The comments on John's post yesterday on the double-dividend of pollution taxes raise an important question in pollution tax design: What should we do with the revenues generated by the pollution tax?
I know y'all can read and are tech-savvy enough to scroll down and find the discussion for yourself but to save a little time, I first duplicate the discussion here.
To recap the original post, John says: "When there is more than the optimal amount of pollution and a big old nasty budget deficit, pollution taxes are a nice policy option. The double-the-pleasure, double-the-fun usefulness of this policy is known as the double dividend."
In response, Jim Linnane says: "Great concept; however, pollution taxes should not be touted as a source of revenue. Proceeds of pollution taxes should be used to mitigate the effects of the pollution, especially to compensate those affected by the pollution."
Sounds logical, but then Mike Hammock counters "Jim Linnane, that's true so long as the mitigation is not itself distortionary. We want to preserve the incentive of people to move away from (or to refrain from moving toward) polluted areas."
Mike Hammock has nailed this one and receives the Env-Econ comment of the day award. Congratulations Mike! For your efforts you receive a free life-time subscription to Env-Econ.net. In true Env-Econ fashion, I will now beat Mike's answer into the ground.
The problem with using pollution tax revenues to pay the victims for the damages they incur, is that the compensation creates the incentive for the victim to bear more damages. Think of it this way. When victims are deciding whether to move or not, they perform a cost benefit analysis. The benefits of staying are the joy the homeowner gets from being in their current location, not having to uproot the kids, enjoying their dream house, etc. The costs of staying are the costs of exposure to pollution.
So what happens if we compensate the victims according to how much pollution they are exposed to? The costs of staying are reduced and the cost/benefit ratio shifts in favor of staying. That is, the victim is willing to bear more pollution costs to stay--the demand for pollution increases! This is a classic moral hazard problem. The solution to the problem actually creates the incentive for more of the problem.
So are there anyways to compensate victims of pollution using revenues from a pollution tax without distorting the incentives? Sort of. A lump sum payment to all victims--that is a payment independent of the amount of damages the victim incurs--will not distort the victims' incentives. By simply making a payment of $100 to each victim, the victim still must bear the additonal (marginal) cost of each unit of pollution. The marginal damage from the last unit of pollution is the relevant cost in the benefit/cost decision. A lump-sum payment doesn't change that cost.
Take another example. Recently, Congress was considering a $100 gas tax rebate to all drivers to compensate for higher gas prices. Ignoring your feelings on whether the rebate is a good idea or not, the $100 payment would have no effect on marginal driving behavior. If the goal is to reduce miles driven--thereby reducing the demand for gas and lowering prices--a lump-sum $100 payment will do nothing. A better solution--albeit one that could never be enforced-- would be to give a per mile rebate for each mile not driven. That way the driver has the incentive to reduce miles driven. In this case, the lump-sum payment would not affect driving behavior, just as a lump sum payment to the victims of pollution would not affect the decision to stay or go.
