TY  - JOUR
AU  - Holland,Stephen P.
TI  - Taxes and Trading versus Intensity Standards: Second-Best Environmental Policies with Incomplete Regulation (Leakage) or  Market Power
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 15262
PY  - 2009
Y2  - August 2009
UR  - http://www.nber.org/papers/w15262
L1  - http://www.nber.org/papers/w15262.pdf
N1  - Author contact info:
Stephen P. Holland
Bryan School of Business and Economics
University of North Carolina, Greensboro
P.O. Box 26165
Greensboro, NC 27402-6165
Tel: 336/334-4925
Fax: 336/334-4089
E-Mail: sphollan@uncg.edu
AB  - This paper investigates whether an emissions tax (equivalent to an emissions cap) maximizes social welfare (defined as the sum of consumer and producer surplus) in the presence of incomplete regulation (leakage) or market power by analyzing an intensity standard regulating emissions per unit of output. With no other market failures, an intensity standard indeed yields lower welfare, although combining it with a consumption tax eliminates this discrepancy. For incomplete regulation, I show that under certain conditions an intensity standard can yield higher welfare than any emissions tax (including the optimal emissions tax). This result persists even with the addition of a consumption tax, which ameliorates output distortions and can sometimes help the intensity standard attain the first best (when an emissions tax/consumption tax combination cannot). Comparing intensity standards to output-based updating shows that the latter yields higher welfare because of its additional flexibility. Finally, I show that with market power an intensity standard can yield higher welfare than the optimal emissions tax. 

The intuition of these results is relatively straightforward. The weakness of an intensity standard is that it relies more on substitution effects than output effects to reduce emissions. With incomplete regulation or market power, this disadvantage may be helpful since leakage may offset gains from reducing output and since market power already inefficiently reduces output.
ER  -