Instrument Choice: Tradable Permits and Taxes

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Policy instruments typically reflect considerations of efficiency, efficacy, and fairness.

Taxes are efficient to implement because of their relative simplicity, but in order to be equitable the tax rate must differentiate between industries, and (or), if implemented at the international level, between less developed economies and more developed economies. Designing a tax policy that is sensitive to distributional issues can be complicating, thereby diminishing the efficiency of the instrument. In addition, though they may be progressive, tax systems do not set limits on emissions, and may therefore be less effective in reducing emissions than instruments that do.

In contrast, a system of tradable permits partly addresses equity issues by “grandfathering” permit allocations among industries that were historically emissions-intensive, and by being relatively more generous in permit allocations to developing countries vis-a vis developed countries. A system of tradable permits also sets a limit on emissions. However, a cap-and-trade system is relatively more costly to implement; in addition, if the permits are free, permit recipients benefit because they do not have to internalize negative externalities, thereby distributing the costs of emissions disproportionately to society, at least in the beginning,

When the two instruments are both deployed in the same setting, there is a further issue of maximizing complementarity and minimizing overlap between the two.

There is a substantial literature that compares tradable permits and taxes. A second body of literature, which focuses on the interaction of the two instruments, emerged around the time of the implementation of the Emissions Trading System (ETS) by the European Union in 2005. With the goal of reducing 1990-level GHG emissions by 8% by the year 2012, the system was the first to combine cap-and-trade permitting and country-level emissions taxation at scale.