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Peterhouse
Part II
Lent
1999
“Taxing pollution is invariably superior to regulating it.” Discuss with reference to the former Greater London Council’s policy of banning truck movements in inner London at night in order to reduce noise pollution in residential areas.
The basic source of
environmental problems is the fact that the price system is simply not applied
to many resources. In the Pigouvian tradition, economists have frequently
proposed the adoption of a system of unit taxes (or subsidies) to control
externalities, where the tax on a particular activity is equal to the marginal
social damage it generates. A reorientation of the tax system would change
relative prices so as to provide incentives for the conservation of scarce
resources. In practice, however, such an approach has rarely proved feasible
because of our inability to measure marginal social damage, and regulation has
become the most common form of controlling pollution. However, a system of direct controls involves
inefficiencies, including the high real enforcement costs that generally
accompany it. In the end, each of the available policy instruments has its
particular merits and shortcomings, and each is best adapted to deal with
particular circumstances.
An externality if an indirect effect that either a production or a
consumption activity has on a utility function, a consumption set or a
production set. By “indirect” is meant both that the effect is created by an
economic agent other than the one who is affected, and that the effect is not
transmitted through prices. The noise from truck movements in residential areas
is an example of a consumption externality. This definition indicates that the
basic notion of externality depends on the definition of economic agents and
the existence of markets to coordinate transactions among these agents.
Should governmental control
of externalities take the form of prohibitions and of direct quantitative
regulations of certain activities, or the form of taxes to discourage
activities which create external diseconomies? Consider a factory that is
polluting the atmosphere by emitting smoke. It is not necessarily in the social
interest to prohibit all the pollution. The cost of complete abatement of
pollution might be exceedingly high. There is an optimal level of pollution
which is illustrated below. Suppose that in the absence of any control an
industry would find it convenient to emit OO units of pollution. The curve OC
measures the increasing marginal damage done to society as the amount of
pollution increases. But pollution abatement is costly, and the stricter the
abatement the higher probably the marginal cost. The rising marginal cost of
pollution abatement is shown by the curve OD. OA, determined by the point of
intersection of these two curves, is the optimum amount of pollution. Note that
while the cost of pollution abatement is a reasonably definite one, the
marginal social damage curve, which must also be estimated in pounds by the
government authority concerned, presents difficulties of a different order
altogether. The present value of the social damage done by pollution is a
matter of considerable doubt and uncertainty. Indeed, the value of the social
damage done will have in many cases to be set at a figure determined in a
rather arbitrary manner.
The economic case for
intervening in the transport sector is that “transport involves large costs,
some incurred directly or indirectly by users, and some as a result of its
environmental effects. Hitherto, most of the latter costs have fallen on the
community rather than on the users or the builders of the transport system.
Seriously misleading price signals have resulted, leading to decisions in all
areas of transport which have harmed the community”. (Report on Transport and the Environment, 1994). To an economist,
the problem is one of market failure – the markets are failing to allocate
resources efficiently because users face misleading price signals. If these
were corrected to reflect external costs, or externalities, and if transport
users responded efficiently to the corrected price signals, the result should
be an efficient use of transport. This view suggests that the problem is how
best to move to a situation in which the marginal social benefit of transport
is equated to the marginal social cost incurred by the community and the
environment. How far can this be achieved by market means, using corrective
taxes and proper charges for road use, and how much reliance needs to be placed
on non-market controls over the supply of and access to road space (such as the
banning of truck movements in inner London at night)?
Baumol and Oates have listed
a number of criteria for evaluating environmental policies. One of the
fundamental differences between pricing techniques and the direct-controls
approach to environmental protection is that the latter characteristically
treats environmentally damaging activities as illegal acts, while the former
considers them normal consequences of economic activity which should certainly
be curtailed, but without the use of the police powers of the state. In this
respect, the use of pricing incentives, at least in principle, differs markedly
from the reality of outright prohibition. The effectiveness of prohibition
clearly depends on the vigour and clout of the enforcement mechanism. Violators
of a regulation must first be caught in the act. They must then be prosecuted,
found guilty, and given a substantial penalty. If any of these steps fails, the
violators get away (virtually) free despite their disregard for the law. At the
same time, however, the levying of a tax may involve the installation of some
sophisticated metering device in every truck and its policing by the tax
authority.
The regulatory approach is
often thought to be superior to the use of pricing incentives in terms of
fairness. Yet the appearance of fairness is largely illusory, because pollution
abatement is generally more costly for some producers than for others. In the
case of trucks, a charge for using inner London roads would affect some firms
more. If our objective is to distribute noise quotas fairly, we might do better
to require reduction quotas such as the unit of the cutbacks were the same for
all polluters. A unit tax, leaving each firm free to decide how much noise it
will cause, will produce a given reduction in noise pollution at a minimal cost.
Those firms which find it cheap to restrict their movements in inner London at
night will reduce their pollution much more than those firms which find it
costly to use a different route or travel at a different time. From this
perspective, a charge for using the roads at night may arguably be more
equitable than a uniform percentage reduction in noise.
The potential revenue
contribution of pollution taxes is by no means negligible. Thus, taxes levied
to close the existing divergences between marginal costs and marginal revenues
associated with certain activities, kill two birds with one stone: they
directly reduce the particular externalities which they are directly designed
to counteract, and at the same time they raise revenue for other necessary government
expenditures, thus reducing the need to impose revenue-raising taxes which
would themselves introduce or intensify certain other externalities, e.g. by
distorting incentives.
A tax imposed per unit of
pollution emitted is not the only way of using the price mechanism to regulate
pollution. If it is possible and desirable to control the quantity of pollution
emitted by each polluter, the following procedure might be adopted. The
authority concerned determines the total amount of pollution which shall be
permitted. Licenses to pollute up to his amount are then put up to auction, so
that the total permitted amount of pollution is distributed over all producers
in such a manner that at the closing auction price per unit of licensed
pollution each producer has in fact decided how much pollution it is profitable
for him to emit. This auctioning of licenses to pollute has many of the same
basic features as a system of a tax levied per unit of pollutant. Both raise
revenue by charging for an external diseconomy, and both enable the price
mechanism to be used to determine the cheapest and most efficient way of
obtaining a reduction in pollution. The basic difference is that in the case of
the straightforward tax the authority first guesses what the optimum tax is,
and can then judge whether some revision of the tax is desirable in the light
of the resulting quantity of pollution, whereas with the auctioning of licenses
the authority first guesses what is the desirable quantity of pollution to
permit and can then judge whether, in the light of the price which polluters
will offer for licenses to pollute, it should increase or decrease the licenses
which in future it puts up for auction.
There is an administrative
aspect which will tilt the balance in favour of direct quantitative regulation.
To prohibit entirely some activity may be very much easier to monitor and
enforce than to restrict the activity to some positive level or to charge a tax
per unit of that activity. Whether or not trucks use inner London roads at
night at all may be much easier to determine than whether in using the roads
they have exceeded the creation of a certain restricted number of decibels of
noise. The loss of welfare caused by prohibition of truck movements will be
zero or at the worst very little. Where this is so, and where at the same time
prohibition is administratively much easier than other forms of control,
complete prohibition is obviously the sensible policy.
The potential for averting
activities has important implications for the choice of policy to control
externalities. Averting behaviour involves individual efforts to reduce the
level of disturbance, given any particular level of externality. Averting
behaviour is an important way of dealing with unwanted noise, and efficient
procedures for regulating noise must take averting possibilities into account.
If a cost-benefit analysis is used to formulate policy and averting
possibilities are not considered, the valuations attached to any changed
positions will be too low; the chosen policy will usually aim for externality
levels that are too close to the status quo.
Coase (1960) was the first
economist to explore the broad implications of the importance of averting
behaviour. He was interested in showing that, where externalities are involved,
private contractual arrangements can lead to efficient outcomes. The
difficulties in applying the Coase theorem to many-receiver diseconomies are
well-known. There is a prisoners’ dilemma problem, whether the producers have
rights, in which case the receivers will have little incentive to provide each
other a public good, or whether the receivers have rights, in which case they
will strategically overstate their damages, leading to a suboptimal level of
externality. The possibility of taking averting actions, even if paid by the
polluter, does not change matters. Receivers will still be locked in a
situation of strategic interaction. With producer liability, there will be too
little of the diseconomy; with receiver liability, there will be too much.
Competitive behaviour in this artificial market is thus unlikely and strategic
behaviour may lead to an allocation that is less desirable than the
laissez-faire equilibrium. Hence, the private bargaining solution will not work
in the many-receiver case, making government intervention desirable. This can
take a variety of forms that include taxes, subsidies and direct regulation or
standard-setting. Unlike private bargaining, these forms are not likely to be
upset by the self-interested or strategic behaviour of free riders. And unlike
an artificial market, they do not require agreement between the diseconomy
producer and each receiver on the amount of diseconomy that can be produced at
a given price.
Yet government regulation
often does not adequately recognise certain types of responses to regulation by
individuals. Taking account of changes in averting behaviour should improve the
quality of decisions about noise control. For example, strategic behaviour may
enter if collective action is difficult to achieve. Imagine an uncoordinated
community of individuals disturbed by traffic noise. The environmental
authority is going to assess the losses imposed on the community by traffic and
then regulate appropriately. No individual would gain from leaving his window
open just to alter the authority total and therefore ultimately the traffic
noise. If the community could organise itself, matters might be different. They
could agree as a general policy to leave windows open. Each open-windowed
resident would be contributing to a collective good: a higher marginal
valuation of noise produced.
Both charging and regulation
of externality-creating activities require large amounts of information in
order to come anywhere close to achieving social efficiency. While charging
requires considerably less information, a problem with the tax approach is that
is difficult to apply differentially according to the location of the polluters
and across time. A tax rate on truck movements that was sufficiently high to
deal with noise at night would be far too restrictive during the day. This
inflexibility resulting from uniform charges could be reduced by building
variations into the schedule of fees itself. There is no reason in principle
why an environmental authority cannot employ peak-load pricing techniques. The
authority may adopt two schedules of noise pollution, one for during the day
and a second with higher rates for the night hours. Yet the problem of
measuring and monitoring the noise emitted remains, and may be impossible to
solve given the current state of technology. Hence, it appears that the
decision to simply ban truck movements in inner London at night may have been
the most sensible one.