Pollution-reducing innovations under taxes or permits

This paper compares the effects of effluent taxes and pollution permits whe n a pollution-reducing innovation is in prospect. If the government can adj ust the level of taxes and permits after the innovation has occurred, taxes and permits are fully equivalent. The equivalence breaks down, however, wh en the government can pre-commit. In this case, taxes give a higher incenti ve to invest in R&D than permits when the post-innovation output level is s ufficiently high. The welfare ranking of taxes and permits is then analyzed . Loosely speaking, taxes are superior when the social damage associated wi th pollution is not too high.