Regulation under Financial Frictions: A Quantitative Analysis of Taxes versus Tradable Permits

22 Pages Posted: 8 Mar 2017

See all articles by Wenbiao Cai

Wenbiao Cai

University of Winnipeg - Department of Economics

Manish Pandey

University of Winnipeg

Date Written: February 12, 2016

Abstract

We examine the differential effects of using taxes and tradable permits to regulate emissions in an economy with financial frictions. We construct a two-sector model, where the regulated sector output is produced by entrepreneurs who differ in their endowment of managerial skills and assets and face a borrowing constraint. Government uses either an output tax or sets up a market for permits to restrict emissions by reducing the regulated sector output. We analytically show that tradable permits generate misallocation of resources while taxes do not. We parameterize the model and quantitatively examine the effects of using taxes or tradable permits to restrict the regulated sector output to the same level. We find that compared to taxes, using tradable permits results in lower aggregate productivity, welfare, and government revenue. Our findings suggest that taxes would be a better instrument than tradable permits for regulating emissions in countries with less-developed financial markets.

Keywords: Financial Frictions; Tradable Permits; Taxes; Type-Dependent Regulation

JEL Classification: H23; L52; O44

Suggested Citation

Cai, Wenbiao and Pandey, Manish, Regulation under Financial Frictions: A Quantitative Analysis of Taxes versus Tradable Permits (February 12, 2016). USAEE Working Paper No. 17-300. Available at SSRN: https://ssrn.com/abstract=2928815 or http://dx.doi.org/10.2139/ssrn.2928815

Wenbiao Cai (Contact Author)

University of Winnipeg - Department of Economics ( email )

Winnipeg, Manitoba R3B 2E9
Canada

Manish Pandey

University of Winnipeg ( email )

Winnipeg, Manitoba R3B 2E9
Canada

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