Should Environmental Taxes Be Precautionary?

Abstract

The precautionary principle requires that we take additional actions to prevent harms when the harms from an activity are uncertain and possibly irreversible. This paper considers whether environmental or other Pigouvian taxes should similarly be precautionary. Should environmental taxes be set higher than otherwise if harm from pollution is uncertain and irreversible and where we are likely to learn more about the nature of the harm the future. It concludes that environmental taxes should be set equal to expected marginal harm from pollution given the currently available information and should be neither raised or lowered because of the prospect of learning or irreversible harm. The reason is that taxes equal to expected marginal harm decentralize decisions to market participants who will, facing these taxes, make appropriate choices about the timing of pollution. Taxes act similarly to property rights in a complete market where market participants produce Pareto outcomes. There are a number of caveats to this conclusion including the possibility of endogenous learning, in which our understanding of the environmental effects of pollution or the available mitigation technologies depends on the level of taxation.

Keywords: Pigouvian taxation, environmental taxation, precautionary principle, climate change, real options, instrument choice

JEL Classification: H23, K10, Q50