Regulation under Financial Frictions: A Quantitative Analysis of Taxes versus Tradable Permits

Abstract

We examine the differential effects of using taxes and tradable permits to regulate emissions in an economy with financial frictions. We construct a two-sector model, where the regulated sector output is produced by entrepreneurs who differ in their endowment of managerial skills and assets and face a borrowing constraint. Government uses either an output tax or sets up a market for permits to restrict emissions by reducing the regulated sector output. We analytically show that tradable permits generate misallocation of resources while taxes do not. We parameterize the model and quantitatively examine the effects of using taxes or tradable permits to restrict the regulated sector output to the same level. We find that compared to taxes, using tradable permits results in lower aggregate productivity, welfare, and government revenue. Our findings suggest that taxes would be a better instrument than tradable permits for regulating emissions in countries with less-developed financial markets.