National Treatment and the optimal regulation of environmental externalities

Abstract. We analyze the role of National Treatment in the regulation of environmental product standards for an open economy. A social planner uses product standards to control emissions from the consumption of a traded good. We show that whether National Treatment of standards interferes with welfare‐maximizing policy depends on the instruments available to the policy maker (consumption or emissions tax) and differences in the cost of complying with the standard. We also highlight the asymmetric incidence of the domestic and import product standard when taxes are suboptimal. This asymmetric incidence can also cause welfare‐maximizing policy to violate National Treatment.     

On the interaction between imperfect compliance and technology adoption: taxes versus tradable emissions permits

This paper analyzes the effects of the interaction between technology adoption and incomplete enforcement on the extent of violations and the rate of abatement technology adoption. We focus on price-based and quantity-based emission regulations. First, we show that in contrast to uniform taxes, under tradable emissions permits (TEPs), the fall in permit price produced by technology adoption reduces the benefits of violating the environmental regulation at the margin and leads firms to modify their compliance behavior. Moreover, when TEPs are used, the deterrent effect of the monitoring effort is reinforced by the effect that technology adoption has on the extent of violations. Second, we show that the regulator may speed up the diffusion of new technologies by increasing the stringency of the enforcement strategy in the case of TEPs while in the case of uniform taxes, the rate of adoption does not depend on the enforcement parameters.     

Comparing Environmental Policy Instruments in the Presence of Imperfect Compliance – A Case Study

In this paper, we aim to include rule making, implementation, monitoring and enforcement costs into the cost comparison of policy instruments. We use a simple partial equilibrium model and apply it to the textile industry. The model includes discrete abatement functions and costly monitoring and enforcement. The case study uses individual firm data to simulate the differences in abatement costs and compliance decisions between firms. We compare combinations of regulatory instruments (emission taxes, emission standards and technology standards) and enforcement instruments (criminal fines, civil fines and transaction offers). We show that the inclusion of information, monitoring and enforcement costs indeed alters the relative cost efficiency of the different instruments.     

Emission taxes vs. environmental standards under partial ownership arrangements

This paper analyzes two pollution control instruments, uniform taxes and absolute standards, when polluting firms engage in partial ownership arrangements (POAs). Specifically, we examine the case of a bilateral POA between competing firms in which both hold equity shares on each other's profits as silent investments. We show that taxes and standards are equally efficacious in affecting the firms' output decisions and pollution emissions. Compared to the social planner's solution, a bilateral POA results in suboptimal outcomes with lower industrial output and consumer surplus. Firm profits are higher and environmental quality improves (since emissions decline), but social welfare decreases. We compare the equilibrium results associated with two different types of POAs (bilateral vs. unilateral), and examine their differences in welfare implications for the choice of policy options between taxes and standards.     

Efficiency losses from overlapping regulation of EU carbon emissions

In order to achieve their climate policy targets EU member states apply various regulatory instruments. We investigate the potential efficiency losses arising from the imposition of emission taxes on sectors that are covered by the EU Emissions Trading Scheme (EU ETS). Our analysis indicates the possibility of substantial excess cost through overlapping regulation. We show that unilateral emission taxes on sectors subject to the EU ETS are environmentally ineffective and increase overall compliance cost of the EU ETS.      

Optimal environmental regulation based on more than just emissions

I develop a principal-agent model of environmental regulation in which the regulator can acquire two costly signals of the firm’s abatement effort. Acquisition of the second signal is conditioned on the observed value of the first, emissions signal. The optimal contract takes the form of an emissions standard when only the emissions signal is acquired, and a set of contingent emissions standards when both signals are acquired; the standards are coupled with uniform, maximal penalties for noncompliance. Acquisition of the second signal may be optimal when intermediate values of the first signal are observed but not when extreme values are observed.      

Environmental policy instruments and corruption

ABSTRACT

In this paper we discuss the choice of taxation or regulation of environmental externalities. The subject might appear to be a well-trodden path, but we believe we have a new angle on this well-established question. We think we are being quite realistic when we assume that corrupt practices lurk behind every corner, threatening to derail the good intents of any regulator. With this starting point we compare the result of trying to impose taxation contra regulation in environments where the implementation in both cases will be marred by corrupt practices of under-reporting emissions and bribing inspectors. In a simple and stylized model of these circumstances we show that taxes tend to perform the same or better in the sense that a pollution tax induces greater compliance and lower pollution than does a regulatory standard. We also show that the advantages of a tax are particularly great in countries where the enforcement ability of authorities is weak, which is commonly thought to be the case in developing countries.     

Self-Reporting and Private Enforcement in Environmental Regulation

Self-reporting of compliance status has become a common feature in the enforcement of environmental regulation. In this paper, I generalize existing models of enforcement with self-reporting to include the possibility of private enforcement of regulation through citizen suits. This allows me to identify an additional argument for the efficiency of self-reporting: it can increase the likelihood of a successful suit and thus facilitate private enforcement of regulation. Specifically, if self-reporting sufficiently increases the expected penalty for losing a citizen suit, if the costs of private enforcement are low, and if inspection costs are high enough relative to enforcement costs, self-reporting lowers expected regulatory and social costs by allowing the regulator to rely on private enforcement and decrease his enforcement efforts.

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Multiple equilibria in the context of inspection probabilities depending on firms’ relative emissions

This paper presents a model of environmental regulations with firms that are heterogeneous with respect to the cost for reducing emissions to the legally permitted level. Given that the enforcement capacity is limited due to budgetary constraints and that each firm's inspection probability depends on its emissions relative to other firms’ emissions, the likelihood of being punished for violations is endogenously determined and multiple equilibria may therefore arise. Hence, both good outcomes with high compliance rates and bad outcomes with many violations are possible. Multiple equilibria are most likely to emerge at intermediate levels of deterrence and at low permitted emission levels. However, it is generally not straightforward how stricter legislation impacts on equilibrium outcomes, indicating that behavioral expectations among regulated firms are an important factor to consider when adapting enforcement to changes in the law.     

Government policy in the formal and informal sectors

The paper quantitatively investigates, in general equilibrium, the interaction between the firms' choice to operate in the formal or the informal sector and government policy on taxation and enforcement, given a level of regulation. A static version of Ghironi and Melitz's (2005) industry model is used to show that firms with lower productivity endogenously choose to operate in the informal sector. I use cross-country data on taxes, measures of informality, and measures of regulation (entry and compliance costs, red tape, etc.) to back out how high the enforcement levels must be country by country to make the theory match the data. The welfare gains from policy reforms are on average 1.2% (measured in terms of consumption) for OECD countries. I also find that the welfare gains from reducing regulation are on average 2.1%. Finally, performing a similar decomposition to that of Hall and Jones (1999), I find that distortions associated with informality account for a factor of 1.5 of the output per capita difference between the richest and the poorest countries.     

Factors that determine the cost-effectiveness ranking of second-best instruments for environmental regulation

This paper develops a conceptual model to analyze how specific factors affect the compliance costs of three suboptimal policy instruments, when compared to the optimal ambient permit system (APS) benchmark. The model considers a non-uniformly mixed pollutant and explicitly incorporates the following factors: number of polluting sources; size, in terms of emissions, of each process; marginal abatement costs for each process; effluent concentrations; the transfer coefficient that relates emissions to environmental quality at the receptor; and the desired environmental quality target. APS is compared to a suboptimal emission permit system (EPS), and two Command and Control (CAC) policies—equal percentage reduction (PER) and a uniform effluent concentration standard (STD). The results show the importance of the different factors and their interactions in determining each policy instrument’s cost-effectiveness ranking. Surprisingly, EPS performs well within the usual values of these factors and in specific cases STD and PER also perform similarly to APS.      

Effective Enforcement of a Transferable Emissions Permit System with a Self-Reporting Requirement

We propose an enforcement strategy to achieve complete compliance in a transferable emissions permit system when firms are required to provide reports of their own emissions. Like the literature on self-reporting in the enforcement of standards, we find that self-reporting can conserve monitoring costs, but for a different reason. In addition, we show that targeted monitoring—the practice of monitoring some firms more closely than others—is not necessary in a competitive permit system. Furthermore, tying penalties to the equilibrium permit price can stabilize the monitoring effort necessary to maintain full compliance in the face of permit price fluctuations.     

REGULATORY DEALING: TECHNOLOGY ADOPTION VERSUS ENFORCEMENT STRINGENCY OF EMISSION TAXES

We analyze the role of targeted enforcement of emissions taxes when the regulator wants to minimize aggregate emissions via the adoption of new more environmentally friendly technology. The regulator wants to speed up the path of technology adoption generated by a policy of uniform enforcement (that monitors adopters and nonadopters with the same probability) by engaging in a regulatory deal where a reduced monitoring probability is granted in “exchange” for adoption of the new technology. We set up a theoretical model, characterize the circumstances in which such dealing minimizes aggregate emissions, and test our hypothesis using economic laboratory experiments. Our analytical and experimental results suggest that even though such a deal might imply an increased level of violation by adopters, such tolerance is rather an integral part of an overall enforcement strategy that minimizes aggregate emissions when the rate of adoption is endogenous. (JEL L51, Q53, Q55, Q58)     

Taxing multinationals: The scope for enforcement cooperation

Policymakers seeking to raise more tax revenues from multinational enterprises have two alternatives: to raise tax rates or to devote more resources to improve tax compliance. Tougher tax enforcement increases the cost of profit shifting, and thus mitigates tax competition. We present a tax-competition model with two policy instruments (the corporate tax rate and the tightness of tax enforcement). In line with the Organisation for Economic Cooperation and Development's Base Erosion and Profit Shifting project, we analyze the scope for enforcement cooperation among asymmetric countries, considering that taxes are set noncooperatively. We show that the low-tax country may fail to cooperate if asymmetry is large enough and that tax havens would never agree to cooperate. Then we identify two drivers for enforcement cooperation. The first driver of cooperation is the complementarity of enforcement actions across countries. This is because the efficiency loss from enforcement dispersion is greater under complementarity. The second driver of cooperation is tax leadership by the high-tax country, which acts as a level-playing field in the tax competition and reduces the extent of disagreement on enforcement.     

Policy choice for end-of-pipe abatement technology adoption under technological uncertainty

Regulators have increasingly become concerned about end-of-pipe abatement technologies because they not only play a crucial role in air pollution control but also ensure the achievement of the deep carbon emissions reduction target. This paper investigates the effect of emission taxes and standards on the adoption of end-of-pipe abatement technology when the arrival time and degree of improvement of the new emissions abatement technology are uncertain. We find that the ranking of emission taxes and standards in terms of motivating early adoption depends on the policy stringency. More specifically, for high levels of environmental stringency, standards induce an earlier technology adoption than taxes, while the opposite conclusion holds for low levels of environmental stringency. The sensitivity analysis shows that these findings are robust to various relevant crucial parameters. Finally, the implications for the choice of environmental policy have been provided.     

Implementing cooperative solution concepts: a generalized bidding approach

This paper provides a framework for implementing and comparing several solution concepts for transferable utility cooperative games. We construct bidding mechanisms where players bid for the role of the proposer. The mechanisms differ in the power awarded to the proposer. The Shapley, consensus and equal surplus values are implemented in subgame perfect equilibrium outcomes as power shifts away from the proposer to the rest of the players. Moreover, an alternative informational structure where these solution concepts can be implemented without imposing any conditions of the transferable utility game is discussed as well. The authors thank Yukihiko Funaki, Andreu Mas-Colell, David Pérez-Castrillo and Jana Vyrastekova for helpful discussions. We also appreciate the comments from the seminar and conference participants at Keele University, Tilburg University, University of Haifa, University of Warwick, CORE at Louvain-la-Neuve, Catholic University Leuven, Pablo de Olavide University in Seville, University of Vigo, the 2006 Annual Conference of the Israeli Mathematical Union in Neve Ilan, Israel, and the 61st European Meeting of the Econometric Society in Vienna, Austria in 2006. In particular, we are grateful to the associate editor and an anonymous referee. Their valuable comments and constructive suggestions contributed to a significant improvement of the paper. Wettstein acknowledges the financial support of the Pinchas Sapir Center for Development in Tel Aviv University.     

Optimal monitoring of credit-based emissions trading under asymmetric information

Project-based emissions trading schemes, like the Clean Development Mechanism, are particularly prone to problems of asymmetric information between project parties and the regulator. In this paper, we extend the general framework on incomplete enforcement of policy instruments to reflect the particularities of credit-based mechanisms. The main focus of the analysis is to determine the regulator??s optimal spot-check frequency given plausible assumptions of incomplete enforcement under asymmetric information on reduction costs and heterogeneous verifiability of projects. We find that, depending on the actual abatement cost and penalty schemes, optimal monitoring for credit-based systems is often discontinuous and significantly differs from the one to be applied for cap-and-trade schemes or environmental taxes. We conclude that, in a real-world context, project admission should ultimately be based on the criterion of verifiability.     

A second-best evaluation of eight policy instruments to reduce carbon emissions

This paper uses a numerical general equilibrium model to compare the costs of alternative policies for reducing carbon emissions in a second-best setting with a distortionary tax on labor. We examine a carbon tax, two energy taxes, and both narrow-based and broad-based emissions permits and performance standards. The presence of pre-existing tax distortions raises the costs of all these policies, and can affect their relative cost rankings. In fact, the superiority of emissions taxes and emissions permits over other instruments can hinge on whether these policies generate revenues that are used to reduce other distortionary taxes.     

Choosing wisely: the natural multi-bidding mechanism

Pérez-Castrillo and Wettstein (Am Econ Rev 92:1577–1587, 2002) propose a multi-bidding mechanism to determine a winner from a set of possible objects. Each agent announces a vector of bids and a project, which is used as a tie-breaking rule for the case where several aggregate bids finish first in the bidding. We show that removing the (non-intuitive) project announcement and using instead the projects which received some agent’s highest bid to break ties, severely hinders the performance of the mechanism. Specifically, a Nash Equilibrium exists only if there are at least two individually optimal projects and all individually optimal projects are efficient. I am grateful to an anonymous referee for his detailed suggestions and comments and to the SSHRC (Canada) for financial support.     

Corporate tax evasion: The case for specialists

We analyze the role of accounting specialists who help corporations evade/avoid taxes in a game of incomplete information played by a tax authority, corporate taxpayers, and an accounting specialist. In addition to a full equilibrium characterization, we establish that (i) marginal changes in enforcement are not effective when evasion/avoidance is pervasive; (ii) fines on firms as opposed to specialists are more effective in such situations; (iii) reducing auditing costs and increasing “creative accounting” costs are effective in curbing evasion when tax compliance is relatively high.