This paper examines the choice between revenue-raising and non-revenue-raising instruments for environmental protection in a second-best setting with pre-existing factor taxes. Using analytical and numerical general equilibrium models, we find that interactions with pre-existing taxes fundamentally influence the costs of regulation and seriously militate against pollution abatement policies that do not raise revenue. Indeed, if the marginal environmental benefits from pollution reductions are below a certain threshold value, then any level of pollution abatement through non-revenue-raising (NRR) policies like emissions quotas is efficiency-reducing. Under conditions roughly approximating SO2 emissions from electric power plants in the U.S., we find that under an NRR (emissions quota) policy the possibility of efficiency gains disappears if marginal environmental benefits are below $109 per ton. Moreover, imposing the "Pigouvian" (rather than second-best optimal) level of quotas can reduce welfare, even when environmental benefits are as high as $220 per ton. These results are largely independent of the size of the polluting or regulated sector relative to the overall economy.
These findings stem from two underlying effects. The tax-interaction effect is the adverse impact in factor markets arising from reductions in after-tax returns to factors (labor) associated with the higher production costs brought about by environmental regulation. In a world with prior taxes on factors, this effect leads to significantly higher costs of regulation relative to what would apply in a first-best world with no pre-existing taxes. Revenue-raising regulations (taxes) enjoy a revenue-recycling effect that offsets much of the tax-interaction effect, but non-revenue-raising regulations (quotas) enjoy no such offset. As a result, for any given target level of emission reduction, the gross efficiency costs of non-revenue-raising policies are higher than those of revenue-raising policies.
These results are relevant to government regulation outside the environmental area. To the extent that government regulations of international trade or agricultural production raise the costs of output and thereby reduce real factor returns, these regulations exacerbate the labor market distortions from pre-existing taxes and thus can involve higher social costs than would be indicated by partial equilibrium analyses.