On a Fundamental Advantage of Permits Over Taxes for the Control of Pollution

We extend the tax versus permits literature by considering permit supply functions and pollution tax functions that are generalizations of the usual constant permit supply and constant pollution tax rate. In our model, pollution is not uniformly mixed and the regulator is uncertain about the polluting firms’ abatement costs. We determine the optimal permit supply functions and the optimal pollution tax functions. Using these functions, we show that permits lead unambiguously to lower total expected costs than taxes. We analyze the magnitude of this difference for a simple model of climate change. By relating the optimal permit supply functions to Weitzman (Am Econ Rev 68:683–691, 1978) we provide a new interpretation of his results.