Using an emission tax, the government simply sets an amount of tax that
companies pay for every unit of pollution they produce. The ideal tax rate would be the exact social cost per unit of pollution.
This policy has a couple of advantages. For one thing, it successfully forces businesses to internalize negative externality costs.
It also solves the problem of economic inefficiency by allowing firms to maximize profits and pollute at the most efficient level. If one company incurs great expense in reducing pollution, it can simply pay the
tax. If another company can easily reduce pollution, it will do so to avoid having to pay the tax. This means that less cost is induced by eliminating the same amount of pollution.
This method is superior to direct controls (setting allowable pollution levels) because direct controls are economically inefficient. However, the comparison with tradable emission permits is more complicated.
One drawback to emission taxes is that the government must correctly calculate the
tax level to maximize economic efficiency. This requires a thorough analysis of all the social costs caused by each unit of pollution.
Sometimes a government may want to ban all emission of a pollutant. In this case, a