Is a taxation solution to the pollution externality problem preferable to other possible solutions?

University Degree Business and Administrative studies

Victoria Taylor - - 21/11/02

Is a taxation solution to the pollution externality

problem preferable to other possible solutions?

In the last few decades decreases in air quality, acid rain, depletion of the rainforest and other forms of pollution have become a growing concern for the whole world. As a result, protection of the environment has become a major political and economic issue. The deterioration of the environment clearly lies in the field of economics as it is a direct consequence of production and consumption trends. Therefore can the setting of environmental taxes be the best method of solving this major problem?

Firstly we need to consider why we require any type of environmental controls. Previously the environment was seen to be in never ending supply, to be used as we liked and therefore seemed to be a free market. This, as with any free market, lead to over consumption of natural resources. In recent years we discovered that these materials are not in unlimited supply, and therefore required conservation, not exploitation. The main problem was, or is, that as society had become used to the standard of living that accompanied the products which created this adverse externality. Therefore beneficial regulations or incentives, for both the environment and the public, had to be created.

Economic incentive instruments can be categorised into three main sections; direct alteration of costs or prices, for example taxes on products or certain processes which increase the total external costs of a firm. This is the cost a firm is required for to pay to stop a percentage of its total pollution. This may also cause an increase in consumer price; indirect alteration of price or costs, such as direct subsidies which provide firms with financial assistance to encourage purchase of more advanced environmentally friendly equipment; finally, changed legislation or regulation quota creates a market for the trading of permits between plants or industries.

The British economist Pigou first envisioned taxes set on pollution emissions, in 1920. He suggested that polluters should pay a tax based on the estimated damages the emissions could cause. This damage should be based on concise information and not only project the short run effects but the long run effects, such as global warming.

For the tax, T1T2, to do its intended job, of reducing pollution levels, it has to be set in line with the optimal social level, Qo (see Figure 1). To show this we can consider the example of wastewater discharge from many sources, as this will be in keeping with the example that will follow. The optimal level is found by comparing the marginal net private benefit curve and the marginal external cost curve. The optimal pollution level is not found where the pollution is termed to be zero as this is not a feasible option because the costs of prevention would be extremely high. The optimal level, Qo, is therefore found at a compromise between reasonable prevention costs and the benefit from the profit of the goods produced. This is shown by figure 1. If the firm works below Qo it will not benefit from the maximum profits made by the maximum output, but as the firm produces at a higher output past Qo then the profits they make on the extra units will be less than the tax imposed on the units and therefore the firm will be working at a loss.

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Policies set up in the Philippines to ensure environmentally sustainable economic growth is a good example of research into where taxes should be set. After three years or preparation with the World Bank they launched their first taxes on water discharge which required the polluter to pay a fee for every unit of pollution they discharge. This fee was in addition to meeting the existing discharge standards. In principal the system was expected to cover all polluting activities and all media. To achieve this they would have to implement the system in gradual steps; therefore they used this first phase to evaluate the benefits of the policies. The government will then build on this stage to mainstream the program throughout the country. The Philippines also recognised that the revenues from these fees could be put to good use and therefore set up a water quality management scheme and also gave 20 percent of the proceeded to the government to cover administrative costs.

The excess revenue and reinvestment into schemes, which will improve the environment further, found in this example also shows two of the main benefits that accompany taxes as a means of pollution control. Other benefits that can be found from taxing pollution emission include the already established system for collection, which will therefore not incur high initial or enforcement costs; a reduction in secondary pollutants which may have accompanied the targeted emission and the incentive for increased improvement on pollution output. An example of the final benefit can be found in the United States where after a tax was put on the production of ozone depleting products in 1989 the level of production never exceeded 65 percent of the allowable level. Production of CFC’s has now fallen faster than world production, which was not expected before the tax was introduced.

With all benefits there is also a complement of problems. We have already mentioned the problem of where the tax should be set. A problem that then arises once the tax is set is who actually pays the taxes? And who should pay for the taxes? As green taxes are an example of the “polluter pays principle”, this is the principle that states those who cause the pollution should pay the damage costs that go along with it. This can cause large problems with the general public depending on how elastic the market that generates the pollution is elasticity of a market tells how sensitive consumers are to price. Elastic markets are very sensitive to price and therefore as price changes the quantity demanded will change by a proportionately larger amount. This generally occurs in a market where there are many substitute goods that consumers can change to: for example if a tax was put on washing powders that contained phosphates the consumers of the powder would simply change brands if the tax resulted in an increase in the price. Therefore in an elastic market, producers have to pay the brunt of the costs or suffer a fall in consumers. Some commentators claim that the decrease in profits causes industry to put pressure on governments to not adopt a taxing policy as it incurs larger charges than most alternate schemes. The curves in figure 1 show this as profits fall from the whole green area to simply area A as a result of decreased output (D) and tax costs (B+C) when the tax is imposed. The alternate type of demand curve is an inelastic one where there is not a vast array of alternates for consumers to change to and therefore when a tax is placed on the goods they require and the price increases there is only a small proportionate change in the quantity demanded. This results in a much larger fraction of the tax being paid by consumers because the producers realise that people will be forced to pay the increased price.

The final problem occurs on an international level. If one country imposes an environmental measure on its own industries those industries will then be at a disadvantage to foreign competitors who do not have such measures and therefore have cheaper running costs. This will make domestic goods less attractive to consumers and tip the balance of payments towards imports, reducing the national economy.

An example that illustrates what problems can occur with such a tax can be seen in China. In 1979 China experimented with environmental taxes and standards. By the early 1980’s the system was incorporated into law and expanded to cover the whole country. The amount of revenue gained by the government rapidly increased from 1.2 billion Yuan in 1986 to 2.7 billion Yuan in 1993, and after that it seemed the environmental measures had been set and accepted as a good measure much too quickly. This resulted in twenty nine pollutants in wastewater, thirteen pollutants in industrial gases, noise all forms of solid and radioactive waste being subject to a fee. This rapid expansion meant that charge rates were calculated too low and enforcement was not strong enough. Therefore the taxes were below the marginal costs of pollution control and were not indexed to inflation; this resulted in only a small change in the output of pollution emissions because the polluters did not see the taxes as a large enough threat. Consequently it can be seen that a government should not rush into taxes because if they are not calculated correctly then they will not be taken seriously.

The main environmental instrument used in the UK is setting a quantity based standard to which emissions must be below. Setting a standard is usually made without reference to the value of the goods being produced (MNPB curve – Figure 1) and therefore may not have the desired effect. Generally these standards have a fixed fine that accompanies the standard this type of regulation require a large amount of enforcement, especially if the fine relatively low because if the fine is set below or a small amount above the profit that the firm could make on the extra units produced then they will take the risk because overall they will not make a loss. This enforcement also increases the total abatement costs to the government because there will be the wages of the enforcers and penalty administration to be paid unlike with a tax, which already has a system set up for enforcement and admin and therefore the costs will be fairly low.

Figure 2 shows the comparison between setting a standard and setting a tax. You can see that three firms are being regulated to the same standard, which is set at the pollution abatement S2. The alternate method to this will be setting a tax at T so that firms 1, 2 and 3 pay a total abatement cost of the area under their marginal abatement curve up to points X, B and Y respectively. Therefore the total abatement cost under the standard, TACst, will be greater than that with the tax, TACtax. As standards are set they do not provide any incentive to lower the pollution emission below that level unlike taxes which lower as the output of a firm lowers. The other advantages associated with taxes mentioned earlier also may not apply to standards and therefore taxes seem to be an overall preferable solution.

The other methods such as permit trading and deposit-refund schemes can not be used on such a large scale as taxes. Pollution permits create a market between plants in an industry for trade of said permits. The benefits of this are that they provide an initial incentive to install cleaner machinery to lower the amount of emissions the firm will need permits for. But with all markets once they settle to the correct level of permits and emissions there will be no more incentive to lower pollution levels. Also permits can cause pollution black spots where one firm with higher abatement costs has bought a high amount of permits and is therefore still producing the same amount of pollution, therefore not giving an even spread of optimum pollution levels in each plant like with taxes.

This shows that overall taxes can be seen as the best method for reducing pollution. It does have the problem of associated bad press and high amount of initial research required. This is one of the main reasons why taxes have not been implemented to their best capability. The power the tax has does depend on the market it is being implemented on; if the market is highly inelastic then the increase in consumer prices may mean that it is not implemented. Even though taxes are the best overall method of emission reduction it may not be suited to all industries and therefore all economic incentive instruments should be considered and a mixture used on each industry.