Emission Taxes and Damage Thresholds in the Presence of Pre-existing Regulations

This paper makes two contributions to the economics of pollution policy. First, many studies have looked at the effects of emission taxes in the absence of regulations and vice versa, but the implications for optimal tax design when one is layered on top of the other have been ignored, even though the practice is commonly observed. I develop a model of multiple polluting sectors capable of providing a tractable characterization of this case. Second, numerical modeling has shown that tax interactions can yield a positive damage threshold below which any emission tax is welfare-reducing even if marginal damages are positive, but this has largely been ignored in both the theoretical and policy literatures. I show that a positive damage threshold occurs when the policy is not revenue-raising and/or the rest of the tax system is not optimized, but can also occur in a second-best context with optimal taxes and full revenue-recycling, a result not previously shown. Introducing a pollution tax when one firm is already subject to an emissions constraint yields a positive damage threshold that goes up, the more the regulation distorts the income tax base. Hence, under more general conditions than have previously been realized, pollution taxes are not guaranteed to raise welfare even when marginal damages are positive and revenues are fully recycled.