A Tax on Output of the Polluting Industry Is Not a Tax on Pollution - The Importance of Hitting the Target

Sep 19, 2026

A welfare analysis examines why environmental taxes that target output of a polluting industry may fail to target pollution directly. The study builds a general equilibrium model with substitution in production and consumer demand, deriving second-best optimal tax rates on emissions or on output. Using parameter values, it estimates welfare impacts from small tax changes and quantifies the cost of missing the target, reflecting the welfare gains from properly targeted emission taxes that capture both substitution and output effects.

LanguageEnglish

CategoryGeneral

FormatPDF

Pages33

Reading Time12 min

AccessFree to download

1.1 Introduction

Substitution vs output effects of pollution taxes

Why taxes often miss the target

This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Behavioral and Distributional Effects of Environmental Policy Volume Author/Editor: Carlo Carraro and Gilbert E. Metcalf, editors Volume Publisher: University of Chicago Press Volume ISBN: 0-226-09481-2 Volume URL: [http://www.nber.org/books/carr01-1](http://www.nber.org/books/carr01-1) Conference Date: June 11â€“12, 1999 Publication Date: January 2001 Chapter Title: A Tax on Output of the Polluting Industry Is Not a Tax on Pollution The Importance of Hitting the Target Chapter Author: Don Fullerton, Inkee Hong, Gilbert E. Metcalf Chapter URL: [http://www.nber.org/chapters/c10604](http://www.nber.org/chapters/c10604) [Chapter pages in book:](Chapter pages in book:) (p. 13-44) 􀀂 A Tax on Output of the Polluting Industry Is Not a Tax on Pollution The Importance of Hitting the Target Don Fullerton, Inkee Hong, and Gilbert E. Metcalf 1.1 Introduction A tax per unit of pollution can induce all the cheapest and most eﬃcient forms of pollution abatement (Pigou 1932) . To reduce its tax liability, the ﬁrm can switch to a less-polluting fuel, add a scrubber, change disposal methods, or otherwise adjust its production process. These methods of substitution in production reduce the pollution per unit of output. In addition, the tax raises the overall cost of production, so the higher equilibrium output price chokes oﬀ demand for the output. Thus the tax has a substitution eﬀect that reduces pollution per unit, and an output eﬀect that reduces the number of units. Yet few actual taxes are targeted directly on pollution (Barthold 1994) . Taxes on gasoline are prevalent around the world, and the use of gasoline is indeed correlated with vehicle emissions. This gas tax might provide some incentive to reduce emissions by driving less, but it provides no incentive to reduce emissions per gallon (such as by adding pollution-control equipment) . The United States taxes chemical feedstocks associated with contaminated Superfund sites, and this tax may help reduce pollution, but Don Fullerton is professor of economics at the University of Texas at Austin and a research associate of the National Bureau of Economic Research. Inkee Hong is a doctoral candidate in the Department of Economics at the University of Texas at Austin. Gilbert E. Metcalf is professor of economics at Tufts University and a research associate of the National Bureau of Economic Research. For funding, the authors thank the National Bureau of Economic Research and the National Science Foundation (SBR-9811324) . For helpful suggestions, the authors thank Eliana de Bernardez Clark, Larry Goulder, Gilbert H. A. van Hagen, Rob Williams, and conference participants. This paper is part of the NBER’s Public Economics research program. The views expressed in this paper are those of the authors and do not reﬂect those of the National Science Foundation or the National Bureau of Economic Research. it provides no incentive to use a cleaner production process, to avoid spills, or to use any other method of reducing pollution per unit of chemical input (Fullerton 1996) . In Europe, some industrial eﬄuent taxes are calculated using an assumed industrywide rate of eﬄuent per unit output, so the ﬁrm cannot reduce its tax by reducing its own eﬄuent per unit (Hahn 1989) . These taxes miss the substitution eﬀect. In this paper, we measure the welfare eﬀect of improperly targeted instruments. We build a simple analytical general equilibrium model with substitution in production and demand by consumers, and we derive second-best optimal tax rates on emissions or on output. These rates are based on preference parameters, technological parameters, and preexisting tax rates. We discuss these optimal tax rates, and then we choose plausible values of the parameters to calculate the eﬀects of a small change in each tax rate. For alternative initial conditio

FAQs

Why is an output tax not the same as a tax on pollution?

Because a tax on output can induce substitution in production that reduces pollution per unit, while higher production costs also reduce output. The resulting incentives do not align perfectly with directly targeting emissions, so the tax may miss the target.

What model does the paper use to evaluate welfare effects?

It develops a simple analytical general equilibrium model that includes substitution in production and demand by consumers. The paper derives second-best optimal tax rates on emissions or on output based on preference, technological, and preexisting tax parameters.

What reasons does the paper give for why actual policy misses the target?

Policy may not fully appreciate the importance of hitting the target, emissions may be difficult to measure so taxes use correlated activities, and measurement technology improvements may lead policymakers to adjust the tax base slowly.

Sep 19, 2026

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