The relative efficiency of environmental policy instruments in a second-best setting with costly monitoring and enforcement

In this paper we in corporate monitoring and enforcement aspects in the choice of environmental policy instruments in a general equilibrium framework. Goulder et al. (JPE, 1999) look into the choice of policy instruments in the presence of distortionary taxes. We extend this model by no longer assuming full compliance from the firms. A violating firm is caught with a certain probability by the inspection agency. Once a violator is detected, he always has to pay a certain fine. We find that as long as we have a positive, finite expected fine and a probability of detection smaller than unity, that there will always be a certain proportion of noncompliance in the economy. We calculate the gross efficiency costs of different policy instruments (emission tax, output tax, tradable permits and technology mandate). Given the efficiency costs in a full-compliance setting, we find that these costs are smaller for all instruments if we work in a setting with incomplete compliance. We illustrate the model in a numerical setting concentrating on price instruments (emission tax, output tax and tradable permits). One of the results is that the relative inefficiency of grandfathered tradable permits vis-à-vis emission taxes found in a second-best setting, decreases when we include monitoring and enforcement considerations. 1 We would like to acknowledge the financial support of the DWTC research program Indicators for sustainable development contract nr. HL/DD/015 ('Law and economics of the Choice of Environmental Policy Instruments'). Stef Proost acknowledges the support of the Fund for Scientific Research, Flanders. Moreover we would also like to thank Inge Mayeres for her useful comments and suggestions.