What is the best environmental policy? Taxes, permits and rules under economic and environmental uncertainty

We welfare rank different types of second-best environmental policy. The focus is on the roles of uncertainty and public finance. The setup is the basic stochastic neoclassical growth model augmented with the assumptions that pollution occurs as a by-product of output produced and environmental quality is treated as a public good. To compare different policy regimes, we compute the welfare-maximizing value of the second-best policy instrument in each regime. In all cases studied, pollution permits are the worst recipe, even when their revenues are used to finance public abatement. When the main source of uncertainty is economic, the best recipe is to levy taxes (on pollution or output) and use the collected tax revenues to finance public abatement. However, when environmental uncertainty is the dominant source of extrinsic uncertainty, Kyoto-like rules for emissions, being combined with tax-financed public abatement, are better than taxes. Finally, comparing pollution and output taxes, the latter are better.