eliminating the Pareto-relevant costs while compensating the Pareto-irrelevant one (distributional problem)  It looks like an application of the Coase Theorem.  The state initially holds the exclusive property rights on the polluted good (E)  The state is the representative of all polluted individuals and thus negotiates with the polluter by accepting to sell rights on E (therefore accepting pollution) only at price equal to or higher than Cm(Q)  Negotiation will eventually come to an end with the polluted (represented by the state) selling at price t* rights corresponding to Q S  Transaction implies that the polluter pays the total tax revenue (t* x Q S ) for these rights

8. 8 The Pigouvian tax - CONS  Asymmetric information: once more, to fix the optimal tax we need to know both the value of Cm(Q) and Bm(Q). For the former, we have already discussed the difficulties we may encounter. For the latter, the state may find problems in finding information about Bm(Q) as, under taxes, the polluter will have all the interest to do not reveal it (evidently t* increases as Bm(Q) increases). The tax-imposing institution has to face this problem of incomplete information about the polluter  Risk of over-taxation: even if we accept that property rights “naturally” belong to the state and that the polluter pays principle must hold, it remains true that the Pigouvian tax implies that: 1) The tax “takes away” from the polluter more than the Pareto-irrelevant cost (externality). This implies a net redistributional effect against the polluter itself and in favour of the polluted (over- compensation) 2) The tax applies also to the pollution levels still under the assimilation capacity (Q 0 ) thus inducing an unjustified taxation for low levels of Q

9. 9 Environmental standards - 1  To achieve a solution (in both allocative and distributional terms) about the use of environmental goods, one often adopted alternative to imposing environmental tax is fixing environmental standards  In practice, those standards are technical thresholds that can not be exceeded by the polluters, therefore a sort of maximum admitted cost generated in terms, for instance, of water or air pollution and expressed as maximum admitted concentration of nitrates in water, of PM10 in air etc. Such standards are mostly established on the basis of technical (medical, biological, engineering…) evaluations rather than according to economic considerations.  Nonetheless, we are interested in dealing with environmental standards as viable alternative to environmental taxes, therefore according to their economic implications in terms of allocative efficiency and distributional effects. Thus, it is worth recalling that:  We are considering pollution in a sort of static representation, that is, assuming a constant technology for which there is a univocal relation between the production level of Q and the consumption of the environmental good E.  Therefore, the standard can be viewed as the minimum acceptable level E* under which it is not admitted to go and, therefore, as the maximum level Q* the polluter is allowed to produce.  For production levels lower than Q*, the polluter does not bear any cost for polluting. If production exceeds Q*, the polluter has to pay a sanction (a fine) of amount M.

10. 10 Q* M* As for the environmental tax, the sanction is a cost for the polluter. Therefore, a standard exclusively satisfying a “technical” objective Q* implies a minimum sanction of M*. QSQS MSMS If the standard has also an economic (allocative) purpose (achieving the social optimum) it should be fixed at Q S and the minimum (and efficient) sanction at M S. The sanction acts as the Pigouvian tax in allocative terms, while it has no distributional implications (no polluter pays principle, no over-taxation) It must be taken into account, however, that the sanction is not certain any time the standard is exceeded (violated). It depends on how difficult and costly controlling activities are. The polluter will thus behave on the base of the expected sanction (or the actual sanction), that is, M P = p M S, where p is the probability of being sanctioned upon violation of the standard. If p = 0.5, the actual sanction is 1/2 M S and the standard will be not respected (Q P ) unless the sanction is raised to 2M S 1/2M S QPQP Environmental standards - 2

11. 11 A synthesis of alternative instruments (Source: Silvestri) C&C = Command and Control PROS (+) and CONS (-) Effectiveness (wrt objective) Efficiency (allocative) Stimulus to improvements (dynamic effects) Equity-Ethical concerns C&C regulations E. Standards +--+ Fiscal measures E. Taxes +=+= E. Subsidies ---- Contractual instruments Tradable Permissions +++- Coase-wise Negotiation -+-- E. Certification ++++