TAXATION AND OPTIMAL POLLUTION 85

6.2 THE OPTIMAL PIGOVIAN TAX

6 TAXATION AND OPTIMAL Look at Figure 6.1 which repeats the pollution diagram introduced
in Chapter 4. If we imposed a tax on each unit of the level of activity
POLLUTION giving rise to pollution, and made the tax equal to r*, we can see that
such a tax would have the effect of shifting MNPB left towards
(MNPB-*). Very simply, r* has to be paid on each unit of activity,
so that the marginal net benefit is reduced by *. The polluter will
now aim to maximise private net benefits, subject to the tax, and this
occurs at Q*. The tax * is thus an optimal tax (because it achieves
6.1 INTRODUCTION the social optimum at Q*). How is * determined? It is equal to MEC
at the optimum. This defines an optimal Pigovian tax - it is equal to

Recall that the aim of the marginal external cost (i.e. marginal pollution damage) at the
pollution regulation is assumed to be one of optimal level of pollution. A damage function tells us how pollution
finding ways of reaching Q*, the socially
optimal level of pollution. damage varies with the level of pollution emitted, and what the
Chapter 5 asked whether needed to look for any government-
we
initiated 'economic instruments' taxes, monetary value of that damage is. (It should then be possible to
- regulations, etc. at all. We
-

relate it back to the level of activity of the polluter.) Indeed, there are
concluded that 'markets in externality' were feasible in a limited
number of cases, but that, generally, some form of intervention quite a few steps involved in finding such damage functions. The
would be required. sequenceis
Many economists advocate a particular type of intervention a Economic activity ofthe polluter -Pollution emissionsPollution
tax on the polluter based on the estimated concentration in the environment- Pollution exposure - Physical
damage done. Damage
another word for external cost. Such a tax is known as a
Pigovian damage function Monetary value of damage
tax, after Arthur C. Pigou (1877-1959) who was Professor of
Appendix 6.1 shows this sequence in more detail for power station
Political Economy at Cambridge University from 1908 to 1944,. In
his Economics of Welfare (first published in 1920) he proposed a tax
emissions. The need to find the whole damage function (or a good
part of it) arises because we want to find the optimal level of
as a suitable means of equating private and social cost. Pigovian pollution - i.e. we need at least some part of MEC in Figure 6.1.A
taxes tend to be known today as pollution charges, and some single point is no good to us if we are designing pollution taxes. We
examples of charges which approximate Pigovian taxes do exist. review the techniques for finding damage functions in Chapter 10.
In this chapter we look at the theoretically 'ideal", or 'optimal' But not only do we need a good part of the MEC function, we also
Pigovian tax. It is as well to remember, however, that no real-world
charge could come closc to the theoretically correct Pigovian tax.
need to know MNPB. If the polluter is a firm may be very
this
difficult because of commercial confidentiality of information.
Instead of 'optimal' levels of pollution and optimal taxes, we tend to Indeed, many economists consider that the government, as the taxing
speak of acceptable' levels of pollution. It so happens thal pollution authority, is in a poor position to extract this information.
This
charges in general arc not very common. The main form of information between the polluter and the rcgulator is
asymmetry of
regulatory instrurment uscd throughout the world is the stanmdard. We often regardcd as . objcction to any form ol government
will offer somc explanations in this chapter 1or the general neglect of intervention.
tax/charge solutions. not be
In practice,these informational difficulties may
be concerned to get the right direction
overwhelming. We may only
 POLLUTION 87
TAXATION AND OPTIMAL
S6 ECONOMIKS OF POLLUTION
external costs (EC), is a

where SC is equal to private costs (C) plus

Costs requirement for maximum NSB. Alternatively,
benelits

MNPB MEC P CJEC

or
(6.4)
ONPB EC
Q
MNPB * private minus costs.
where NPB is net private benefits, i.e. price
must equal
Equation(6.3) is the rule that price the polluting product
of to give
equation (6.3)
marginal sOcial cost. Equation (6.4) rearranges
net private
the optimisation rule we have been using, i.e. marginal
benefits should equal marginal external costs. Using equation
(6.3)
Q* Economic activity we see that it can be met if we impose a tax, *, where

(6.5)
EC
Figure 6.1 The optimal pollution tax.

of change in pollution levels, rather than achieve a theoretical where Q* is the level of activity, solving equation (6.3). Then,
optimum If so, charges are surely a proper weapon in the regulat ory
(6.6)
armoury P
6.3 ILLUSTRATING THE OPTIMAL PIGOVIAN TAX
MATHEMATICALLY 6.4 POLLUTION CHARGES AND PROPERTY RIGHTS

Net sociali benefits (NSB) made up of the gross benefits of the

are
There is a further 'problem' with the pollution charge. Figure 6.2
but this time have shaded in the amounts of
minus private costs C, minus external costs, EC: repeats Figure 6.1, we
polluting activity at QT he
taxcharged. Thus, if the polluter contiiued to produce
.e would be liable for a total pollution tax bill of ObdQ* *Q*deQr (the
ECIQ) (6.1) to areas acdQ* and
NSB PQ reader should confirm that these are equal
the dotted area will not be
Q*dQl, respectively). Now, Q*deQr
-

where P is price, Q is output (polluting activity) and Pis parametric

benefits of output
(i.e. P does not depend on 2 as it would under imperfect paid because the tax bill exceeds the net private
Instead the polluter will move back to Q* to avoid the tax,
competition). Then, QQT.
But once at
just as the theory requires. So far there are no surprises.
(6.2) the polluter still ObdQ* despite the fact that he is now
Q pays
to be
emitting the optimal amount of polhution. T'he polluter appcars
twice once (assume the polluter is
by losing profits
is a first-order cond1tion for maximising NSB. Hencec being penalised
and again when he
a firm) get back to Q* in order to avoid the tax,
to
(6.3) is operating at the optimal level of pollution.
P2090 it
Is this socially justified? The ans wer to this is that depends
on
 88 ECONOMIKS OF PoLUUTION
TAXATION AND OPTIMAL POLLUTION 89

Cests MEC with 'precipitators' and 'scrubbing' equipment, to treat sewage before
nelits
it is emitted to water, and so on. far we have assumed that the
polluter adjusts to the pollution charge by altering the level of
activity giving rise to the pollution. In order to allow for the
abatement equipment option we introduce a new diagram. In Figure
MNPB 6.3 we see the familiar MEC curve but we have dispensed with the
MNPB curve. Instead, MAC is a marginal abatement cot curve. (t
1S shown as a straight line for convenience: in reality it is likely to be
curvilinearor 'stepped') The horizontal axis now shows the level of

pollution. MAC shows the extra costs of reducing the level of

pollution by expenditures on abatement. For example, the marginal
cost of reducing pollution just below level W is MAC1. The marginal
cost of reducing pollution below W2, however, is MAC2. That is, the
MNPB * QT lower the level of pollution the higher is the marginal cost of reducing
it still further. This may seem odd at first sight, but it reflects a
to 'clean up'
general empirical observation. It is comparatively cheap
little
initial amounts of heavy pollution, but once we get to very
Figure 6.2 Pollution taxation and property rights. it further requires advanced forms of treatment,
pollution reducing
our vicw of property rights. If the firm has no right to use the
environment for emitting wastes, then the pollution charge Obd0* is Cost
a charge for using property belonging to others (the state, say). If the
firm has every right to use the environment as it sees fit, then not only
s the charge on optimal pollution wrong, but so is the charge that
would apply between Q" and QT in Figure 6.2, i.e. the charge concept MAC:
iS Wrong altogether. Lastly, we might say that the firm has no right to MAC MEC
pollute above Q". but every right to emit the optimal level of
pollution (associated with OQ").
It is evident, then, that the design of pollution tax depends on what
view is taken of the polluter's rights to use the environment as a 'waste
sink. Those rights may be enshrined in law, but are often a mix of
legal interpretation and traditional practice. Appendix 6.2 raises a
fourth issue about the design of Pigovian taxes. MAC

6.5 PO1I.UTION CHARGES ANID ABATEMIENI (OSTS Poltion

Polutn
A leature of polhution chargrs is that they shoud encourage the ahateen

installation of pollution abatement (or 'control) cquipment. Thus, it the abatcment cost external cost approach.
Is
possible to remove particul:"1c matter and
sulphur from chimneys Figure 6.3 Optimal pollution:
 ECONOMKS OF POLLUTION TAXATION AND OPTIMAL POLLUTION 91
0

MEC 6.6 A FORMAL PROOF THAT MAC = MEC PRODUCES

Costs
nctils OPTIMAI. POLLUTION

Let Qc be the flow of cconomic output produced with pollution

control, and Qn be the flow without control. Then,

Qc On- TAC (6.7)

where TAC is the total costs of abatement. Let the value of services of
the environment with pollution control be Ec, and without control
MNPB
EN. Then
Ec ENTEC (6.8)
where TEC is the total external (damage) cost. Total social benefits
Pollution are (Qct Ec) in the economy, SO
Figure 6.4 The abatement cost-net benefit relationship.
TSB+Qc+ Ec QN TAC + EN -TEC (6.9)
using chemicals, special filering equipment, and so on. Hence the Qn+ Ex - [TAC + TEC]
general shape of MAC.
Now, pollution, W, affects TSB, TAC and TEC, so
Now the optimal level of pollution in Figure 6.3 is where
MAC MEC. This looks very similar to our previous result TSB TAC,TECI=0 .10)
(MNPB MEC). Indeed, there is a formal connection. Previously we W W
dealt with cases where the polluter adjusted to a tax by reducing
is a condition for maximising TSB. Or
oulput. We noted that the net cost to the polluter of doing this was
the foregone profu (net private benefit). So, MNPB could be thought (MAC MEC (6.11)
of as an ahatement cost curve in the context where only output
(The minus sign simply indicates that we 'read' MAC from right to
reductions can be used to reduce pollution. MAC is then
simply the left.)
analogue of this cost curve, but in a context where abatement
Note that equation (6.9) also tells us that maximising TSB is the
equipment s the means of reducing pollution.
the MNPB function on Figure 6.3.
same minimising (TAC + TEC), i.e. minimising the sum of
as

Indecd,we can
superimpose
This is shown in Figure 6.4. From a to b, MAC << MNPB which
abatement and damage costs. This result is used in some textbook
presentations.
means it is cheaper to abate pollution than reduce output. From b to
0, however, output reduction is cheaper than abatement. Hence it is
the 'arrowed line' that shows the 'least cost'
path of reaction to 6.7 PIGOVIAN TAXES AND IMPERFECT COMPETITION
regulation. This provides an intuitive proof that MAC = MEC
defines an optimum, for we know that MNPB
=MEC defines an The main difficulty with Pigovian taxes highlighted so far is the need
optimum, and MNPB is simply MAC when output reductions are to know both the MNPB (or MAC) and MEC functions.
the only way of
But, just as
responding to regulation. we discovered with the Coase
theorem, relaxing the
Finally, note that the optimal Pigovian tax is once again *, which assumption
of
is
perfect competition causes problems.
now equal to MEC at the optimal level of pollution and MAC at
the same pollution level. Figure 6.5 shows the imperfectly competitive firm with private
marginal cost, MC, and marginal social cost curve, MSC. MEC is
 92 ECONOMICS OF POLLUTION
TAXATION AND OPTIMAL POLLUTION 93
MSC
Prices
costs Prices
Costs MSC

MC
MC
MR
MC

M
MC

QOutput
QMono
MR 0 Q Monop - Output

Figure 6.5 Pigovian taxes/subsidies and imperfect competition. Figure 6.6 A positive Pigovian tax under imperfect competition.

then the vertical distance between MSC and MC.
Optimal output is
given by 2 where P= MSC. But if we place a tax equal to MEC at
t h e apparent requirement for an optimal tax, the effect is toshift
MC upwards to MC. But the firm equates marginal revenue and
MC to intersect MR to give P*, O*. This time we see that a positive
tax emerges.
The difference between the two cases is that the positive tax emerges
when MR >MC at Q*, and the subsidy (negative tax) emerges when

marginal cost,
so its after-tax
profits are maximised where MR = MC> MR at Q*. Which of these cases applies is determined by the
MC. This output Q and price P, and this is decidedly
produces size of MEC: the bigger MEC is, the more likely it is that MR> MC
non-optimal. and a positive tax will be appropriate. This suggests that pollution
taxes are still appropriate under imperfect competition if the
HowMC
do we get to *2 From Figure 6.5 it is evident that we need to
move down MC that
to so MC MR
gives Q* and P*, But
=
externality is large relative to private costs. But in neither tax nor
is
this implies a subsidy of S", not a tax.
Moreo ver, this subsidy is subsidy case does the optimal tax equal MEC*. Why not? What
equal 1o the distance hetween (the old) MC and the MR at the
happening is that we are asking the pollution tax to solve
rwo
existence of
opimum imperfections in the market, the externality and the
We It is hardly
can in fact repeat the exercise and come up with a
positive tax. monopoly (downward-sloping demand curves).
Figure 6.6 shows this result. Note that MSC is than under perfect
drawn so as to be surprising that the result is less precise
significantly different to MC. To find the tax we need to construct is
competition when only one imperfection, the cxternality. present.
 POLLU1ON IAXAION ANID OPIMAL. POLLUJT1ON 95
94 1UNOMKS O+

The reader should contirm for him- or herself that if the monopoly
imperfection is corrected first, by ensuring a move to P= MC, then osts, MAC MAC:
Tax
the Pigovian tax set cqual to MEC° will achieve the desired result.
MAC
We can summarise these findings and compare the perfect and
imperfect competition cases. Notice the formal similarity of the rules.

Perfect competition
P-MC* or * =MR - MC* (since P = MR)
and

MEC

where indicates the value at the optimum.

Imperfect competition
If M C > MR, S* = MC*- MR* and S* is unrelated to MEC*

IfMR> MC", *= MR*-MC* and = MEC*

where tax and S = Subsidy.
Pollution icduction( abalcncnl)

Figure 6.7 Taxes as a low-cost method of achieving a standard.

6.8 CHARGES AS A LOW-COST SOLUTION TO
STANDARD SETTING

Now suppose we set a standard which says that we have to achieve

There is one other feature of the tax/charge solution to externality
which is of some importance. It is that, compared to standards set
without 1axes, charges will tend 1o be a iower-cost method of
achieving a given standard. This result is due to Baumol and Oates
(1971). We offer a diagrammatic proof here.
Figure 6.7 shows pollution reduction (i.e. level of abatement) on
the horizontal axis, and money values on the vertical axis. MACI,
MAC; and MAC; are then marginal abatement cost curves for three
differeni firms producing the same product. Note that the MAC
curves slope upwards from the left to the right, and not from right to
left as in Figure 6.3. This is simply because we have put pollution
reduction on the horizontal axis, as opposed to pollution levels.
MAC for each firm differs simply because of different technologies in
use in the firms: we have no reason to suppose they will be the same.
We observe that, for any given level of abatement, firm 1 has the
highest costs of abatement, firm 2 the next highest and firm 3 the
lowest. For simplicity, we assune S1S=S,S, and SS + S%=3S
Seachof firm
pollution abatement. One way of doing this is simply to tell
to abate pollution by an amount OS. This means firm 1
will go to point A, firm 2 to point B, and firm 3 to point C. We
achieve the overall standard of 3S.
An alternative is to set a tax r*. The tax is set so that firm 1 goes to
point X, firm 2 to point B, and firm 3 to point Y. To see why,
consider firm 1. Up to S it is cheaper for the firm to abate pollution
than it is to pay the tax (* lies above MAC). Afier Si, however, the
firm will pay the tax rather than abate (* lies below MAC). A
similar analysis applies to the other firms. Note that the overall
standard 3S; is achieved, but that firm I, with the highest abatement
costs, has abated pollution less than S, while firm 3, with the lowest
abatement costs, has abated more than S.
There seems nothing to choose betwecn the standard-setting
approach and the taxation approach. Both achieve the overall
standard of 3S. But there is a difference in the costs of compliance
96ECONOMICS OF PoLLUTION

with the standard. To find those costs we need TAXATION AND OPTIMAL POLLUTION 97
to add up the
areas under the MAC ocurves as follows: rclevant
in the real
world, pollution taxes are the exception, not the rule. Not
only are the charges limited in extent, their
formulation tends to owe
Standard-setting solation little to the theory outlined in this
Total abatement costs TAC« OAS; chapter. Why is this? Pezzey (1988)
+
OBS, +OCS offers a number of interesting
suggestions to explain the limited role
of taxes, and these are discussed
below.
Tar solution
Total abatement costs TAC =OXS, +
OBS+ OYS Uncertainty about thejustice of Pigovian taxes
Industry will always understandably resist new taxes. But this is not
The two total costs the same. To
are not see this, deduct TACx from adequate to explain opposition if the situation is that some form of
TAC regulation will be introduced. One fear, however, is that the tax will
go beyond'taxing Pareto-relevant (non-optimal) pollution, to taxing
TAC-TACa =
SiXAS; -S:CYS for optimal pollution, and even for physical pollution in a
But SXAS: is clearly W<A context. Industry might tolerate the former (which Pezzey calls
greater than S:CYS, so that
the 'standard' polluter pays principle) but not the latter (the
TAC.TACa 'extended" polluter pays principle).
We have demonstrated that standard-setting incurs greater total
Lack of knowledge of the damage function
ahatemeni costs than 1axing
achieve the same standard. Hence the
to
A strict Pigovian tax requires that we know at least part of the MEC
u s of taxes is a low-cost solution for
achieving a given standard. curve, which is the marginal interpretation of the overall total
Whether it is the least-cost solution to standard-setting depends on external cost function, or 'damage function'. The ways in which
what other mechanisms we have for achieving a standard
c.g. damage functions might be measured are reviewed in Chapter 10.
-

marketable permits (see Chapter 8). Typically, we can only find out
by simuiating' pollution control - i.e. by devising computer
Sumulations which 'mimic' the actual situation and then assessing the
response to each method of securing a standard.
Notice that we have said nothing about the standard
being
optimal To find an optimal standard we need information on the
damage function. What is being demonstrated is that, even where we
impose accessible 'standards, a 1ax has an imporlant role to play.
The judgement of many economists and perhaps even more
pollution control agents is that damage functions are very difficult
toestimate in practice. Moreover, they argue, even if we secure some
estimates it is not difficult to find other experts who will argue
different damages, opening the way for disputes about the legal basis
for
for a tax or charge. This objection has some validity, and the charge
that the damage figures can be "massaged' could be serious in
countries where it is possible to dispute the basis of taxation in the
courts. But the idea that an 'optimal' Pigovian tax can be
calculated
is unrealistic. The point of damage estimates is to obtain
some

numbers
6.9 WHY ARE POLLUTION TAXES NOT WIDESPREAD? overall 'feel' for the levels of damage, not to find accurate
of information needed would
(even if they could be found). The kind
wide of the mark in taking a particular
Pollution taxes have many virtues. They make use of market tell us whether we are very
we are in the right 'ballpark'. Morcover,
the use
mechanisms by charging a price for hitherto unpriced but valuable pollutantor whether
and production is not unusual in
services provided by the natural environment. To some cxtent, they of taxes to regulate consumption
few would dispute that tobacco
mimic' the market since the tax could be varied to reflect increasing modern economies. For example,
have a social cost 'component'. In the same way.
scarcity of these services They have optimality properlies il both and alcohol taxes
to social cost
pollution should bcar some relationship
damage costs and abatement costs are k nown, and, even il they are taxes on
not known, they have lcast-cont (ic. 'cost elfectivenexs') properties. Yet estimates.
98 ECONOMICS OF POLLUTION TAXATION AND OPTIMAI. POLIUTION 9

The status quo

Pollution regulation has, by and large, grown from earlier public B.oud-buwd polluton-control Pusbk diulun
4Datemem echnn
melhods
heaith laws. These were mainly in the nineteenth century
formulated
when the only real mechanism for controlling pollution was direct
all chumrey ltks cal tianngl a
desulphusnetum, Ihludned ted
regulation based on standards and backed up by inspection and plant x a t i o n
a l Hred
omDUs1, CikciroNak

power1alon precipitalos, vEiuri xrubbers

penalties for transgression. Taxes are thus a 'new' idea in the context l e zas K r u b b e r s

of pollution control. Newness is not generally welcome in regulatory

circles. not east because the regulator wants to know why the Mrnduais dru hargrd
wA

existing system is inadequate. It is not just a matter of pointing to the P'ulverird fucl avh
esidual ludge duxC
desirabie characteristics of taxes: it is necessary also to show that containingE suipnur Sulphur uxdes
and or spent r o g e n 01des
alternative systems, and especially the one already in place, are worse Solveuls Particulale matler

than the proposed one. There are indeed benefits in 'sticking with
what we ve got'". Particular concerns will be whether regulatory taxes
Transler lunction: Aimospher
are compatible with the existing legal system, and what the Iransler 1unction:
transportation. wet and ary
pping or landiill

transitional costs are. posa practices may deposition. processes

cpendcnt on iocal topography.
ic
ad to interemeid meleorologIcal conditios
polulion transicr
Va tip icacnales
and hcight ol chimney lack

APPENDIX 6.1: THE EMISSIONS-DAMAGE SEQUENCE Air quality and water qual1ty Air quality in surrounding
Global climale
FOR AN ELECTRICITY POWER STATION possible contribution lo evels within radius ol up to d i s t r c t s (3 20km radius)

greennousc ellect S00 km may be allected due

to long alstance transportation
acid rain problems (irans-
Figure A6.I shows how pollution from power stations impacts on frontier polution)
Ambient condiions
the economy and individuals. Depending on the choice of Ambicnt conditions:
Concentrations of
Local waler qualty. pollutants at a partcular
coal-fired power station discharges
local visual and amenity
abatement-control technology, a quality deteriorations location and place
residual gases and matter into the area, and solid wastes to ground
and water. This is 'transferred' to the atmosphere according to local
Human cpovurc

meteorological conditions and topography. These ambient concentra- tuncton line

indoors, rle)
tions relate to human exposure according to various behavioural
conditions, e.g. time spent at work, at home and travelling. Exposure
and ambient concentration tend to be the same thing for non-human hpuvure ol vegetation.
Jonest, bukl1ngs, ctc
then links
receptors of pollution. The 'dose-response' relationship
done to emissionsor cxposure, giving rise to various impacts
damage
which localised and some that may travel across national
are
tglatnonhp
we need
boundaries. To find society's valuation of the damage done 10.
to adopt monetary valuation techniques as discussed in Chapter

which, if any, of the abatement techniques are operative.

Depending on

chain associated with power

Figure A6.1 Links in the environmental
(Continued overleaf.)
station pollution and damage impacts.
 100 ECONOMICS OF POLLUTION
TAXATION AND OPTIMAL POLLUTION 101

Damage
ellet Costs,
benefits
MEC
MNPB

Economic activity. Q
Munctari ialuatun
aluc tu nICty
t toial damage cllect
Emissions

( o t mgcnt i a l u a t scon Hednic prces Iravel conds Market prices

Figure A6.I (continued) Figure A62 Three incidences of a pollution tax.

APPENDIX 6.2: THE TARGET OF A PIGOVIAN TAX of the

level of activity corresponding to the assimilative capacity
We noted in the main text that damage estimation took place in the environment.

context of a sequence of activities and events: the pollution-creating Now suppose a tax is imposed such that the polluter pays OacO
in tax. We now see that, not only is he paying in the context
of
activity. the pollutant emissions, their concentration in the which
environment, the exposure, the damage done, and the monetary optimal externality, he is also paying a tax of OabA
evaluation of the damage. The 'proper' Pigovian tax is related to the corresponds to his 'use' of the environment even though no physical
done at the optimum. But we saw this was pollution is occurring (on other than a temporary basis). This seems
monerary value of damage to add to the 'unfairness' of a blanket tax on all emissions, regardless
complicated. Taxes, if they are to be introduced at all, are more likely
of whether they create any damage at all (associated with OA),
to be levied on emissions or ambien1 concenirations measured in
optimal damage (associated with A0* or non-optimal damage
physical terms.
We cannot assume that emissions and concentrations are related in (associated with Q*Qr).
Once again, however, it depends what we think the polluter is
a one-to-one fashion. Ignoring atmospheric factors, which will alter or the use of
the spatial distribution of the emission-concentration relationship, paying for: all damage done, non-optimal damage only,
the
we need to take account of assimilative capacity, a concept
the environment. In the last case, the polluter is paying for
we assimilative functions of the environment and it is then proper to pay
introduced in Chapter 2. Figure A6.2 repeats the basic form used in some form of tax associated with OA. Nonetheless, the tax in Figure
the text, but the level of emissior.s is also shown. Up to emission level i ased.or
A6.2 is based on damage, so that it seems odd to use a tax
e,the environment assimilates the waste. Thereafter, emissions one criterion damage done to reflect another criterion, namely
cause physical changes which, we assume, cause immediate economic use of a scarce resource.
damage. The effect, then, is that MEC only begins to rise at A, the