Pollution-reducing innovations under taxes or permits

This paper compares the effects of effluent taxes and pollution permits when a pollution-reducing innovation is in prospect. If the government can adjust the level of taxes and permits after the innovation has occurred, taxes and permits are fully equivalent. The equivalence breaks down, however, when the government can pre-commit. In this case, taxes give a higher incentive to invest in R&D than permits when the post-innovation output level is sufficiently high. The welfare ranking of taxes and permits is then analyzed. Loosely speaking, taxes are superior when the social damage associated with pollution is not too high.