Revenue-raising versus other approaches to environmental protection: The critical significance of preexisting tax distortions

Using analytical and numerical general equilibrium models, we show that preexisting factor taxes produce a "tax-interaction effect" that substantially increases the costs of pollution taxes and quotas. Under policies that raise revenue and recycle it through cuts in marginal factor tax rates, this effect is partially offset by a "revenue-recycling 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 between policies that do or do not exploit the revenue-recycling effect depends crucially on the extent of emissions reduction. We examine these theoretical findings empirically in the context of U.S. policies to reduce SO, emissions.