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Second Environmental Economics Round Table Proceedings

Convened by Senator Robert Hill, Minister for the Environment and Heritage, Canberra, 5 July 2000
Environmental Economics Research Paper No. 7
Commonwealth of Australia, 2000
ISBN 0 642 19485 8

Roles for and effects of pollution taxes

John Freebairn
Department of Economics, The University of Melbourne



As a general rule, decisions about the quantities to produce and consume of natural resources and about the choice of production methods to maximise social welfare would choose those quantities and methods to equate marginal social benefits with marginal social costs. These rules apply to the use of natural resources for raw materials, as a direct provider of amenity benefits, and as a sink for waste disposal. In those cases where marginal social benefits and costs are equal to marginal private benefits and costs competitive market decisions will achieve maximum social welfare. Such cases arise more frequently than many would claim.

However, there are many situations in the management of natural resources where marginal private benefits and costs differ widely from marginal social benefits and costs. For example, most firms and households when driving vehicles and using electricity ignore the costs of visual pollution and greenhouse gasses that fall on others; or farmers irrigating and using chemicals ignore costs associated with salinity and chemical residues falling on downstream farmers and household water users; or the timber industry ignores the loss of flora and fauna biodiversity in their private investment and production decisions. In these situations of external or spillover costs and benefits, and in other situations characterised by the production and consumption of public goods, competitive private market decisions will not result in choices maximising social welfare. Market failures associated with externalities and public goods provide a set of necessary conditions, but not sufficient conditions, for government intervention in decisions on natural resource management.

Government intervention to more closely align quantities of production and consumption of natural resources, and production methods, to levels equating marginal social costs and benefits can take several forms. They include so called command and control methods, eg. regulations on production methods such as on chemical use, scrubbers in smokestacks, catalytic converters in cars and trucks, restricted ares for logging, and lining of waste dumps. Another set of government interventions sometimes referred to as incentive based regulations include taxes, eg. on fossil fuels, on leaded petrol, on waste disposal, subsidies, eg. on tree planting, green technology R&D, and tradeable permits, eg. on sulphur dioxide emissions and on lead in the US. Governments may also directly involve themselves in natural resource management and in providing information to encourage preferred private sector decisions. The different forms of intervention have been analysed in many places (see, for example, environmental economics text books such as Kahn, 1998, Goodstein, 1999, and Kolstad, 2000).

This paper focuses on the potential application of pollution taxes, or green taxes, as a method of bringing external or spillover costs of some natural resource management decisions into the costs and benefits of private sector decisions on production, production methods and consumption of natural resources. Section 2 presents a general model of the application of taxes on pollution and their effect on natural resource management decisions and outcomes. More specific implications for the taxation of environmental externalities in the context of Australian products traded internationally are provided in section 3. Sections 4 and 5 consider in more detail the economic efficiency and redistributional effects, respectively, of pollution taxes. A final section provides some concluding comments.

General Idea of Pollution Taxes

This section describes, as an illustration, how a system of carbon taxes might be used to improve rational choices on the production and consumption of fossil fuels; other potential applications are noted at the end of the section.

For simplicity, we begin with a partial equilibrium model of the production, consumption and pricing of fossil fuels. Under competitive conditions, buyer (households and firms) demand or marginal willingness to pay for fossil fuels shows quantity demanded falling with price, curve D in Figure 1, and producer willingness to supply is shown by the upward sloping curve S in Figure 1 representing marginal cost to the fossil fuel producers (the supply curve may be flat for constant marginal costs or even downward sloping in special circumstances). The competitive market solution on how much fossil fuel to produce and consume based on costs and benefits seen by private agents is given by the intersection of the supply and demand curves at quantity Q and price P. At this quantity private marginal benefits equal private marginal costs.

It is generally accepted that the burning of fossil fuels causes external or spillover costs on third parties. External costs can include acid rain problems, lead poisoning, visual pollution, and addition to greenhouse gases. Of course, the extent of these external costs is highly debated and contentious. From society’s perspective, decisions on the welfare maximising level of use of fossil fuels would include the external costs along with the private costs and benefits in the decisions on how much fossil fuel to produce and consume. Building on the competitive market of Figure 1 where only private benefits and costs were considered, Figure 2 adds in the external costs. In particular, the social marginal cost curve SS now allows for marginal private costs, the S curve as before, plus marginal external costs, the MEC curve. Then, the social maximising level of production and consumption of fossil fuels is determined where marginal social benefits of fossil fuel use (here also equal to marginal private benefits) represented by the D curve equal marginal social costs (here equal to marginal private costs plus marginal external costs) represented by the SS curve. This is where the curves D and SS intersect at quantity Q*.

Note that the social optimum level of production and consumption of fossil fuels, Q* in Figure 2, is less than the private market quantity, Q, which ignores the external costs. Society is better off by the area EAB (given as the costs foregone by restricting production from Q to Q*, ie. area Q*EAQ, which in turn equals Q*CBQ of private costs plus Q*GFQ of external costs, less the foregone benefits of less fossil fuel consumption, ie. area Q*EBQ). Also note that it is optional to still have some pollution and some external costs. The fact that private sector competitive markets often ignore some of the external costs associated with the production and consumption of fossil fuels provides a prima facie case, or a set of necessary but not sufficient conditions, for some form of government intervention to reduce the quantity.

Pollution or green taxes, and in this case a carbon tax, is one instrument government could use to reduce the production and consumption of fossil fuels to improve social welfare. To illustrate, take Figure 3 which builds on Figures 1 and 2. As before, the D curve represents marginal private benefits of fuel consumption, S the marginal private costs of fuel production, and SS the marginal social (private plus external) costs of fossil fuel production and use. If a carbon tax of T = EK = MP* per tonne of fossil fuel is levied on producers (or consumers), the private marginal cost rises by the tax from S to S1 = S + T, where T is the per unit carbon tax. Then, private sector competitive markets choose the quantity where S1 and D intersect. Assuming the tax is equal to the marginal external cost of pollution associated with fossil fuel production and consumption, then the private market chooses the social optima quantity Q*. In effect, setting the pollution tax at a rate equal to the marginal external cost internalises the externality into private sector decisions.

Figure 3 can tell us about the distributional effects of a pollution or green tax. The price to buyers rise, from P to P*, in order to ration the desired smaller quantity of fossil fuel and to reduce pollution. Government’s gain tax revenue given by the per unit tax times quantity, or by area MP*EK. Producers receive a lower net price, M = P* — T rather than P, which indicates less production is called for. Importantly, while the tax initially is paid by producers, ie. they write the cheque to the government, changes in market prices mean that some of the tax is passed on to consumers as higher market prices. The less price responsive (or more inelastic) demand relative to supply, the more is the proportion of the carbon tax finally borne by buyers.

The analysis so far can be summarised as follows. Setting a pollution tax equal to the marginal external costs which currently are ignored by private sector producers and buyers will internalise the externality, and reduce production and consumption to the quantity that maximises social welfare. Governments gain revenue, those affected by externalities gain from less pollution, buyers of fossil fuel lose by paying higher prices, producers of fossil fuel receive lower net returns, and in net the gains exceed the losses.

It is useful to take the analysis beyond the single product market focus of the preceding assessment to consider also other parts of the economy. Pollution taxes would be levied on only a portion of the economy where external costs are important. Other parts of the economy, for example most services, would not be taxed. Then, a system of pollution taxes changes the comparative advantage of polluting versus non-polluting activities. As a result, production and consumption of products producing external costs, and employment in these industries, would contract, while production and consumption of other products, and employment in these non-polluting activities, would increase. That is, introduction of a system of pollution taxes would lead to changes in the composition of production, consumption and employment in the economy with polluting industries losing and non-polluting sectors gaining. At the end of the restructuring process the closer alignment of social benefits and costs for different sectors of the economy results in net aggregate efficiency gains.

While the discussion above was illustrated with the example of carbon taxes to correct for externalities associated with fossil fuels, other examples can be noted. Emissions taxes might be levied to match the external costs of air pollution, waste water pollution and solid waste disposal by industry, and on water and solid waste disposal by households. Taxes could be placed on external salinity costs associated with cutting down trees by farmers and the timber industry. Similarly, incentives to reduce the use of irrigation and chemical herbicides and pesticides for agricultural production leading to external costs on downstream users could be subject to pollution taxes. The external costs of loss of biodiversity associated with clearing native vegetation is another potential example. The main points from the analysis of carbon taxes follow by a relabelling of terms in the text and of axis in the figures.

Australian Traded Products

Most activities in Australia associated with natural resources are traded internationally, and typically but not always Australia is a net exporter. The analysis of section 2 above is more applicable for non-traded products or for the case of a global pollution tax on all world production. In this section the paper considers the more likely scenario where Australia imposes pollution taxes on externalities in isolation, or makes a decision to tax some of its natural resource activities other countries do the same.

Consider the case of an export product, eg. coal, and the imposition of a pollution tax in response to concerns about externalities such as acid rain and greenhouse gases associated with coal use. In implementing a pollution tax to internalise the externality there is an important choice between placing the tax on production, akin to an origin base tax, or a tax only on domestic consumption, akin to a destination base tax. Figures 4 and 5 illustrate the implications of the two options. There is an export market with De being the demand for exports curve, shown to be relatively price responsive, in the right hand panel, and a domestic market with demand given by Dd in the middle panel. Together, total demand for Australian coal is given by Dt = Dd + De in the left hand panel. The private marginal cost of Australian coal production is the competitive supply curve S. Under competitive private market conditions the intersection of the supply and aggregate demand curves determine market price, P, and in turn production, domestic sales and export sales.

Now, in Figure 4 impose a per tonne production tax of T only on Australian coal, with the tax set at the estimated marginal external cost of coal use. The production tax raises private production costs shifting the Australian supply curve upwards from S to S1 = S + T. The market price rises from P to P1 where the S1 and Dt curves intersect. The higher market price reduces both domestic sales and export sales, and the magnitude of pollution falls. The net price to producers falls from P to P1 — T = P11. The more elastic export demand, the more of the tax burden that ultimately falls on Australian producers; in the extreme case of a perfectly elastic export demand the market price does not fall and Australian producers bear all the pollution tax.

In Figure 5, by contrast, the pollution tax is levied only on domestic consumption of Australian coal, but not on that part of production exported. In the first instance the domestic demand curve in the middle panel shifts down by the tax from Dd to D1d = Dd — T, where T is the per tonne tax on Australian coal consumption. In turn, total demand in the left hand panel falls from Dt = Dd + De to D1t = D1d + De. The new equilibrium market price falls from P to P1. Export buyers actually benefit from the lower price, domestic users pay a higher price P1 + T = P11 and lose, and producers lose with the lower price. In the extreme case of a perfectly elastic export demand, there will be no world market price change, domestic consumers bear all the tax in higher prices, producers neither win nor lose, and sales are shifted from the domestic market to the export market.

For most agricultural, mining and tourism exports which are intensive users of natural resource inputs Australia provides a small share of world production and trade. Then, the export demand curve in the far right hand panels of Figures 4 and 5 is highly elastic, and in many cases close to perfectly elastic. In this context the comparative efficiency and distributional effects of a production tax and of a domestic consumption tax are very different. With a production tax producers would bear most of the burden of the pollution tax, and Australian exports would fall to be replaced by increased exports by competitor countries. Only in the special case where both most of the externality costs are associated with the production process and they fall on Australians would Australia in net gain; otherwise, and this is the more likely case, Australian welfare is reduced. By contrast, with a pollution tax on domestic consumption, domestic consumers will have most of the tax passed on as higher prices. Where most of the lower externality costs are received by Australians, Australian net national welfare increases. The choice between a tax on production or a tax on consumption is just one example of the general rule that the pollution tax should be levied as close as practicable to the cause of the external cost, namely the production of coal or the burning of coal for consumption.

Efficiency Benefits

Pollution taxes, along with marketable permits, belong to a class of market incentive based regulations for reducing the production and consumption of products which have external or spillover costs. In principle they have very desirable properties in raising overall national welfare, but there are some practical implementation issues.

The essential attraction of pollution taxes for improving national welfare is that the taxes in effect bring all costs, private production costs and external or spillover costs, into market decisions on what quantities to produce and consume and by what production methods. They do this in an explicit and transparent way. Competitive market forces then drive private choices which are consistent with those which maximise national economic efficiency.

Efficiency gains from pollution taxes come in terms of so called static gains and dynamic gains. If the pollution tax is set close to the marginal externality cost, production and consumption of different products will contract to the quantities where marginal social benefits equal marginal social costs. Also, the costs of meeting pollution targets are minimised since all producers of the pollution face the same cost, that is tax, per unit of pollution.

Dynamic efficiency gains from pollution taxes arise because there is a continuing incentive by way of paying less pollution tax to develop and adopt technology which reduces pollution. This is an important advantage when comparing pollution taxes with command and control regulations.

These in-principle efficiency benefits of pollution taxes to improve decisions on natural resource management can become reality only under strong assumptions. First, the efficiency gains are maximised only if the tax rate is set equal to the marginal external cost. This term is very difficult to measure, and it almost certainly will change over time. However, in fairness, setting a quota for tradeable permits or determining regulations requires the same information. Second, it is assumed that the tax is levied on the pollution output. In practice indirect pollution taxes rather than direct pollution taxes are proposed for practical reasons. To illustrate, in the case of greenhouse gases from the burning of fossil fuels, the direct pollution tax would be per cubic metre of greenhouse gases emitted. For practical reasons the tax usually is per tonne of carbon content of fuels, or even more indirectly an output tax per vehicle or per kilowatt hour of electricity. These indirect taxes remove some of the desirable incentives to reduce greenhouse gases emitted.

Third, pollution taxes, like permits and regulations, have to be administered effectively. In particular, administration requires accurate measurement of, and regular monitoring of, the sums to be taxed. Relatively high monitoring costs lie behind many decisions to apply an indirect tax on an externality, eg. on carbon content of fossil fuels or on cars, rather a direct tax on the externality, eg. emissions of greenhouse gases giving rise to costs to third parties.

Of recent there has been much assessment of the so called 'double dividend' associated with pollution taxes. The first dividend is the efficiency gain from reducing the net social costs of too much production and consumption of the products which pollute. This includes the static and dynamic efficiency gains described above. A second dividend was claimed from the use of the tax revenue collected from the pollution tax to reduce other taxes on labour, capital, and so forth which themselves distort decisions in other markets, and in this way the pollution taxes reduce efficiency losses associated with these other, and to be replaced, taxes. Recent analysis using computable general equilibrium models has cast doubt on the second dividend. As shown in the previous sections, pollution taxes generally raise the prices of pollution intensive products and these price rises in turn give rise to their own distortion costs. For example, the higher prices for market goods and services reduce the incentive to work versus leisure and thus generate the same types of distortions to work versus leisure decisions as does a tax on wage income. While there is no debate about the efficiency gains of using a pollution tax to reduce the production of products with external costs, once all the second round effects of the tax are taken into account the presence of a second and additional efficiency dividend is doubtful; and ultimately it becomes an empirical task to weigh-up some pluses and minuses.

Redistributional Effects

A comprehensive assessment of who benefits and loses from taxes on pollution requires that a number of second round effects reflecting adjustments in economic behaviour as firms and households respond to changes in incentives are taken into account. Ideally a comprehensive assessment requires the use of a general equilibrium model.

The analysis of earlier sections has highlighted that the legal or initial incidence of pollution taxes often will be different to the economic or final incidence. In most cases businesses will write the cheque to the government. This is the legal or initial incidence. But, businesses in time pass on the tax either as higher prices for buyers, as lower wages to workers, as lower returns to investors, or a combination. The less elastic demand for the product being taxed relative to its supply, the higher the share of the pollution tax ultimately passed forward to buyers and the less passed back to providers of labour and capital. The analysis of section 3 above suggest that for Australian natural resource intensive industries, most of a pollution tax on production will be borne ultimately by owners of the natural resources as lower returns, and in the case of pollution taxes on domestic consumption most of the ultimate tax burden will fall on domestic consumers as higher prices.

Where most of the pollution tax is passed forward in higher prices the final incidence of many pollution taxes will be regressive. Goods which are natural resource intensive and candidates for pollution taxes include electricity, gas, food and metal products. Generally these products take a larger share of the expenditure of households with lower incomes than for those with higher incomes. Services, which are not natural resource intensive, and therefore unlikely to be affected much by pollution taxes, are relatively more important in the expenditure of higher income households.

As well as generating costs, pollution taxes provide benefits in the form of lower spillover costs. For example, pollution taxes on fossil fuels are motivated to reduce visual pollution, the adverse affects of acid rain, the adverse effects of climate change associated with greenhouse gases, and so forth. Many of these benefits are in the form of public goods with similar quantitative gains for poor and for rich. That is, the benefits in these cases will be highly progressive in their incidence.

Assessing the overall redistributive effects of the benefits and costs of pollution taxes ultimately has to become an empirical task. Once both benefits and costs are included in the assessment it is not clear just on the basis of theory that the net outcome will be progressive or regressive. Provided that pollution taxes yield efficiency gains, and that is a major rationale for the taxes, the income in aggregate rationale welfare provides a capacity for the losses to be compensated.

Concluding Comments

Pollution taxes can be an effective way for governments to improve resource management decisions where current private decision makers ignore some of the social costs of their decisions. Examples include visual pollution, acid rain and greenhouse gases associated with the burning of fossil fuels, the flow-on costs associated with disposal of waste water and hard wastes by businesses and households, the effects of forestry and land clearing on salinity and biodiversity, and the effects of chemical wastes on flora, fauna and in some cases on humans. An ideal pollution tax would be levied on the most direct point of the externality and set at the marginal external costs associated with the activity being taxed. For the case of Australian export activities, application of these principles would mean taxation of only domestic sales where externality costs arise from consumption of the product, and taxation of production (ie. domestic plus export sales) only when the production activity generates external costs.

Pollution taxes can improve economic efficiency and raise national welfare. In effect, they internalise external costs and bring them into private decisions regarding the production and consumption of natural resources. Static efficiency gains arise from more closely aligning social marginal benefits of decisions with social marginal costs. But also, in the longer run pollution taxes provide incentives and rewards for R&D and for the adoption of technology to reduce adverse side effects associated with the production and consumption of natural resources.

The introduction of pollution taxes will redistribute economic fortunes. Their very objective is to shift production, consumption and employment away from those activities creating external costs. But, at the same time, the taxes improve the relative competitive position of production, consumption and employment of other goods and services which expand. The economic or final incidence of pollution taxes generally differ from the statutory incidence. In many cases much of the tax will be passed on to buyers as higher prices. The burden of these higher prices may be regressive. However, the benefits of lower pollution in most cases will be relatively more important for those on lower incomes. Well designed pollution taxes increase national welfare and provide the capacity for gainers to more than compensate any losers.


Goldstein, E. (1999), Economics and the Environment, second edition, Wiley, New York.

Kahn, J. (1998), The Economic Approach to Environmental and Natural Resources, second edition, Dryden, Fort Worth.

Kolstad, C. (2000), Environmental Economics, Oxford University Press, New York.


figure 1- competitive market figure 2 social division figure 3 carbon tax figure 4 production tax figure 5 consumption tax