Another incidence result occurs if these taxes replace current regulations that are designed to mitigate pollution9. Consider, for example, a simple example where pollution (X) is restricted to an amount (X0) by regulatory efforts. Now we replace those regulations with a system of pollution taxes that induces firms to reduce their pollution to X0. To see how this would work, consider Figure 1. The downward sloping line graphs marginal benefits of pollution (MB) to the firm. In the absence of any government intervention, firms would pollute to the point where marginal benefits equal marginal costs. If marginal costs are zero, then firms would pollute up to an amount equal to Xx in the figure.
A quota designed to reduce pollution to X0 is represented by the vertical dashed line in the figure. With this quota, the marginal benefit of pollution is now equal to P0. Costs are increased by the use of a quota regulation. The restriction on pollution means that pollution now has scarcity value and a shadow price equal to its marginal benefit (P0). This scarcity value translates into higher prices. The incidence of the environmental reform now depends on 1) whose income is ultimately reduced by the imposition of environmental taxes and 2) whose purchasing power is increased by the reduction in the price of goods following the elimination of a quota. But these two effects exactly offset so that the net impact of the environmental tax from an incidence point of view is zero. The government, however, has the revenue with which it can reduce other taxes. In this case, the appropriate incidence analysis is simply an absolute incidence analysis focusing on the reduction of taxes financed by the environmental tax revenues. I hold environmental regulatory policy fixed in this analysis and so ignore these additional distributional effects.