Equivalence of Taxes and Subsidies in the Control of Production Externalities

Abstract

We are always better off having many policies that can achieve a given objective because it extends the criteria that can be included in policy selection. This paper studies the equivalence between taxes and subsidies in the control of negative production externalities. In our models, under the tax regime, firms that take no treatment action to mitigate the damage caused by their negative externalities are punished, whereas under the subsidy regime, firms are rewarded for externality treatment activities. We employ a formulation where firms differ in the vintage of their production technology and as a result differ in profitability, negative externality generation, ·and the cost of treatment. We consider three measures as policy objec­ tives: total output, total damage from negative externalities, and sodal welfare. We find reason­ able conditions where, with an appropriate setting of uniform lump-sum and unit subsidies, the policy maker can achieve a pair of policy objectives equivalent to those obtained using unit taxes. Thus, either tax or subsidy regimes can be used to achieve desired levels of one or two policy objectives, allowing other factors such as fairness, equity, or international trade issues to be considered in policy selection.

Keywords: Public Policy, Externalities, Taxes, Subsidies, Environmental Policy, Social Welfare, Production Technology