6.5 Solutions: property rights, regulations, and incentive policies  (Page 5/14)

Second, even if we are able to design a perfect externality tax in theory, such a policy can be difficult to enforce. The enforcement agency needs to be able to measure the total quantity of the thing being taxed. In some cases that is easy—in the case of carbon dioxide for example, the particular fixed link between carbon dioxide emissions and quantities of fossil fuels burned means that through the easy task of measuring fossil fuel consumption we can measure the vast majority of carbon dioxide emissions. However, many externality-causing activities or materials are difficult to measure in total. Nitrogen pollution flows into streams as a result of fertilizer applications on suburban lawns, but it is impossible actually to measure the total flow of nitrogen from a single lawn over the course of a year so that one could tax the homeowner for that flow.

Third, externality taxes face strong political opposition from companies and individuals who don't want to pay the tax. Even if the government uses the tax revenues to do good things or to reduce other tax rates, the group that disproportionately pays the tax has an incentive to lobby heavily against such a policy. This phenomenon is at least partly responsible for the fact that there are no examples of pollution taxes in the U.S. Instead, U.S. policy makers have implemented mirror-image subsidy policies, giving subsidies for activities that reduce negative externalities rather than taxing activities that cause those externalities. Environmental policy in the case of U.S. agriculture is a prime example of this, with programs that pay farmers to take lands out of production or to adopt environmentally friendly farming practices. A subsidy is equivalent to the mirror-image tax in most ways. However, a subsidy tends to make the relevant industry more profitable (in contrast to a tax, which reduces profits), which in turn can stimulate greater output and have a slight perverse effect on total pollution or environmental degradation; degradation per unit output might go down, but total output goes up.

Tradable permits

Another major type of incentive policy is a tradable permits    scheme. Tradable permits are actually very similar to externality taxes, but they can have important differences. These policies are colloquially known as "cap and trade". If we know the efficient amount of the activity to have (e.g., number of tons of pollution, amount of timber to be logged) the policy maker can set a cap on the total amount of the activity equal to the efficient amount. Permits are created such that each permit grants the holder permission for one unit of the activity. The government distributes these permits to the affected individuals or firms, and gives them permission to sell (trade) them to one another. In order to be in compliance with the policy (and avoid punishment, such as heavy fines) all agents must hold enough permits to cover their total activity for the time period. The government doesn't set a price for the activity in question, but the permit market yields a price for the permits that gives all the market participants strong incentives to reduce their externality-generating activities, to make cost-effective trades with other participants, and to innovate to find cheaper ways to be in compliance. Tradable permit policies are similar to externality taxes in terms of efficiency, cost-effectiveness, and incentives to innovate.