The World’s Largest Open Access Agricultural & Applied Economics Digital Library This document is discoverable and free to researchers across the globe due to the work of AgEcon Search. Help ensure our sustainability. Give to AgE con Search AgEcon Search http://ageconsearch.umn.edu [email protected] Papers downloaded from AgEcon Search may be used for non-commercial purposes and personal study only. No other use, including posting to another Internet site, is permitted without permission from the copyright owner (not AgEcon Search), or as allowed under the provisions of Fair Use, U.S. Copyright Act, Title 17 U.S.C. University of Massachusetts Amherst Department of Resource Economics Working Paper No. 2007-6 http://www.umass.edu/resec/workingpapers The Optimal Pricing of Pollution When Enforcement is Costly John K. Stranlund1, Carlos A. Chavez2 and Mauricio G. Villena3 Abstract: We consider the pricing of a uniformly mixed pollutant when enforcement is costly with a model of optimal, possibly firm-specific, emissions taxes and their enforcement. We argue that optimality requires an enforcement strategy that induces full compliance by every firm. This holds whether or not regulators have complete information about firms’ abatement costs, the costs of monitoring them for compliance, or the costs of collecting penalties from noncompliant firms. Moreover, ignoring several unrealistic special cases, optimality requires discriminatory emissions taxes except when regulators are unable to observe firms’ abatement costs, the costs of monitoring individual firms, or any firm-specific characteristic that is known to be jointly distributed with either the firms’ abatement costs or their monitoring costs. In many pollution control settings, especially those that have been subject to various forms of environmental regulation in the past, regulators are not likely to be so ill-informed about individual firms. In these settings, policies that set or generate a uniform pollution price like conventional designs involving uniform taxes and competitive emission trading with freely-allocated or auctioned permits will not be efficient. Keywords: Compliance, Enforcement, Emissions Taxes, Monitoring, Asymmetric Information, Uncertainty JEL Classification: L51, Q58 ________________________ 1John K. Stranlund, Department of Resource Economics University of Massachusetts, 214 Stockbridge Hall 80 Campus Center Way, Amherst, MA 01003 E: [email protected] P: 413-545-6328 F: 413-545-5853 2Carlos A. Chavez, Departmento de Economia Universidad de Concepcion, Concepcion, Chili E: [email protected] P: 56-41-2203067 F: 56-41-2254591 3Mauricio G. Villena, School of Business Universidad Adolfo Ibanez, Santiago, Chile E: [email protected] P: 56-2-6754636 F: 56-2-2784413 The Optimal Pricing of Pollution When Enforcement is Costly JOHN K. STRANLUND Department of Resource Economics University of Massachusetts-Amherst CARLOS A. CHÁVEZ Departamento de Economía Universidad de Concepción MAURICIO G. VILLENA Escuela de Negocios Universidad Adolfo Ibáñez Correspondence to: John K. Stranlund Department of Resource Economics 214 Stockbridge Hall 80 Campus Center Way University of Massachusetts-Amherst Amherst, MA 01003, USA. Phone: (413) 545-6328 Fax: (413) 545-5853 E-mail: [email protected]. Acknowledgements: We gratefully acknowledge financial support provided by Conicyt-Chile, under Project Fondecyt No. 1060679, and Fondecyt International Cooperation under Project No 7060098. Partial support was also provided by the Cooperative State Research Extension, Education Service, U. S. Department of Agriculture, Massachusetts Agricultural Experiment Station, and the Department of Resource Economics under Project No. MAS00871. Joe Moffitt and John Spraggon provided valuable comments and suggestions. 1 The Optimal Pricing of Pollution When Enforcement is Costly Abstract: We consider the pricing of a uniformly mixed pollutant when enforcement is costly with a model of optimal, possibly firm-specific, emissions taxes and their enforcement. We argue that optimality requires an enforcement strategy that induces full compliance by every firm. This holds whether or not regulators have complete information about firms’ abatement costs, the costs of monitoring them for compliance, or the costs of collecting penalties from noncompliant firms. Moreover, ignoring several unrealistic special cases, optimality requires discriminatory emissions taxes except when regulators are unable to observe firms’ abatement costs, the costs of monitoring individual firms, or any firm-specific characteristic that is known to be jointly distributed with either the firms’ abatement costs or their monitoring costs. In many pollution control settings, especially those that have been subject to various forms of environmental regulation in the past, regulators are not likely to be so ill-informed about individual firms. In these settings, policies that set or generate a uniform pollution price like conventional designs involving uniform taxes and competitive emission trading with freely-allocated or auctioned permits will not be efficient. Keywords: Compliance, Enforcement, Emissions Taxes, Monitoring, Asymmetric Information, Uncertainty JEL Codes: L51, Q58. 2 The Optimal Pricing of Pollution When Enforcement is Costly 1. Introduction In a first-best world of environmental policy, an optimal tax to control emissions of a uniformly mixed pollutant involves a uniform per unit tax set equal to marginal damage from emissions at the efficient level of aggregate emissions. Alternatively, a competitive emissions trading program with either freely-allocated or auctioned permits will generate a uniform price for pollution that is the same as the first-best tax. In a first-best world, however, regulations do not have to be enforced and regulators have complete information about all the benefits and costs of pollution control. These assumptions are always violated in real world applications. In this paper, therefore, we consider the optimal pricing of pollution when compliance must be enforced and regulators may have only incomplete information about firms’ costs of controlling their emissions and the costs of regulatory enforcement. The model is cast as the joint determination of optimal, possibly firm-specific, emissions taxes and their enforcement. We demonstrate two new results with significant policy relevance. First, under a constant expected marginal penalty for tax evasion and the assumption that collecting tax revenue from compliant firms is cheaper than collecting penalties from noncompliant firms, the optimal policy requires sufficient enforcement effort to induce full compliance by all firms. This is true even when regulators have only incomplete information about firms’ abatement costs and the costs of enforcement. In the theoretical literature on compliance with emissions taxes most authors simply assume that full compliance is not or can not be achieved (e.g., Harford 1978, 1987; Sandmo 2002, Montero 2002, Cremer and Gahvari 2002, and Macho-Stadler and Perez-Castrillo 2006). This is also true in most theoretical analyses of the compliance and enforcement problem 3 in emissions trading schemes (e.g., Malik 1990, Keeler 1991, Stranlund and Dhanda 1999, Montero 2002).1 Without downplaying the relevance of examining incentive-based policies when enforcement is not sufficient to induce full compliance, our work suggests that these situations involve sub-optimal policy designs. Our second main result is that, except for unrealistic special cases, discriminatory taxes are optimal except when regulators are unable to observe firms’ abatement costs, the costs of monitoring individual firms for compliance, or any firm-specific characteristic (e.g., input and output levels, production and abatement technologies, etc.) that is known to be jointly distributed with either the firms’ abatement costs or their monitoring costs. In this case, a regulator is unable to distinguish firms from one another and, therefore, is unable to determine discriminatory tax rates. However, in many situations, perhaps even most situations, regulators will not be so ill- informed. In most real settings, particularly in developed countries, firms have been subject to some form of pollution control for many years. Consequently, regulators have prior experience with and knowledge about the firms that can be used to construct an optimal policy. For example, past experience is likely to have provided regulators with information about the costs of monitoring different firms. Moreover, past experience may have allowed regulators to determine how observable firm characteristics like output, levels and kinds of inputs, abatement and production technologies, etc., are jointly distributed with their abatement or monitoring costs. We demonstrate that with this type of information, even though it may be incomplete, optimality requires discriminatory pollution prices. 1 Still others in this literature restrict themselves to only full compliance outcomes (Malik 1992, Stranlund and Chavez 2000, Chavez and Stranlund 2003). Only Stranlund (2006) considers the optimal design of emission trading policies with costly enforcement. He demonstrates that when regulators are fully informed about firms’ costs of controlling their emissions the optimal policy calls for inducing full compliance. 4 An important consequence of our work is that when regulators have enough information to distinguish firms from one another in a meaningful way, any emissions control policy that sets or generates a uniform price cannot be optimal. In particular, conventional designs involving uniform tax rates as well as competitive emissions trading with freely-allocated or auctioned permits cannot be fully efficient. While our result that enforcement costs will typically call for discriminatory pollution prices is not widely known, we do not claim that it is entirely new.2 Cremer and Gahvari (2002), examine the optimal design of an emissions tax policy for homogeneous firms under the assumptions of costly enforcement and that tax revenue is used to offset other taxes in an economy. While they obviously obtain an optimal uniform tax for a particular industry because of their assumption of identical firms within the industry, they also recognize that the tax rate will be different in other industries in part because of differences in marginal enforcement costs and abatement costs. One could easily use their results to argue that discriminatory taxes are likely to be optimal in an industry composed of heterogeneous firms. Our work differs from Cremer and Gahvari’s in several important ways. First, while they determine optimal taxes and their enforcement jointly as we do, they limit their analysis to policies that generate positive violations by all firms. In contrast, we argue that the optimal policy should induce full compliance, which suggests that Cremer and Gahvari limited themselves to policies that are, in fact, sub-optimal. The second important difference between our work and Cremer and Gahvari’s is that they assume complete information about firms’ abatement and enforcement costs throughout their work, while we investigate the extent to which 2 Beyond the control of uniformly mixed pollutants from point sources, which is the setting for this work as well as all of the literature we discuss, it is well known that discriminatory emissions taxes are optimal when pollutants are spatially differentiated (see Xepapadeas (1997), chapter 2 section 8 for references, including zonal taxes) and when emissions are generated by nonpoint sources (e.g., Segerson 1988). 5 discriminatory taxes remain optimal when regulators have incomplete information about abatement and enforcement costs.3 Finally, Cremer and Gahvari (2002) also investigate how recycling emissions tax revenue to reduce other taxes in an economy affects optimal emissions taxes. In contrast, we assume that tax revenue is not used to offset other taxes in order to focus on the roles of costly enforcement and incomplete information in determining optimal pollution prices. Malik (1992) provides an early hint that policies that generate a uniform pollution price are likely to be sub-optimal when one accounts for enforcement costs. Malik models a competitive emissions trading program under complete information that is enforced to achieve full compliance and demonstrates that even though the permit market leads to a distribution of emission control that minimizes aggregate abatement costs, it does not minimize the sum of aggregate abatement and enforcement costs. An important distinction between our work and Malik’s is that he is concerned with the optimal distribution of emissions while we are concerned with the optimal distribution of emissions prices. The two approaches are obviously complementary, but our pricing approach is instructive because it illuminates what we believe is the fundamental reason for the sub-optimality of emissions trading that Malik identifies; that is, a competitive emissions trading policy leads to a uniform price, while enforcement costs typically call for discriminatory prices. Our model differs from Malik’s in other important ways as well. First, he simply assumes that regulators devote sufficient enforcement resources to induce full compliance in an emission 3 In a recent contribution, Bontems and Bourgeon (2005) consider optimal environmental taxes under incomplete information and costly enforcement. They take a standard revelation approach that relies on eliciting truthful reports by firms of their “types”. (See Lewis (1996) for a review of this approach.) In their work, a policy consists of a type- specific lump sum tax, an emissions standard, a monitoring probability, and a fine for violating the standard. This is very different from the way environmental economists and policymakers usually think of emissions taxes. Emissions taxes are usually per unit taxes, no restrictions are placed on firms’ emissions, and noncompliance occurs if a firm attempts to evade its tax liability by under-reporting its emissions. 6 trading program, while we demonstrate that inducing full compliance to a tax regulation is optimal. Second, like Cremer and Gahvari (2002), Malik (1992) assumes complete information throughout his work, while we consider optimal pollution pricing when regulators have only incomplete information. The rest of the paper is organized as follows. In the next section we develop a model of compliance behavior under emissions taxes. In section 3, we lay out the components of the costs of enforcing a policy of emissions taxes, which include the costs of monitoring firms, and the expected costs of collecting penalties from noncompliant firms. We then demonstrate that an optimal tax policy must induce full compliance by every firm, even when a regulator has only incomplete information about firms’ abatement costs and the costs of enforcement. In section 4 we use our full-compliance result to determine optimal emissions taxes. The optimal design will typically involve discriminatory taxes except when a regulator has rather poor information about firms’ abatement and monitoring costs. In fact, we specify the exact limit on the quality of the regulator’s information at which it becomes optimal to set a uniform tax. We discuss this interpretation as well as other implications of our results in section 5, and conclude in section 6. 2. Compliance behavior under emissions taxes The regulatory model of this paper is the standard one in which a regulator first commits itself to a tax policy and its enforcement and then the regulated firms react to this policy with their choices of emissions and compliance. In this section we determine the firms’ responses to any tax/enforcement policy. Throughout consider a fixed set N of heterogeneous risk-neutral firms. These firms may or may not belong to the same industry, but each emits the same uniformly mixed pollutant. A 7 summary of the costs of all the methods firm i can use to reduce its emissions is given by its abatement cost function, C(q), which is strictly decreasing and strictly convex in its emissions i i q.4 The firm’s emissions are taxed at rate t. The firm is required to submit a report of its i i emissions, r , and it is noncompliant if it attempts to evade some part of its tax liability by i reporting r <q . i i The regulator cannot observe the firm’s emissions without a costly audit. Let π denote i the probability that the regulator is able to determine i’s compliance status. Like most other authors, we assume that monitoring produces a measure of emissions that is accurate enough to judge a firm’s compliance status without error. The detection probability is common knowledge and the regulator commits itself to it at the outset. If monitoring reveals that i has under-reported its emissions, it faces a unit penalty of φ on q −r >0.5 We assume that φ>t throughout. This i i i allows full compliance to be a possible outcome throughout the paper. No upper bound is placed on φ, because none of our results depend on setting arbitrarily high penalties. To simplify our analysis we restrict it to policies that motivate all firms to reduce their emissions below what they would chose in the absence of any sort of regulatory control, but that do not cause any firm to choose zero emissions. Under these policies firm i chooses it emissions and emissions report to solve: min C (q )+t r +πφ(q −r) (qi,ri) i i i i i i i [1] s.t. q −r ≥0,r ≥0. i i i 4 A firm’s abatement cost is the reduction in its profit that comes from reducing its emissions below what it would choose in the absence of an inducement to control its emissions (Montgomery 1972). 5 Our assumption of a linear penalty function is not common in the literature. Most authors assume that the penalty function, or at least the expected penalty function, is strictly convex (e.g., Harford 1978, 1987; Sandmo 2002, Cremer and Gahvari 2002, and Macho-Stadler and Perez-Castrillo 2006). We briefly address the use of linear penalties vs. convex penalties in the next section. 8