REVENUE-RAISING VERSUS OTHER APPROACHES TO ENVIRONMENTAL-PROTECTION -THE CRITICAL SIGNIFICANCE OF PREEXISTING TAX DISTORTIONS

Using analytical and numerical general equilibrium models, we show tha t preexisting factor taxes produce a ''tax-interaction effect'' that s ubstantially increases the costs of pollution taxes and quotas. Under policies that raise revenue and recycle it through cuts in marginal fa ctor tax rates, this effect is partially offset by a ''revenue-recycli ng effect.'' Grandfathered pollution quotas, such as those used under the 1990 Clean Air Act Amendments to regulate electric utilities' SO2 emissions, do not benefit from this offset. The cost differential betw een policies that do or do not exploit the revenue-recycling effect de pends crucially on the extent of emissions reduction. We examine these theoretical findings empirically in the context of U.S. policies to r educe SO, emissions.