The Cost of Environmental Policy in a General Equilibrium Framework

Resources For The Future Inc, Washington DC

Investigators

Abstract

The costs of environmental policy are frequently thought of as the direct costs to firms and individuals associated with compliance. Yet, modeling efforts over the past ten years have consistently demonstrated that interactions with existing tax distortions can increase (and under less common circumstances decrease) the cost to society by a factor of several times. This is in complete agreement with early work by Harberger who emphasized that taxation in one market can lead to large welfare effects in other related markets. At the same time, however, classic theoretical work on public good provision by Diamond and Mirrlees suggests only a modest divergence between direct and social costs. This disagreement can be traced to opposing assumptions about the nature of the tax system: optimal versus fixed taxes. Despite considerable work on the topic of regulation in the presence of existing taxes, there has been little attempt in the environment literature or the public finance literature to reconcile these results in a unified model. This is particularly important for environmental policy since the relative cost of different policy options (e.g., tradable permits versus command-and-control) depends on these effects. This project develops a general equilibrium framework that can be used to examine the social cost of different environmental policies under alternate assumptions about government fiscal behavior. The analytic framework is based on classic public finance models suitably modified to consider these differences. Expressions are derived for the marginal social costs associated with the various combinations of environmental policy and fiscal behavior, linking this exercise with previous work and providing much needed intuition about distinct outcomes. The practical goal is to provide guidance to analysts and policymakers, who wish to evaluate environmental policy with specific, or at least transparent, assumptions about fiscal policy. The scholarly goal is to unify work on both public good provision and environmental regulation under alternative fiscal assumptions. Cost-benefit analysis is one of the foremost tools of environmental policy analysis. Even when benefits are difficult to quantify, cost studies often provide the impetus for or against proposed regulation. Since considerable theoretical and empirical work has demonstrated the potential for social costs to diverge significantly from private costs, a thorough and yet practical understanding of the determinants of that divergence is important. It is important for accurate cost analysis and it is important for good policy decisions. By clarifying the connection between government fiscal policy and social costs of environmental policy, the proposed research can enlighten the discussion of costs and benefits and improve the quality of cost analyses.