Policy commentary

Environmental Federalism - Wallace E. Oates

Sep 21, 2009 | Wallace E. Oates

The basic principles of economics make a compelling case for environmental regulation because of the excessive use of our freely available, but scarce, environmental resources under a system of free markets—or, in the jargon of economics, as a result of “externalities.” But in a federal system, with several levels of government, the next question involves the locus of regulatory authority: which level of government should undertake a specific regulatory responsibility? 

A cursory look at U.S. policy on this issue reveals some puzzling anomalies. Under the Clean Air Act in 1970, the U.S. Congress instructed the newly formed U.S. Environmental Protection Agency (EPA) to set standards for ambient air quality in the form of maximum permissible concentrations of pollutants applicable to every jurisdiction in the country. Only two years later, under the Clean Water Act (1972), the states were assigned the responsibility for setting standards for water quality within their own boundaries. It is not at all clear why standards for air quality should be centrally set and uniform across the nation, while determining standards for water quality is left to the states.

Economics, as it turns out, can provide some guidance on this issue. From an economic perspective, standards for environmental quality should be tightened so long as the benefits from incremental cleanup exceed the additional costs. However, the geographical setting for applying this principle varies among different forms of pollution. In some instances, such as carbon dioxide emissions that contribute to global climate change, all that matters is the aggregate level of emissions—the precise location of their emission into the atmosphere doesn’t matter (at least for purposes of global climate change). For pollutants of this kind, what we need is a national (or, really, a global) program to restrict emissions.

In contrast, the variation in both the benefits of cleanup activities and costs of certain other forms of pollution can vary dramatically across different jurisdictions. This, for example, can be the case for various forms of air and water pollution, where one size doesn’t fit all. An efficient outcome in such a setting requires different standards for environmental quality depending on how damaging the effects are and how costly it is to control the polluting activity.

A particularly interesting and provocative case in point arose in the waning days of the Clinton administration in 2000, when EPA introduced a new measure to reduce the permissible level of arsenic in U.S. drinking water by 80 percent. The “arsenic rule” applied to all jurisdictions in the nation. Careful analysis of the new provision revealed that it promised only a minuscule reduction in health risk on a national scale. EPA estimated that the tough new standard could save approximately 20 to 30 statistical lives per year (the value of a “statistical” life is typically understood by economists to be the cost of reducing the average number of deaths by one). But this estimate was subject to sufficient uncertainty that it is not unreasonable to believe that no lives would be saved under the standard. 

Of special interest in this case was the enormous variation across the country in the cost per household of meeting the arsenic standard. Huge economies of scale exist in the treatment of drinking water such that the new measure could be met in a large water district like New York City for under $1 per year per household. In fact, many large districts were already in compliance with the new standard. But in very small water districts, largely in rural areas, the cost of meeting the new standard was in excess of $300 per household per annum, dwarfing any prospective gains. Indeed, far greater health benefits could be achieved if such sums were used for other public (or private) health measures, such as increasing the frequency of mammograms, colon screenings, or a host of other procedures. One size certainly didn’t fit all in this case: the arsenic rule may have made sense for large water districts, but it was economically wasteful for smaller districts.

Critics of this approach to environmental federalism contend that it overlooks the fact that municipalities compete for new business investment and jobs. If we leave important matters of environmental regulation to state or local governments, we can set in motion a competitive “race to the bottom,” with officials setting lax environmental standards as a means of reducing the cost to new (and existing) businesses. Consequently, the critics argue, it is necessary to centralize the setting of standards to avoid a competitive depreciation of environmental quality.

However, a closer look suggests that both in theory and in practice the case for a race to the bottom is not very compelling. A standard theoretical model in which government seeks to maximize the well-being of its citizenry reveals no such race. People care about the quality of the environment—and a government that fails to respond to these concerns is unlikely to stay in office. Moreover, the existing evidence provides little support for this view. Under the Reagan administration in the 1980s, several measures were introduced that effectively moved the responsibility for environmental management on a number of fronts back to the states, creating a favorable setting for a race to the bottom. Three empirical studies have carefully examined this episode, however, and none found any evidence of a competitive reduction in environmental standards. On the contrary, increased state spending on environmental programs and improvements in environmental quality continued unabated through this period. 

Basic economics thus suggests an important principle for the structure of environmental regulation: polluting activities that degrade environmental quality in a local jurisdiction should therefore be a local responsibility (including the setting of standards). This way, regulatory measures can be tailored to the specific circumstances of each jurisdiction. In contrast, those forms of pollution that reach beyond state or local borders require a national approach to the setting of standards. This does not, incidentally, imply that there is no role for a centralized agency with regard to local environmental issues. An agency like EPA can provide critical information and guidance on the potential damages from various forms of pollution and on the costs of pollution control. State or local jurisdictions would then be in a position, either through their own officials or, perhaps, through some kind of referendum, to establish standards and a regulatory framework that address the particular circumstances of local environmental issues.     

The appropriate use of decentralized environmental decisionmaking can have further benefits. In a federal system, state and local governments have the opportunity to introduce new and innovative regulatory measures. They can serve as laboratories in which to conduct experiments that can provide valuable lessons on the potential of new approaches to public policy. Under the Clean Air Act, for example, many state and local governments introduced a variety of emissions-trading systems that both demonstrated their effectiveness and exposed certain problems in their design. I doubt that the United States would have introduced the very successful national cap-and-trade program in the 1990 Clean Air Act Amendments to control sulfur emissions to reduce acid rain without the invaluable earlier experience with this policy approach at state and local levels.


Further Reading:


Oates, Wallace E. 2002. A Reconsideration of Environmental Federalism. In Recent Advances in Environmental Economics, edited by J. List and A. De Zeeuw. Cheltenham, U.K.: Edward Elgar, 1–32.


Oates, Wallace E. 2002. The Arsenic Rule: A Case for Decentralized Standard Setting? Resources 147 (Spring): 16–18.

Oates, Wallace E. and Robert M. Schwab. 1988. Economic Competition Among Jurisdictions: Efficiency-Enhancing or Distortion-Inducing? Journal of Public Economics (April): 333–354.