Instrument Choice: Taxes and Subsidies

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Pollutants can be taxed as either inputs to or outputs of industry. The most cost effective way to tax carbon, for example, is by measuring it as a constituent of fossil fuels before firms consume those fuels. Alternatively, GHGs, including C02, can be taxed as emissions, though measuring emissions is typically more costly and less precise than measuring inputs.

As a further consideration, taxes can be assessed ad valorem, in which case the levy fluctuates with the market price of a unit of energy, or by unit, in which case the rate is fixed. For example, in the United States gasoline is taxed by the unit (gallon).

As with taxation, the rate of subsidy can be ad valorem or fixed. A substantial literature suggests that ad valorem taxes and ad valorem subsidies are equivalent in both outcome and cost (Droge & Schroder, 2005). In addition to compensating firms for reducing emissions, subsidies are also used to stimulate the research and development (R&D) of emissions-abatement technologies.

In designing taxation or subsidy schemes, policymakers typically focus on the ratio of clean production (consumption) to polluting production (consumption) in an industry. To improve that ratio, clean production can subsidized, polluting production can be taxed, or both instruments can be deployed at the same time. The entry and exit behavior of firms in the industry, as well as the impact on welfare (social utility) of a tax or subsidy, are also important considerations in crafting policy.

The literature on the interaction of taxes and subsidies develops models for an ideal balance of the two instruments under different emissions targets, considers the impact of one on the other, and makes suggestion as to their co-implementation.