Reuters (3rd October 2019)

In blow to U.S., EU pledges quick move on tax for polluting firms

Syllabus Links

Negative externalities (Edexcel 1.3.2, AQA 4.1.8.4, OCR 1.2.8)

Check out the YouTube video here.

Check out the “Technical Stuff” video on Negative Externalities of Production here.

Potential questions

Using a suitable diagram, show the impact of environmental pollution in the production process

Adding taxes to imported goods from companies with poor pollution standards is the best way forward. Discuss

Some ideas to consider:

The imposition of a pollution tax is one way to overcome the environmental damage caused when companies release harmful elements into the atmosphere, the rivers, oceans and so on. The twist with this story today is that they have been proposed at a time when a potential trade war between the EU and the USA is heating up.

In yesterday’s blog we looked at why the USA has chosen to impose tariffs (taxes on imports) on European Union products, and suggested there would be some form of retaliation. Is this move towards pollution taxes on firms an indirect form of retaliation or a determined effort to clean up the environment? The cynics among us may suggest the former, the Greta Thunberg’s among us would be hoping for the latter. I will focus on the latter idea.

Whenever production takes place, we see both external costs and external benefits. These are costs and benefits to a third party not directly involved in the production of that good or service. Taking a simple example, if a local factory pollutes a stretch of river by releasing harmful chemicals into the water, the fishermen that enjoy this relaxing pastime will find that there no fish to catch. They did not create the pollution, nor are they likely to be employed by the firm or consume its products. They are a third party not directly involved with the pollution, but significantly affected by it. This is a negative externality of production and can be seen on this diagram.

The factory will produce at the point where its private costs (MPC – Marginal Private Cost), the costs of labour, raw materials, lighting and heating etc, is equal to the private benefit at Q1. The private benefits (MPB – Marginal Private Benefits) include the money received from the sale of the products. They have no interest in the pollution they are causing as a by-product of this production.

The external cost, the cost of the pollution, is not considered. Therefore, the cost to society as a whole, the Marginal Social Cost (MSC = MPC + external costs) is greater than the MPC. Therefore, at the private free market output level where MPC=MPB, we have potentially significant external costs damaging the environment. We are overproducing the good and creating a welfare loss highlighted by the green triangle. To overcome this, we need to reduce the amount produced to Q2. There are several policies we could use.

The first policy, and the central theme of this article, is to add a pollution tax to the company creating the pollution in the first place. This will increase the costs of production for that firm, reducing the amount they can produce (supply shifts to the left – falling at each price level) and overcomes the welfare loss caused. For a useful understanding of how such a taxation would work, check out this “Technical Stuff” video here. One potential consequence of this is that polluting companies may now move to areas of the world where environmental standards and laws are less strict.

A second policy is to use “tradeable pollution permits”. These allow companies to produce pollution up to a given amount. If they produce more than this level, they must buy additional permits from other companies. This gives an incentive to producers to implement cleaner, greener technology. The less pollution they emit, the more permits they can then pass on to other companies. This is a policy widely used across the EU these days.

A third solution may be to provide additional support, potentially in the form of tax breaks or subsidies for companies that invest in green technology and reduce their pollution levels. Given the potential costs involved in changing production techniques, a little help in either paying less tax, or a cash handout to cover some of the extra costs, may be just the thing a cash strapped company needs.

It may be that the government dictates a policy of “command and control”, simply telling companies to stop production. The potential impact on employment levels may make such an approach less beneficial if large employers cease production as a result.

However, how can we check the amount of pollution generated with any accuracy? Is the science behind measuring pollution that accurate yet? Could a company appeal against the decision and drag the process through expensive appeals that could cost more than the potential pollution tax collected?

And then back to the first point! Is this a well-timed statement aimed at the United States and reminding President Donald Trump that by leaving the International Paris Climate Protection Deal in November 2020, he is opening up all companies in the USA to facing import taxes based on the amount of pollution they could be producing?

As students of economics, you would need to consider whether a pollution tax is the best way forward for improving the environment, or if other policies might be more suitable. You can then decide whether this is a genuine attempt to help clean up the environment, or a thinly veiled attempt to get the USA to follow international rules.

Additional activities

Draw and explain a diagram showing the implementation of taxes on a producer

“This is not an attempt to clean up the environment! It is a blatant attack upon U.S. producers and a deliberate attempt to further boost tensions in a trade war between the USA and the European Union!” Critically evaluate this statement

Additional information

Understanding the European Union’s emissions trading system.

Clean energy wire website (21st August 2018)

Policies to reduce pollution emissions have cut deaths over 40 years: Study

ITV News (25th June 2019)