Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin - PowerPoint PPT Presentation

Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture 12: Environmental Taxation ECON 551: Lecture 12 1 of 55

Agenda 1. Overview 2. Five methods of pollution abatement 3. Double Dividend Debate 4. Choice of Instruments 5. Canadian Policy Developments ECON 551: Lecture 12 2 of 55

An ongoing Initiative: Ecofiscal Commission  5-year limited-term thinktank — just ending now!  Focused on pricing externalities.  Brings together group of economists and former politicians. http://youtu.be/RBNPHv0R-aw ECON 551: Lecture 12 3 of 55

Environment taxes as % of total tax revenue 2012 18 16 14 Source: OECD http://stats.oecd.org 12 Percentage 10 8 6 4 2 0 TUR SVN ISR KOR NLD IRL ZAF EST DNK HUN FIN ITA PRT POL SVK LUX ISL AUT DEU SWE NOR ESP FRA NZL CHL CZE CHN GBR CHE BEL CAN USA ECON 551: Lecture 12 4 of 55

Agenda 1. Overview 2. Five methods of pollution abatement 3. Double Dividend Debate 4. Choice of Instruments 5. Canadian Policy Developments ECON 551: Lecture 12 5 of 55

Setup for studying externalities Here’s the common framework we will use:  2 consumers, h =1,2  Wealth 𝑥 ℎ (no income; endowment economy)  Goods ℎ , … , 𝑦 𝐾 ℎ indexed by j : 𝑦 1  Prices 𝑞 1 , … , 𝑞 𝐾  Externality a , results from action of consumer 1 Indirect utility function: 𝑦 ℎ 𝑉 ℎ (𝑦 ℎ , 𝑏) 𝑡. 𝑢. 𝑞 ∙ 𝑦 ℎ ≤ 𝑥 ℎ 𝑊 ℎ (𝑞, 𝑥 ℎ , 𝑏) = max ECON 551: Lecture 12 6 of 55

Setup for studying externalities To keep the model as simple as possible, let’s eliminate income effects with a quasi - linear indirect utility function; assume price-taker. 𝑊 ℎ (𝑞, 𝑥 ℎ , 𝑏) = 𝜚(𝑏) + 𝑥 ℎ Assume externality is negative, utility is concave: 𝜖𝜚 1 𝜖𝑏 > 0 , 𝜖𝜚 2 𝜖𝑏 < 0 , 𝜖 2 𝜚 ℎ 𝜖𝑏 2 < 0 Consumer 1’s problem: 𝜚 1 (𝑏) + 𝑥 1 ⇒ 𝜖𝜚 1 𝜖𝑏 (𝑏 ∗ ) = 0 max 𝑏 2 ’s. Nothing he can do about a . Consumer 2 just eats his 𝑦 𝑘 ECON 551: Lecture 12 7 of 55

Five potential solutions to externality problem a. Planner’s solution b. Effluent charge / Pigouvian tax c. Quota / regulation / Command and Control d. Property rights e. Tradeable permits. ECON 551: Lecture 12 8 of 55

Planner’s solution (a): First, assume a planner…  No prices.  Planner just assigns allocations based on maximizing social welfare.  Let’s just use utilitarian SWF; add up the individual utilities. 𝜚 1 (𝑏) + 𝜚 2 (𝑏) max 𝑏 ⇒ 𝜖𝜚 1 𝜖𝑏 + 𝜖𝜚 2 𝜖𝑏 = 0 ⇒ 𝜖𝜚 1 ̂) = − 𝜖𝜚 2 𝜖𝑏 (𝑏 𝜖𝑏 (𝑏 ̂) ECON 551: Lecture 12 9 of 55

Planner’s solution (a): 𝜖𝜚 1 − 𝜖𝜚 2 𝜖𝑏 𝜖𝑏 𝑏 ∗ 𝑏 ̂ 𝑏  𝑏 ̂ is the efficient outcome.  𝑏 ∗ is the competitive outcome. ECON 551: Lecture 12 10 of 55

Effluent charge / Pigouvian tax (b):  Arthur Cecil Pigou, 1877 – 1959  University of Cambridge economist  His book The Economics of Welfare (1920) argued for a tax to account for social cost of goods with externalities. ECON 551: Lecture 12 11 of 55

Effluent charge / Pigouvian tax (b): 𝜖𝜚 2 𝜖𝑏 (𝑏 ̂) . Mandate a tax 𝑢 𝑏 per unit of a . Set tax at rate: 𝑢 𝑏 = − Consumer 1 now solves: 𝜚 1 (𝑏) − 𝑢 𝑏 𝑏 max 𝑏 ⇒ 𝜖𝜚 1 𝜖𝑏 − 𝑢 𝑏 = 0 ⇒ 𝜖𝜚 1 𝜖𝑏 = 𝑢 𝑏 = − 𝜖𝜚 2 𝜖𝑏 (𝑏 ̂) We end up right at 𝑏 ̂ , the efficient outcome. ECON 551: Lecture 12 12 of 55

Effluent charge / Pigouvian tax (b): 𝜖𝜚 1 𝜖𝑏 − 𝜖𝜚 2 𝜖𝑏 t t 𝑏 ∗ 𝑏 ̂ 𝑏 Comments:  For now, assume revenue is returned as lump sum transfer – goal of tax isn’t to raise revenue. (We’ll deal with ‘double dividend’ later…)  Why does this work? Tax forces consumer 1 to internalize the externality.  Note the high information requirement. Have to know costs and benefits.  Note the centralization of the solution. ECON 551: Lecture 12 13 of 55

Quota / regulation / Command and Control (c): ̂ . You’re done. Another solution is to simply choose a quota. Set it at 𝑏 This is essentially the same thing as the Pigou solution, since we assume we know the costs and the benefits.  B ut we’re choosing the quantity rather than choosing the prices. 𝜖𝜚 1 𝜖𝑏 − 𝜖𝜚 2 𝜖𝑏 𝑏 ̂ 𝑏 ECON 551: Lecture 12 14 of 55

Property rights solution (d): The next solution solves the problem essentially by assuming it away – say that there were property rights that could be assigned and that there was a market for the good. Let’s try giving Consumer 2 the property rights. This means that he can shut guy 1 down to zero if he wants.  He makes a take-it-or-leave-it offer to consumer 1 consisting of a transfer T.  Consumer 1 will accept the offer iff 𝜚 1 (𝑏) − 𝑈 ≥ 𝜚 1 (0) Consumer 2’s problem is therefore: 𝑏,𝑈 𝜚 2 (𝑏) + 𝑈 𝑡. 𝑢. 𝜚 1 (𝑏) − 𝑈 = 𝜚 1 (0) max (This assumes constraint is binding.) ECON 551: Lecture 12 15 of 55

Property rights solution (d): Substitute out the constraint for T, leaving us with: 𝑏,𝑈 𝜚 2 (𝑏) + 𝜚 1 (𝑏) − 𝜚 1 (0) max The FOC for this problem is: 𝜖𝜚 2 𝜖𝑏 + 𝜖𝜚 1 𝜖𝑏 − 0 = 0 (note that 𝜚 1 (0) is a constant, so its derivative is zero). This simply returns us to the social optimum: ⇒ 𝜖𝜚 1 ̂) = − 𝜖𝜚 2 𝜖𝑏 (𝑏 𝜖𝑏 (𝑏 ̂) ECON 551: Lecture 12 16 of 55

Property rights solution (d): 𝜖𝜚 1 𝜖𝑏 − 𝜖𝜚 2 𝜖𝑏 𝑏 𝑏 ̂  Say Consumer 2 has the right to stop a . Consumer 1 can offer to pay transfer T (green arrow)  If consumer 1 chooses some a , T has to be paid to consumer 2.  T is the transfer demanded by Consumer 1. Consumer 1 not happy!  After point 𝑏 ̂ , the amount Consumer 1 is willing to pay is no longer enough to compensate Consumer 2. So, production stops at 𝑏 ̂ , the socially efficient amount! ECON 551: Lecture 12 17 of 55

Property rights solution (d): Comments:  Note the low information requirement here. No omniscient planner who can see the value of the externality. Just assign property rights.  Of course, this just defines the problem away. If an externality is a missing market caused by no property rights, then there will be no externality if there are property rights.  Value of this approach is to emphasize that a) property rights are one important cause of missing markets and b) we don’t necessarily have to rely on a central government solution. ECON 551: Lecture 12 18 of 55

Property rights solution (d): Coase extension 𝜖𝜚 1 𝜖𝑏 − 𝜖𝜚 2 𝜖𝑏 𝑏 𝑏 ̂  Now let’s reverse things so that c onsumer 1 has property rights.  So, Consumer 2 has to make a transfer to consumer 1 or else Consumer 1 will just do what he pleases – which is to do a*. ECON 551: Lecture 12 19 of 55

𝜖𝜚 1 𝜖𝑏 − 𝜖𝜚 2 𝜖𝑏 𝑏 ̂ 𝑏 You can show using the same set up that we end up back at: 𝜖𝜚 1 ̂) = − 𝜖𝜚 2 𝜖𝑏 (𝑏 𝜖𝑏 (𝑏 ̂) No matter which guy had the property rights, we got to the same outcome. We’ll discuss this at length soon. ECON 551: Lecture 12 20 of 55

Property rights solution (d): Coase extension Ronald Coase (Nobel 1991) “ The Problem of Social Cost ” (1960 Journal of Law and Economics) 31,000+ Google Scholar citations… “With costless market transactions, the decision of the courts concerning liability for damage would be without effect on the a llocation of resources.” (p. 10) “But the ultimate result (which maximizes the value of production) is independent of the legal position if the pricing system is assumed to work without cost.” (Coase 1960, p. 8) Emphasizes a central role for transaction costs and property rights for understanding the impact of externalities. ECON 551: Lecture 12 21 of 55

Property rights solution (d): Coase extension Now let’s put my own words on it and try to state the ‘Coase Theorem.’ Strong form: If property rights are well-defined and bargaining costs are zero, then agents will achieve, through voluntary transactions, allocations that are Pareto efficient and invariant to the initial allocation of property rights. Weak form: If property rights are well-defined and bargaining costs are zero, then agents will achieve, through voluntary transactions, allocations that are Pareto efficient.  The difference here is the ‘invariant’ part. Example: Trains generating sparks that started fires in farm fields.  Who has the property rights? What happens if rights reversed? Huge impact on understanding the economic implications of legal matters. ECON 551: Lecture 12 22 of 55

Property rights solution (d): Coase extension But, Coase can fall apart:  Uncertainty in bargaining. You don’t know everybody’s cost and benefit functions.  Compensation causes over-investment. In anticipation that you will get a transfer, you change your decision about investment.  Free-riding in negotiation. There may be gains to be had, but co-ordination among beneficiaries may be difficult. (Dixit and Olson 2000)  Endowment effects: people behave differently depending on initial endowments (Thaler…) ECON 551: Lecture 12 23 of 55