Pollution Taxes in a Second-Best World

It is a pleasure to address this group today. I have decided to spend my time discussing recent issues involved in setting environmental taxes in a second-best world. This is an area that has seen an explosion of research and new insights over the past decade and also an area with which many EU countries (as well as candidate EU countries) have been grappling. The basic message of my talk (if there is one) is that the policy prescriptions that most of us learned when studying environmental policy in isolation (that is, in partial equilibrium) often must be significantly adapted once one moves to a general equilibrium framework with pre-existing distortions. Put this way, there is nothing novel here; it is simply a restatement of the Theorem of the Second Best (Lipsey and Lancaster (1956-1957)). This, however, risks trivializing the literature of the past decade. As a contributor to that literature, I'd prefer not to do that. More to the point, there are some very interesting results that bear discussion.

Arbitrage and the Savings Behavior of State Governments

The federal tax code creates strong incentives for tax arbitrage activity on the part of state governments. This arbitrage activity is illegal and previous research has typically assumed that the constraint against arbitrage activity is binding. This paper explicitly tests this proposition by considering whether financial asset holdings increase as the yield spread between taxable and tax exempt securities rises. Using a data set on 40 state governments over a 7 year period, I find that there is a significant response to changes in the yield spread. One implication of these results is that the Tax Reform Act of 1986 which made even greater efforts to curb arbitrage activity is likely to be ineffective.

Specification Testing in Panel Data With Instrumental Variables

This paper shows a convenient way to test whether instrumental variables are correlated with individual effects in a panel data set. It shows that the correlated fixed effects specification tests developed by Hausman and Taylor (1981) extend in an analogous way to panel data sets with endogenous right hand side variables. In the panel data context, different sets of instrumental variables can be used to construct the test. Asymptotically, I show that the test in many cases is more efficient if an incomplete set of instruments is used. However, in small samples one is likely to do better using the complete set of instruments. Monte Carlo results demonstrate the likely gains for different assumptions about the degree of variance in the data across observations relative to variation across time.

Investment in Energy Infrastructure and the Tax Code

Federal tax policy provides a broad array of incentives for energy investment. I review those policies and construct estimates of marginal effective tax rates for different energy capital investments as of 2007. Effective tax rates vary widely across investment classes. I then consider investment in wind generation capital and regress investment against a user cost of capital measure along with other controls. I find that wind investment is strongly responsive to changes in tax policy. Based on the coefficient estimates the elasticity of investment with respect to the user cost of capital is in the range of -1 to -2. I also demonstrate that the federal production tax credit plays a key role in driving wind investment over the past eighteen years.electricity, wind power, production tax credits, tax subsidies