Choice of Policy Instruments: Tax, Regulation or Subsidy

In this chapter, we consider three policy instruments: environmental taxes, regulations, and subsidies. We first show that environmental taxes are preferable to regulations. When the government implements a regulatory instrument and assigns an optimal production volume to each firm in a way to minimize the sum of variable costs of the market, it may misallocate the volume due to limited data available for policymaking and thus, the total variable costs of the market are not likely to be minimized. With environmental taxation, however, the total variable costs are minimized by the market mechanism. We then show that environmental taxes are preferable to subsidies in the long term when firms enter or exit from the industry. Environmental taxation imposes higher tax payments on higher-polluting firms, thereby lowering their profit margins. Consequently, they withdraw from the industry, which results in inducing the industry to lower its environmental impact. This long-term policy effect is less likely to occur by the introduction of a subsidy.