Choice of Policy Instruments: Tax, Regulation or Subsidy

Abstract

In this chapter, we consider three policy instruments: environmental taxes, regulations, and subsidies. We first show that environmental taxes are preferable to regulations. When the government implements a regulatory instrument and assigns an optimal production volume to each firm in a way to minimize the sum of variable costs of the market, it may misallocate the volume due to limited data available for policymaking and thus, the total variable costs of the market are not likely to be minimized. With environmental taxation, however, the total variable costs are minimized by the market mechanism. We then show that environmental taxes are preferable to subsidies in the long term when firms enter or exit from the industry. Environmental taxation imposes higher tax payments on higher-polluting firms, thereby lowering their profit margins. Consequently, they withdraw from the industry, which results in inducing the industry to lower its environmental impact. This long-term policy effect is less likely to occur by the introduction of a subsidy.

In the 1960s, while Japan was enjoying high economic growth, environmental problems became salient. Pollutants emitted from production plants caused pollution diseases such as Itai-itai disease, Yokkaichi asthma, and Minamata disease. At the time, the government adopted regulatory measures and thereby controlled the amount of exhaust gas emitted into the air and the concentration of pollutants in wastewater. Since then, regulatory measures have played a central role in environmental protection in Japan. In the 1980s, when global environmental issues emerged and became a concern worldwide, economic instruments such as environmental taxes and emissions trading schemes started to draw an increasing amount of attention as an alternative to regulatory measures. This is because economic instruments, such as environmental taxes, are less costly means to reduce pollutants than traditional regulatory instruments.

In Chap. 1, we discussed policy instruments that aim to achieve socially optimal output in cases where environmental externalities arise from firms' production. It was discussed that whichever instruments—regulatory instruments, environmental taxes, and subsidy schemes—could maximize social surplus. In practice, however, environmental taxes are considered to be a preferable instrument to subsidy schemes and regulatory instruments. One of the reasons, as will be pointed out in Section II, is the regulatory inefficiencies caused by government failure. We will also explain differences in impact on the industry structure across different policy schemes.

1 Environmental Taxes

In a competitive market, each firm chooses the output level that maximizes its own profit and the sum of all firms' production costs (i.e., the production cost in the market as a whole) will be minimized at that output level. Environmental taxes exploit these profit-maximizing behaviors of firms and guide the total output in the market to an optimal level by reducing each firm's production. In this section, we will see how an environmental tax minimizes the cost of production in the market at the output level chosen by each firm.

In Fig. 2.1, where the vertical (horizontal) axis represents the price (the output), an environmental tax is implemented in such a way that the output achieves an optimal level. In the figure, the curve D is the demand curve for the good. The curve S is the supply curve before the tax is imposed, also representing a market marginal cost (MC curve). The curve S′ is the supply curve after the tax (t*) is imposed. MSC represents the marginal social cost curve, i.e., the sum of a marginal cost (MC) and marginal external cost (MEC) for each level of output. As we saw in Chap. 1, the optimal output is Q*, the optimal environmental tax is t* (per unit of the good), and the price of the good including the tax is P*.

Fig. 2.1

Environmental taxes and optimal output

Here we address the quantity each firm produces at price P* and the associated cost of production. For simplicity, suppose that there are only two firms, firms A and B, in the market. In Fig. 2.2 (2.3), the curves S_A and S_A' (S_B and S_B') represent A's (B's) supply curves before and after the tax is imposed, respectively. As you see in the figures, the tax shifts S_A and S_B up by t^∗ to S_A' and S_B', respectively. The reason for this shift is that for the firms to supply the same quantity as before the tax was levied, the after-price must equal the before-tax price plus the tax; otherwise, the after-price minus the tax (i.e., how much the firm receives by selling one unit of the good) will not be equal to the before-tax price.

Fig. 2.2

Firm A's supply curve and output

At the market price (including the tax) of P*, firms A and B produce Q_A* and Q_B*, respectively. For these outputs, Q_A* + Q_B* = Q* must hold (in equilibrium, the sum of the firms' outputs equals the market output); otherwise, Q* would not be an equilibrium output. For each firm's output, then, how much is the associated production cost? As the before-tax supply curve of firm A is its marginal cost curve, the variable cost of firm A is represented by area O_AHI Q_A*. Similarly, the variable cost for firm B corresponds to area O_BLK Q_B*. The sum of the two areas is the total variable cost in the market. It should be noted that the same cost can also be represented by area OCEQ* in Fig. 2.1 by using the market marginal cost curve (MC curve).

We next address whether and how the variable cost¹ depends on the allocation of output produced by the two firms, given the total output of the market being Q*. For this analysis, we will use Fig. 2.4 that combines Figs. 2.2 and 2.3 in a particular manner. In the figure, O_A is taken as the origin for firm A; firm A's output is measured horizontally left to right. The supply curves for firm A (i.e., S_A and S_A') are identical to those in Fig. 2.2. The supply curves for firm B (i.e., S_B and S_B') mirror those in Fig. 2.3 just like the figure is rotated 180 degrees around the vertical axis. Furthermore, we take the interval between the origins O_A and O_B to coincide with Q*. Thus, each point on the horizontal axis represents a particular combination of the two firms' outputs that result in the total output of Q*.

Fig. 2.3

Firm B's supply curve and output

Fig. 2.4

Market prices and allocation of output between firms A and B

As is shown in Fig. 2.4, it is at price P* that the after-tax supply curves for firms A and B (S_A' and S_B', respectively) intersect with each other. This occurs by construction of Fig. 2.4; you can confirm that at the market price of P*, firm A produces Q_A* (the distance between O_A and M) as in Fig. 2.2, firm B produces Q_B* (the distance between O_B and M) as in Fig. 2.3, and the sum of the firms' output, Q_A* + Q_B*, is equal to Q* (the distance between O_A and O_B) as in Fig. 2.1. You can also see that the variable cost of production in the market is represented by area O_AHILO_B, which is the sum of area O_AHIM (the variable cost for firm A) and area O_BLIM (i.e., the variable cost for firm B).

Using Fig. 2.4, we can show that the variable cost of the production in the market is minimized when firms A and B produce Q_A* and Q_B*, respectively (where the variable cost is represented by area O_AHILO_B). In other words, when the firms' output levels are other than indicated by point M, the variable cost becomes larger even if the total output remains the same. Figure 2.5 is a simplified version of Fig. 2.4, leaving out S_A’ and S_B’, as they are irrelevant for our discussion. Now, consider point N (that is, a point to the right of point M), the combination of the firms’ output levels where firm A produces Q_A¹ and firm B produces Q_B¹. Firm A's variable cost is area O_AHRN, firm B's variable cost is area O_BLSN, and therefore, the total cost of production in the market is: area O_AHRN + area O_BLSN = area O_AHILO_B + area IRS. In other words, the variable cost is larger by area IRS when the output levels are those indicated by point N than when indicated by point M.

Fig. 2.5

Change in the allocation of output between firm A and B and change in the total variable costs

Why does the variable cost increase? It is because the marginal cost of firm A exceeds the marginal cost of firm B; at point N, the marginal cost of firm A is RN and the marginal cost of firm B is SN. If we compare the increase in variable costs resulting from producing one additional unit of output, it is larger for firm A than for firm B at point N. Therefore, if firm A reduces production and firm B increases production by the amount that firm A reduces, the variable cost in the market can be higher, while the total output in the market remains the same.

Next, consider point T (that is, a point to the left of point M). Here, firm A produces less than it does at point M and firm B produces more. In this case, we can see that the overall variable costs in the market increase by area UVI. This means that if the marginal cost of firm B exceeds that of firm A, the variable costs in the market can be higher while the market output remains the same by reducing firm B's output and increasing firm A's output by that amount.

In this way, in a competitive market where an environmental tax is in place, the level of output that each firm voluntarily chooses (point M) will consequently minimize the variable cost in the market. One advantage of environmental taxes is that they can minimize the variable (thus production) costs in the market by exploiting the profit-maximizing behavior of firms.

A major problem with environmental taxes may be the difficulty of determining the level of taxation to impose. To achieve the optimal outcome by using taxation, the policymaker needs to know the demand and supply curves of the market to choose an optimal level of tax to charge. However, given that only limited data is available, it is difficult to accurately estimate the shapes of the demand and supply curves of the market. In such a case, the policymaker need to choose the level of the tax based on limited information, and as a result, the tax may not be sufficient to achieve optimal targets set out in the policy goal.

2 Regulatory Instruments

Regulations can be classified into two types: concentration controls (e.g., vehicle emissions controls) and total amount control, that is, a regulation that limits the amount of pollutant emissions. Here we will consider total amount control. In essence, total amount control directly regulates the volume of emissions. The maximum amount of pollutant emissions also can be controlled indirectly by regulating the amount of production, as emissions depend crucially on production volume. Our discussion will focus on this indirect approach to regulating emissions. In particular, we will consider the case where the government implements total amount control by determining an optimal production volume, designating it as the maximum level of output in the entire market, and assigning individual firms the amount they can produce, so that the sum of their production volume equals the maximum level of output in the market. The advantage of this type of regulation is that the government can achieve the policy targets as long as the firms adhere to their allocated production volume.

When the government controls production volume, it is necessary to minimize the total cost of production in the market and thereby maximize social surplus. To do so, it needs to allocate production to firms in a way to equalize their marginal costs as at point M in Fig. 2.4. However, making such an allocation is difficult for several reasons. First, the government needs to accurately estimate the marginal cost curves for all firms, which is practically difficult given the limited sources of data and information. For this reason, misallocation, such as point N and point T in Fig. 2.5, may occur. If it does, the production (variable) cost of the market becomes greater; although the total volume of production in the market is controlled to the target level, the social surplus is not maximized.

Second, the government may exercise discretion in allocating the production. For example, if the government is influenced by the bargaining power of firms and/or takes into account the regulation's impact on the industries, the allocation will not be made to equate marginal costs across firms. It is likely that a larger amount of allocation is granted to large-sized firms with more bargaining power. In that case, social surplus decreases while the interests of some firms are protected. Furthermore, even if the government issues administrative guidance to firms that do not adhere to their quotas, they may not comply with it.

3 Tax or Subsidy?

At the beginning of this chapter, we mentioned that environmental taxes are preferable to subsidy schemes (i.e., subsidies on the reduction of production/pollution). This might sound odd because we demonstrated in Chap. 1 that it is possible to achieve the optimal level of output, minimize production costs, and maximize social surplus regardless of which instrument is used. It should be pointed out, however, that these are short-term results. In the long run, where firms enter the industry if they can earn an economic profit and exit the industry if they lose money, environmental taxes, and subsidies have different effects on firms’ behaviors and the industry as a whole, as explained below.

The imposition of an environmental tax raises the costs of firms, thereby lowering the profit margins of those currently operating. This implies that firms, especially those that have not installed pollutant removal equipment or implemented energy-efficient technologies in production, must pay heavier environmental taxes and suffer from higher costs, and eventually will be forced to withdraw from the industry. Put another way, firms that remain in the industry will be exclusively those that adopt production systems to reduce energy and resource consumption. Accordingly, the whole industry will transition toward being more environmentally friendly. In addition, the industrial structure will also change: industries with large environmental impact will become relatively smaller than those with small environmental impact and conversely, industries with less environmental impact will grow relatively larger.

Contrastingly, a subsidy may make survival possible for firms that would have withdrawn from the industry in the case of an environmental tax. As a result, entries in the industry will be promoted. Industries that receive subsidies because of their high environmental impact will become relatively larger than industries with low environmental impact. Therefore, the transition to a low environmental impact society likely will be delayed.

In sum, an environmental tax and a subsidy have the same policy effect in the short term when no firm enters or exits from the industry. However, in the long term when entry and exit occur, an environmental tax differs from a subsidy in that the former induces the industry to lower its environmental impact while the latter does not. From a long-term perspective, therefore, an environmental tax is preferable to a subsidy in terms of its effects on the industrial structure.

The advantage of environmental tax comes with some cost, however. Specifically, the process of industrial adjustment may be accompanied by unemployment. When unemployment becomes a problem, governments may have to take measures to promote employment to achieve smooth industrial adjustment and the resulting transfer of labor between industries. It should also be noted that to mitigate unemployment and related social problems, a subsidy scheme may be effective to a certain extent. However, a subsidy should be provided only for a limited time and then replaced by an environmental tax after a certain transition period, given that a permanent subsidy scheme negatively impacts the long-term adjustment of the industry structure.

As a final remark, it should be mentioned that environmental taxes and subsidies also differ from the perspective of public finance. The introduction of an environmental tax will generate a new source of government revenues. Governments may use the increase in tax revenues to fund the tax cuts for existing indirect/income taxes, thereby mitigating the loss of social surplus in the goods and labor markets. On the other hand, subsidies are normally financed through income taxes and indirect taxes. Imposing indirect taxes on goods that do not incur external costs as well as income taxes, however, may lower social surplus in the goods and labor markets. For this reason, an environmental tax may have some advantage over a subsidy from a public finance point of view.

Box 2.1 Renewable Energy Policies and Challenges

The amount of renewable energy in Japan has increased since the introduction of the feed-in tariff (FIT) scheme in July 2012. It grew (at the end of FY2020) approximately four times higher since the implementation of the scheme. The FIT scheme requires electric utilities, such as Tokyo Electric Power Company (TEPCO), to purchase electricity generated from renewable energy sources at a higher rate than the normal electricity tariff. However, utilities are allowed to recover their purchase costs by increasing electricity prices. Thus, consumers bear the cost of renewable energy. The following are some of the challenges faced by renewable energy policies:

First, during periods of high solar generation due to long daylight hours or high wind generation due to strong winds, supply greatly exceeds consumption. Electric utilities are likely to reject purchase of the electricity from renewable energy generators to prevent damage to equipment caused by unbalanced demand and supply, resulting in a major power outage and the electricity generated must be discarded. This problem is more likely to occur in areas where renewable energy sources are concentrated. It is necessary to disperse the location of renewable energy generation areas and to promote the introduction of large storage batteries to solve this problem. Under a new policy scheme starting in FY2022, renewable energy producers that meet certain conditions will be required to switch to a Feed-in Premium (FIP) scheme, which is expected to give them an incentive to install large storage batteries. However, non-eligible renewable energy producers still have no incentive.

Second, solar panels contain hazardous chemicals and pose a risk of environmental pollution if abandoned or improperly disposed of after the power generation equipment is closed. Renewable energy generators may have incentives to abandon the equipment with no appropriate treatment or dispose of it with improper treatment to reduce the burden of disposal costs. A deposit system to cover disposal costs has been established since April 2022.

Finally, disaster risk, such as landslides and mudslides, increases during heavy rains, if photovoltaic power generation facilities are located in areas prone to disasters. However, no scheme, that discourages renewable energy generators to choose high-risk locations, has been introduced. Since April 2020, solar power plants with a capacity of 10 kW or more are required to purchase fire and earthquake insurance to cover the damage caused by natural disasters and earthquakes. This requirement is likely to promote the generators to choose lower risk locations. Because insurance premiums are higher in higher-risk locations. However, it is not legally binding and only implemented as a duty. Mandatory insurance should be considered.