Abstract and Keywords
Market-based approaches to environmental policies, like energy taxes and tradable permits, are cost effective since all participants face the same prices for energy. These approaches can also generate substantial government revenues that can be used to reduce other taxes, improve economic performance, and enhance environmental quality. Market-based policies affect the economic decisions of millions of firms and households. These policies are evaluated in terms of their effects on individual and social welfare. The welfare indicators are accompanied by confidence intervals with associated probabilities that provide measures of uncertainty.
The design of new energy and environmental policies for the United States requires a market-based approach for internalizing the health costs and environmental damages from using energy. The goal of environmental policy is to assure that all market participants face the incremental costs of energy use, so that these costs are incorporated into economic decisions. Market-based approaches like environmental taxes and tradable permits are cost-effective, since all market participants face the same prices for energy. Other approaches leave opportunities to reduce the cost of pollution abatement unexploited and impose undue burdens on economic activity.
Market-based approaches to environmental policy could generate substantial government revenues, so that integration of these revenues into government budgets is an essential part of policy design. In chapter 8 we have shown how revenues from environmental taxes can reduce other taxes, improve economic performance, and enhance environmental quality. However, there can be no presumption that market-based policies will abate pollution or improve economic performance. The environmental and economic impacts of these policies must be assessed empirically in every policy evaluation.
Finally, market-based environmental policies affect the decisions of millions of individual firms and households. We have evaluated these policies in terms of their effects on individual and social welfare. For this purpose we translate the decisions of households into measures of individual welfare that are distributed over the entire U.S. population. We combine measures of individual welfare with value judgments about horizontal and vertical equity to obtain a measure of social welfare. In chapter 8 we rank alternative environmental policies in terms of their impacts on social welfare.
(p.388) The design of new energy and environmental policies for the United States requires a new analytical framework to capture policy impacts on all markets in every period of time. These markets are equilibrated by the intertemporal price system that we discuss in chapter 1. The most important innovation in our framework is to link markets in different time periods through markets for capital services and investment goods in each period. The prices determined in these markets summarize the expectations of future prices needed for current decisions.
In chapter 2 we capture the key features of our analytical framework in the Intertemporal General Equilibrium Model (IGEM). In chapter 8 we illustrate the power of the new approach to policy design embodied in IGEM. We consider a policy that involves using the revenues from a carbon tax to reduce tax rates on capital income. This reduces the cost of capital, determined in the market for capital services, and stimulates capital formation, determined in the market for investment goods. The increase in future capital input offsets the costs of pollution abatement and improves the performance of the U.S. economy. We refer to this outcome as a double dividend.
To analyze energy markets, we have modeled the behavior of individual households in chapter 3. Substitution among goods and services and leisure time is the key to understanding consumer behavior. Our main innovation is to capture the heterogeneity of household behavior by including the demographic characteristics of individual households, together with prices and total expenditure, as determinants of consumer demand. We combine survey data on households with price data that vary over time and across the thousands of households that we consider at each point of time.
The new model of consumer behavior we present in chapter 3 is essential for capturing heterogeneity of individual households. We represent consumer behavior in IGEM by summing demands over all households. To measure the impact of energy and environmental policies on the welfare of individuals, our most important innovation is to recover models of individual consumer behavior from our aggregate model. By exploiting the consumer demand functions at the household level, we are able to construct a measure of welfare for each household.
A major innovation in chapter 3 is to combine measures of individual welfare into a measure of social welfare. Our measure of social welfare rests on value judgments rooted in the well-established principles of horizontal and vertical equity. We are able to evaluate the (p.389) impacts of alternative energy and environmental policies on the basis of equity as well as efficiency. Our measure of social welfare leads to a complete ordering of alternative policies and produces clear-cut policy recommendations.
In chapter 4 we incorporate models of producer behavior for 35 individual industries into IGEM, including 5 industries that comprise the energy sector of the U.S. economy. The remaining industries include Agriculture and Mining, Manufacturing, Services, and Trade. For each industry, we consider substitution among inputs of Capital Services, Labor Services, Energy, and Materials in response to changes in the prices of these inputs. Our most significant innovation in chapter 4 is to distinguish input substitution from changes in technology induced by price changes. We have quantified the importance of price-induced changes in technology in the policy simulations of chapter 8.
In chapter 5 we incorporate demands by the government sector, investment demands, and imports and exports from the rest of the world into IGEM. The government budget includes revenues and expenditures. The budget also incorporates a complete representation of the U.S. tax system, providing a role for the energy and environmental taxes that we consider. Our most important innovation in this chapter is to integrate energy and environmental policies into the government budget. This provides the basis for the base case projections of the U.S. economy presented in chapter 6 and the policy cases considered in chapter 8.
Chapter 7 describes the role of environmental variables in the impacts of alternative energy and environmental policies. The environmental variables are based on official inventories published by the Environmental Protection Agency and energy variables are obtained from the Energy Information Agency. Our most significant innovation in this chapter is to include technologies that are not reflected in the U.S. national accounts and other economic reports. This greatly broadens the scope of environmental impacts encompassed by IGEM.
The distinguishing feature of our approach for designing energy and environmental policies for the United States is to estimate the parameters of IGEM econometrically. The estimates presented in chapters 3, 4, and 5 are accompanied by measures of uncertainty. Our final innovation is to employ the delta method introduced by Tuladhar and Wilcoxen (1999) to derive measures of uncertainty for the IGEM base case projection of the U.S. economy. We derive similar measures of uncertainty for policy evaluations that compare the base case with policy cases. In (p.390) chapter 9 we express these measures of uncertainty through confidence intervals with associated probabilities.
The innovations presented in this book, taken together, constitute a new approach for designing energy and environmental policies for the United States. We have emphasized environmental taxes, following a long line of economists since Pigou (1920). However, we integrate these taxes into the government budget, following more recent literature on the double dividend. We analyze the impacts of energy and environmental policies by means of the intertemporal price system modeled by IGEM. Finally, we evaluate these policy impacts in terms of empirical measures of individual and social welfare.
Very few analytic results are available for choosing among alternative energy and environmental policies. This is the primary reason that the U.S. Environmental Protection Agency (2000, 2010a) emphasizes general equilibrium models in its Guidelines for Preparing Economic Analyses. Econometric general equilibrium modeling is essential for exploiting the vast range of economic data required for evaluating energy and environmental policies and providing sound policy advice.
Although much of the economic literature on energy and environmental policies focuses on market-based approaches like those discussed in this book, these policies are rarely integrated into fiscal reform, as proposed in our subtitle. This has been a major barrier to widespread adoption of market-based policies. Energy and environmental policies that do not use energy markets may not be cost-effective and may impose unnecessary burdens on the U.S. economy. These policies may also fail to cope with the hidden costs of energy, the key policy objective.
In this book our objective is to design policies that are sufficiently stringent to achieve environmental objectives and, at the same time, enhance economic performance. This is no longer the impossible dream that it seemed in 1990 when we constructed the first version of IGEM. The innovations presented in this book make it possible to incorporate the wide range of information on policy impacts that is now available and evaluate these impacts in terms of individual and social welfare. While this is very demanding, our goal from the beginning has been to improve both environmental quality and economic performance, in short, to achieve a double dividend.