The English economist A.C. Pigou was the first to describe a per-unit pollution tax.  Suppose a firm has the Marginal Abatement Cost (MAC) schedule shown here, and without regulation, emits pollution to or beyond the point where MAC = 0, and society's Marginal Damage Costs (MDC) are very high.  If the government imposes a tax of $T per unit of emissions, the firm will minimize its costs by reducing its emissions to the point where MAC rises to equal T.  If T is set at the optimal level T*, the firm emits the socially-optimal level of pollution where its MAC = T* = MDC.  Note that the correct emission standard STD* would achieve the same optimum.

Equivalently, the government could achieve the same outcome by subsidizing firms' pollution abatement at $T per unit.  In this case, the opportunity cost of each unit of emissions is the foregone subsidy.  As with the tax, the firm reduces its emissions and collects the subsidy to the point where MAC = T.

In practice, pollution taxes are likely to have various advantages over standards:

• Taxes are a literal application of the "polluter pays" principle.
• Taxes generate revenues that can fund the regulatory agency's activities; standards don't.
• Taxes automatically equate MAC across firms, even when firms' abatement cost schedules differ.  An efficient set of standards may require differential standards for different firms.
• Taxes leave each firm free to choose its own least-cost abatement technology and abatement level.  Technology standards mandated by the regulatory agency are unlikely to be least-cost for all firms.
• A tax policy don't require the regulatory agency to have much information about firms' production processes and MAC schedules.  Defining efficient standards does.
• The fairness of a uniform pollution tax is evident; the fairness of an efficient set of differential standards isn't.
• Taxes give firms incentives to operate and maintain their pollution controls efficiently.
• Taxes stimulate R&D investment in more efficient pollution control.

• Taxes are politically unpopular, difficult to establish, and difficult to adjust.
• Finding the optimal tax that yields the desired aggregate level of pollution abatement is likely to require some trial-and-error.
• As firms' pollution control efficiencies improve, shifting MAC schedules downward, the pollution tax should be lowered accordingly.
• Pollution tax rates should increase with the economy's overall price index.
• As new firms add more emissions to the pollution aggregate, the tax rate may need to be raised to maintain stable aggregate  pollution levels.

An alternative pollution control policy the regulatory agency could set a maximum allowable aggregate level of pollution emissions, make an initial allocation of permanent permits for these emissions among firms, and then allow the firms to establish a market for permits.  This system achieves the desired level of emissions immediately, and as firms with high MAC's purchase permits from firms with low MAC's, the permit market produces an efficient permit allocation in which firms' MAC's are equal.

A transferable emissions permit (TEP) system has a number of advantages.  The initial allocation is basically more of an equity issue than an efficiency issue, since the permit market will do the necessary realloating of permits to the most efficient users of them.  So the agency doesn't need information about firms' MAC's.  Once the permits are allocated, the agency's main responsibility is to build and maintain firms' confidence in the permit market by punishing firms that emit more pollution than they have permits for; it doesn't intervene in the permit market.

As the permit market realloates permits to the firms that use them most efficiently, it basically reveals a market price for pollution control.  Each firm is free to manage its emissions from multiple sources efficiently so that MAC's are equal across all sources.  New firms needing emissions permits can simply acquire them in the market, and don't need to go through a complex regulatory approval process.  Since the market is open to anyone, investors, speculators, environmental groups and other individuals can buy and sell permits.  In the Acid Rain Program's transferable emissions permit system for sulfur dioxide, some environmental groups have bought up and retired permits.  (The Acid Rain program is summarized in the lecture on stationary-source air pollution policy.)

TEP's versus taxes

TEP's involve setting a maximum aggregate level of emissions and seeing what permit price emerges in the market.  A pollution tax policy involves setting a tax as a price proxy for pollution, and seeing what aggregate level of emissions emerges.  In most cases, the basic objective is to achieve a desired level of pollution, and TEP's do this directly.  In cases where MDC is very steep and MAC is flat, however, the cost of picking the wrong level of emissions under a TEP program may be very high, and taxes are likely to target the optimal emissions level more efficiently.

TEP's offer the same incentives for firms to maximize emissions control efficiency as taxes, and the same incentives for emissions control R&D.

TEP's offer some efficiency advantages over pollution taxes.

• They don't require trial-and-error adjustment of taxes to achieve the desired aggregate level of emissions.
• They give firms some incentive to police each other, since firms that have invested in permits want the value of those permits maintained, and don't want violators avoiding the permit market and depressing permit prices.
• The government can accommodate economic growth by gradually auctioning small numbers of new permits, or curtail aggregate emissions by buying permits out of the market.
• Pollution taxes should be adjusted with inflation; the permit market takes care of this automatically.