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Tax Interaction Effects, Environmental Regulation, and “Rule of Thumb” Adjustments to Social Cost

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Preexisting distortions in factor markets complicate the estimation of the social welfare effects of regulatory interventions. The existence of these tax interaction effects (TIEs) suggests that general equilibrium (GE) approaches should be used to evaluate regulatory policies. However, formal GE analysis is not always feasible for the numerous environmental regulations proposed by federal, state, and local agencies. The question addressed in this paper is whether an empirically based rule of thumb upward adjustment factor is appropriate to properly scale social cost estimates in environmental policy. We argue that such rule of thumb adjustments are significantly less reliable than estimates based on a detailed general equilibrium analysis because of the uncertainty about both the magnitude and sign of the social cost distortion. In addition to addressing this question, the paper gives an overview of TIEs and their relevance to environmental policy.

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