The point of departure for my contribution to this symposium is the striking contrast in the extent of fiscal centralization of the industrialized and the developing countries: government in the developing nations appears to be far more centralized (as measured by existing fiscal indices) than in the industrialized countries. This marked differential in degrees of fiscal centralization is widely documented. Over two decades ago in an empirical study of fiscal federalism (Oates, 1972), I found, for a sample of 58 countries, that measures of fiscal centralization were significantly and negatively correlated with levels of per capita real income. And, more recently, using a sample of 43 countries, my sample statistics (1985) revealed an average share of central-government spending in total public expenditure of 65 percent in the subsample of 18 industrialized countries as contrasted to 89 percent in the subsample of 25 developing nations. In terms of public revenues, the average share of central governments in the developing countries was in excess of 90 percent!

These measures thus suggest that central government in the developing countries assumes the lion's share of fiscal responsibility. Bird (1986), among others, has expressed some legitimate reservations concerning the validity of fiscal data from the developing nations and the resulting summary measures of the sort I have just cited. There are, in particular, some serious problems regarding the extent of coverage and comparability. Moreover, there is considerable variability among countries within the samples.

Since the publication of the first edition of this book in 1975, there have been several important contributions both to the theory of externalities and to the design of policy instruments making use of economic incentives for environmental management. Perhaps most important has been the emergence of instruments that control quantity directly rather than through price adjustments; these measures represent an alternative to the standard Pigouvian prescription for a unit tax on activities with detrimental external effects. Since publication of the seminal paper by Martin Weitzman, economists have explored the properties of a system under which the regulatory authority issues a limited number of transferable permits. This work has shown that in a setting of uncertainty, the expected gain in welfare may be higher or lower under such a permit system than under a tax regime, depending on the shapes of the control cost and damage functions. The choice of one system over the other thus depends on the way damages and control costs change with the level of pollution.

At the same time, there has been growing interest at the policy level in the use of transferable permit systems for the attainment of our environmental standards. In the United States, the Environmental Protection Agency has introduced the Emissions Trading Program for the regulation of air quality; this program allows polluters (subject to certain restrictions) to trade emissions entitlements. Environmental economists have studied emissions trading and have, more generally, investigated the properties of a number of variants of transferable permit systems.

In this chapter we examine the direction of the bias produced by externalities. Is it true, as often asserted, that when an activity generates external benefits, its competitive equilibrium level will always be below its optimum, and that where an activity imposes external costs, its equilibrium level must be excessive?

This is a proposition that underlies much of the policy advice given by economists on externalities issues: allocate more resources to goods that yield beneficial externalities and reduce their allocation to those that generate detrimental externalities. But suppose that advice is not always correct – what do such exceptions imply about the economist's advisory role?

As a matter of pure theory this problem is not as serious as the one discussed in the next chapter, for the difficulty we are considering here does not undermine the Pigouvian tax-subsidy solution. So long as the appropriate convexity conditions hold and the economy is competitive, one need merely impose the appropriate tax rates and the market equilibrium must occur at a Pareto optimum, wherever it may lie in relation to the equilibrium that would hold in the absence of Pigouvian taxes.

In practice, however, as will be emphasized in Part II, we do not know how to find or perhaps even to approximate optimal tax rates and so considerably coarser policy measures must be utilized. Usually these rely heavily on the conventional wisdom that constitutes the subject of this chapter: the acceptance of the view that one should expand outputs that yield beneficial externalities, and conversely.

The preceding chapter explored the difficult issues that arise for the design of environmental policy in an international setting, issues whose source is, in part, the absence of an international agency with the authority to make decisions that can internalize the costs that nations impose on one another. This chapter returns to purely domestic issues, concerning itself with the choice of the appropriate authority for environmental decision-making. In particular, we ask whether it is preferable to delegate the determination of standards for environmental quality to regional (or “local”) governments or to rely on a national environmental agency to set uniform standards for environmental quality that apply throughout the nation.

Current policy exhibits considerable ambivalence on this matter. In the United States, for example, the Congress, under the Clean Air Act, directed the U.S. Environmental Protection Agency to set national standards for ambient air quality. The EPA responded by defining maximum allowable concentrations for six so-called “criteria” air pollutants applicable to all areas of the country. In contrast, under the Clean Water Act, the individual states have responsibility for setting water quality standards. U.S. policy thus relies on uniform national (minimum) standards for air quality, but state-specific standards for water quality. Which approach, a national or a decentralized determination of environmental standards, is the appropriate one?

The results of this chapter suggest that the answer to this question is not simply one or the other approach. Instead, the analysis points to the need both for centralized and decentralized participation in the setting of environmental standards.

This chapter seeks to show that, in addition to the pricing measures advocated in the preceding chapters, there is room in a well-designed environmental policy for at least one instrument that has attracted virtually no defenders among economists – the direct controls, so popular outside the profession.

After the demonstration in the preceding chapters that pricing methods have important efficiency advantages over direct controls, our advocacy of the use of the latter may appear somewhat inconsistent. However, we are not suggesting that the preceding discussion is basically incorrect, but rather that it omits an important consideration. Environmental problems do not always develop smoothly and gradually. Instead, they are often characterized by infrequent but more or less serious crises whose timing is unpredictable. Such emergencies may require rapid temporary changes in the rules of the control mechanism, and it is here that pricing measures appear subject to some severe practical limitations. In this chapter, we will show how the uncertainty associated with environmental conditions greatly complicates the implementation of a program of fees or subsidies.

We will not conclude from this that such programs are useless. We still believe that they have an important role to play and that economists have been right in trying to convince policy makers of their advantages. Rather, we suggest that the ideal policy package contains a mixture of instruments, with taxes, marketable permits, direct controls, and even moral suasion each used in certain circumstances to regulate the sources of environmental damage.

At least from a reading of the newspapers, one gets the impression that environmental policies are an issue in which income class plays a significant role. The poor and the wealthy seem to assign different degrees of priority to environmental protection: the proposed construction of an oil refinery is likely to produce anguished cries from middle- and upper-income inhabitants of a potential site and yet be welcomed as a source of more remunerative jobs by residents whose earnings are low. Similarly, proposals to ban DDT have been received with somewhat less enthusiasm in underdeveloped countries than they have encountered in the wealthier nations. This should, of course, come as little surprise to an economist. Assuming environmental quality to be a normal good, we would expect that wealthier individuals would want to “buy” more of it.

In addition to these differences in the demand for environmental quality, distributive elements also enter when we consider how the costs of a policy of environmental protection are likely to be distributed among individuals with differing incomes. To reach firm conclusions on so broad a subject is difficult, because the methods that are used to finance such policies vary widely. Nevertheless, by making some reasonable assumptions and exploring the available evidence, environmental economists have made some estimates of the incidence of these costs.

Obviously, the distributive side of externalities policy is of interest in and of itself in a world in which inequality and poverty have assumed high priority among social issues.

In Chapter 4 we derived our results for optimal taxes and payments from a competitive model in which individuals and firms both behave as price-takers. In this framework, prices and our prescribed fees are parameters for individual decision-makers; they take them as given and simply respond so as to maximize utility or profit.

In this chapter, we consider some of the complications that market imperfections introduce into the analysis. More specifically, we will examine the implications of two sources of such imperfections. First, a firm that generates externalities (smoke emissions) may not sell its output in a competitive market. For example, we will consider how a profit-maximizing monopolist will respond to the Pigouvian taxes prescribed in Chapter 4. We will show that an emissions tax rate that is appropriate for the pure competitor will not, in general, induce behavior that is consistent with optimality in the second-best world inhabited by a monopolist.

We then consider a second source of imperfection: the presence of polluters who are not “fee-takers.” There can be situations involving few polluters, the manipulation of whose activity levels can influence the unit tax paid on waste emissions. In such cases, we will see that producers (and perhaps also consumers) of externalities will have an incentive to adjust their behavior so as to influence not only their tax bills, but also the tax rate they pay per unit of pollution. As for the monopolist, this necessitates some modifications in the prescription for an optimal fee.

This book is one of a pair of companion volumes devoted to the study of economic policies to enhance the quality of life. Our willingness to embark on so considerable a subject only reflects our conviction that economists as a body have already made sufficient headway on these problems to make such an undertaking worthwhile. We believe, in short, that this is a subject on which economists have a great deal to say that is useful; these books are intended both to bring that material together and to carry the investigation some stages further.

This volume is primarily theoretical and is consequently addressed to our fellow economists. However, it is not meant to be theory for theory's sake. Here our prime concern is policy; we are interested in the theory as a means of understanding the complexities of environmental programs.

The orientation of the other book is primarily empirical; there we will present and evaluate pertinent data and experience for guidance in the choice of policies for environmental protection and for the improvement of other aspects of the quality of life. Though it will be less technical than the theoretical volume and will consequently address itself to a broader audience, we intend it to provide the empirical counterpart to the theoretical structure developed in this book.

Our most direct debt is that to the National Science Foundation, whose support has made our work on the two volumes possible.

The results arrived at in Chapter 8 may seem to constitute insuperable barriers to a rational environmental policy. The very presence of externalities is likely to produce a large number of local maxima among which, in practice, it seems impossible to choose with any degree of confidence; we may not even know in which direction to modify the level of an externality-generating activity if we want to move toward an optimum. It should be emphasized that these problems beset equally all attempts to achieve optimality by any of the means usually proposed – direct controls and centralized decision-making at one extreme and pricing schemes, such as the Pigouvian taxes and subsidies, at the other.

Nevertheless, we believe that it is possible to design policies for the control of externalities that are reasonably efficient. The approach that we will propose in this and the next chapter consists of the use of a set of standards that serve as targets for environmental quality coupled with fiscal measures and other complementary instruments used as means to attain these standards. The standards, while admittedly somewhat arbitrary, are, in principle, not unlike the growth or employment goals that have guided governmental macroeconomic policies. In both cases, employment and environmental policy, the approach is, in practice, basically of the “satisficing” variety, with acceptability standards based on individual judgments and, often, compromise. Yet, in both cases, the choice of effective means to achieve the established goals has been facilitated by a substantial body of economic theory. This theory suggests that fiscal measures can contribute to the efficiency of a program to control externalities. Moreover, the use of these fiscal measures in combination with standards for acceptable environmental quality, avoids, at least in part, the policy problems that have been raised in Chapters 7 and 8.

We have now completed our discussion of the basic theoretical framework. There is much to the theory of externalities that we have made no attempt to cover, for our central objective is the formulation of an analytic structure for the study of environmental policy.

At this point, we seem to have an illuminating, but somewhat destructive, set of results – one that creates severe difficulties for the application of theory to practical problem solving. In this part of the book, we decrease the level of abstraction of our discussion and seek to approach more closely the problems of application. Here too, we will encounter obstacles, though of a different kind from the theoretical complications of Part I. For example, we will find reason to suspect that many proposed environmental programs may well make the distribution of income more unequal.

Nevertheless, we will argue that these obstacles do not preclude the design of effective environmental programs, and, in spite of the difficulties encountered in Part I, that economic theory can be very helpful in the design of these programs.

In particular, Chapter 11 presents a proposal for a feasible tax or fee program. We suggest what we believe to be a practical and effective procedure for the protection of the environment: the use of pollution charges to achieve a predetermined set of standards for environmental quality. Some degree of arbitrariness in the design of such standards is inevitable.

As some growing scarcities have begun to alarm the public, the pricing of exhaustible resources has claimed increased attention. Thus, it seems appropriate to consider the issue here even though it represents something of a digression from the main line of our discussion. Here, again, optimality of pricing is defined in terms of resource allocation, but in this case the central issue is allocation among time periods rather than output categories. The results we will describe are all based largely on standard propositions of capital theory going back to the work of Irving Fisher and Bohm-Bawerk.

Yet when applied to exhaustible resources, some of our conclusions may be slightly surprising. For example, our instincts are likely to suggest that items in danger of depletion should tend to rise in price with the passage of time. We will see, however, that this is by no means generally true, and that, in some cases, optimality requires prices that decline, not only in discounted present value, but in current terms as well. Moreover, we will find that, although an optimal policy may call for prevention of the depletion of certain types of exhaustible resources, in other cases we should encourage their current utilization; obviously, this will be true of an item whose early use makes it possible to preserve some other resource whose returns to the future are larger. Clearly, in dealing with the allocation of resources over time, the issue of intergenerational equity arises unavoidably.

We can rest assured that firms and municipalities that are asked to reduce their damage to the environment will look to state and federal agencies for financial assistance. Such a request may seem uncomfortably analogous to the case of a holdup man who appeals to his victims to finance the costs of his going straight. Sometimes, however, a persuasive case can be made in terms of equity. What of the firm that built its smoking factories well away from the centers of population only to find itself surrounded by inhabitants a few decades later? Is it really the company that is responsible for the damage generated by its emissions of smoke?

We must admit to feeling that too much has probably been made of such cases in the literature, and that there usually is some presumption against rewarding government agencies and private enterprises for the damage they have done to the environment in the past. But whatever the virtues of the matter, the issue is a real one. There will continue to be calls for subvention of industrial activities that may otherwise find themselves at a competitive disadvantage and of local agencies whose budgets are already under heavy strain.

The central question here is whether or not it is possible to attain an optimal pattern of resource use through a program of subsidies rather than fees. In Chapter 4, we showed that there is a set of Pigouvian taxes that will sustain optimal levels of externality-generating activities in a competitive system.

When the “environmental revolution” arrived in the 1960s, economists were ready and waiting. The economic literature contained an apparently coherent view of the nature of the pollution problem together with a compelling set of implications for public policy. In short, economists saw the problem of environmental degradation as one in which economic agents imposed external costs upon society at large in the form of pollution. With no “prices” to provide the proper incentives for reduction of polluting activities, the inevitable result was excessive demands on the assimilative capacity of the environment. The obvious solution to the problem was to place an appropriate “price,” in this case a tax, on polluting activities so as to internalize the social costs. Marshall and Pigou had suggested such measures many decades earlier. Moreover, pollution and its control through so-called Pigouvian taxes had become a standard text-book case of the application of the principles of microeconomic theory. Economists were thus ready to provide counsel to policy makers on the design of environmental policy.

However, things have proved not quite so simple as this. First, at the policy level, environmental economists have Been dismayed at their modest impact on the design of environmental measures. Rather than introducing the economist's taxes or “effluent fees” on polluting activities, policy makers have generally opted for the more traditional “command-and-control” instruments involving explicit limitations on allowable levels of emissions and the use of specified abatement techniques. Pricing measures for the regulation of pollution have been rare.