On the Superiority of Corrective Taxes to Quantity Regulation

The traditional view of economists has been that corrective taxes are superior to direct regulation of harmful externalities when the state’s information about control costs is incomplete. In recent years, however, many economists seem to have adopted the view that either corrective taxes or quantity regulation could be superior to the other. One argument for this view, identified with Weitzman (1974), holds only if the state is constrained to use a fixed tax rate (a linear tax schedule) even when harm is nonlinear. Corrective taxes are indeed superior to quantity regulation if -as seems more plausible -the state can impose a nonlinear tax equal to the schedule of harm or can adjust the tax rate upon learning that it diverges from marginal harm. Another argument, associated with Baumol and Oates (1988), is that quantity regulation gains appeal when the state is uncertain about the harm caused by an externality. In this case, however, a corrective tax schedule (equal to the expected harm schedule) is superior to quantity regulation. JEL Classes H23, D62, K32, L51 Harvard University and National Bureau of Economic Research. We thank William Baumol, Lucian Bebchuk, David Bradford, Don Fullerton, Richard Revesz, Robert Stavins, Kip Viscusi, Martin Weitzman, and workshop participants for comments, George Wang for research assistance, and the John M. Olin Center for Law, Economics, and Business at Harvard Law School for financial support. 0 In the past, the consensus view of economists was that corrective taxes are superior to quantity regulation as a means of controlling harmful externalities. This belief, however, has changed in recent years. Due in large part to the influence of Weitzman (1974) and Baumol and Oates (1971, 1988), economists now commonly state that either corrective taxes or quantity regulation could be superior to the other. This newer view is presented in textbooks and surveys on environmental economics (Bohm and Russel, 1985, Cropper and Oates, 1992, Pearce and Turner, 1990, Tietenberg, 1996) as well as in general undergraduate textbooks (Pindyck and Rubinfeld, 1995, Rosen, 1992). Our purpose here is to explain why, in fact, the traditional notion of the superiority of corrective taxes should continue to be a benchmark for economists’ thinking about the control of externalities. We first consider the standard context of a single externality-producing firm and review the conventional argument that corrective taxes are superior to quantity regulation. We observe that the contrary claim in Weitzman (1974) and related literature depends entirely upon the assumption that the corrective tax is constrained to be fixed and linear even when harm is nonlinear. The rationale for this restriction on taxes, though, is not evident, and we suggest that it is generally inappropriate. We next consider the idea, associated with Baumol and Oates (1971, 1988), that quantity regulation may be desirable when the state is uncertain about the magnitude of harm. As we explain, however, corrective taxes (equal to expected harm) remain superior to quantity regulation even when harm is uncertain. We also examine the choice between corrective taxes and quantity regulation (and permit schemes) in situations in which multiple firms jointly create an externality. Although our discussion of this case relies in part on informal judgments, it suggests that corrective taxes (and