On the Superiority of Corrective Taxes to Quantity Regulation

Abstract:     
The traditional view of economists has been that corrective taxes are superior to direct regulation of harmful externalities when the state's information about control costs is incomplete. In recent years, however, many economists seem to have adopted the view that either corrective taxes or quantity regulation could be superior to the other. One argument for this view, identified with Weitzman (1974), holds only if the state is constrained to use a fixed tax rate (a linear tax schedule) even when harm is nonlinear. Corrective taxes are indeed superior to quantity regulation if -- as seems more plausible -- the state can impose a nonlinear tax equal to the schedule of harm or can adjust the tax rate upon learning that it diverges from marginal harm. Another argument, associated with Baumol and Oates (1988), is that quantity regulation gains appeal when the state is uncertain about the harm caused by an externality. In this case, however, a corrective tax schedule (equal to the expected harm schedule) is superior to quantity regulation.

Number of Pages in PDF File: 18

JEL Classification: H23, D62, K32, L51

working papers series