This paper proposes a positive theory of environmental instrument choice. We study a democratic society that seeks to lower the level of pollution from industrial sources to a pre-specified target. The target can be implemented by one of three instruments: [S]: uniform emission standards; [P]: tradeable permits; and [T]: emission taxes. The conflict of interest between special-interests, representing polluters, and the electorate is resolved by an elected politician. We characterize when each

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... the three policy instruments is chosen in political equilibrium and show that the transition, observed in many countries, from [S] to either [P] or [T] can be understood as a natural consequence of increasingly ambitious environmental targets. r effectiveness point of view. On the other hand, precisely because of heterogeneity, the uniform quota imposed under [S] may be binding only for some firms. When this is the case, aggregate output and total emissions are lower under [S] than under the two incentive-based instruments and the output price is higher. Second, [T] implies a net transfer from the industry to citizenconsumers (the electorate) which is not present under [P] where the industry is not exposed to the financial burden arising from taxation of unabated emission. Thus, the distinction between [P] and [T] is related to who gets the revenues: [T] gives the property right to the revenue to citizenconsumers, while [P] gives it to the industry. The two instruments can, therefore, be interpreted as two extremes along a continuum of policy regimes with joint property rights. If the tax revenue were to be reimbursed to the industry, then [T] would become like [P]. Likewise, if, as discussed by Grafton and Devlin [14], the government combines [P] with a charge that extracts (part of) the rent from the industry or if it auctions off the permits and recycles the revenue to citizenconsumers, then [P] becomes like [T]. Accordingly, the two policy instruments can be given different interpretations. However, to keep as closely as possible to the policy alternatives that have been used in practice, we shall throughout think of [T] as a tax instrument with recycling of revenues to citizen-consumers and [P] as a system of tradable permits under which the permits are allocated to the industry free of charge. We characterize the instrument choice in political equilibrium in terms of economic and political fundamentals, in particular, the stringency of the environmental target. Our model can be seen as a generalization of the theory of environmental regulation pioneered by Buchanan and Tullock [3] in two directions: we expand the set of instruments by [P] and model, formally, the political conflict between industrial polluters and voters. More importantly, however, a static theory is not enough to understand the changes in instrument choices and we develop a dynamic theory that can explain the move from [S] to [P] or [T] when all agents correctly anticipate the future path of the economy, including future political equilibria. We show that the transition from command-and-control to incentive-based policy instruments can be understood as a natural consequence of more ambitious environmental targets. For lax environmental targets, all parties-citizen-consumers as well as the lobby group representing the polluting industry-support [S]. The industry lobby supports [S] because of the price effect that increases total industry profits, and citizen-consumers support [S] because actual environmental damage is lower than with the other instruments. As the target becomes more stringent, a conflict of interest between citizen-consumers and the industry lobby emerges that has to be resolved by the elected politician. The industry lobby gradually becomes more interested in cost-efficiency and shifts its support to [P]. At the same time, the potential tax revenue available for recycling starts to increase and citizen-consumers shift their support to [T]. This eventually moves the economy away from [S] to either [T] or [P]. The precise transition pattern depends on political and economic fundamentals. We discuss in detail two possibilities that broadly correspond to the development in air pollution regulation observed during the 1980s and 1990s in Western Europe and the United States. The [P]-path represents a direct transition from [S] to [P] as observed in the United States. The [T]-path represents a direct transition from [S] to [T] as observed in many Western European countries. Access to a large product market makes the [P]-path a more likely outcome. The same is true when political institutions make it easy for special interests to gain political influence (e.g., by imposing few restrictions on campaign contributions) or reduce the cost of buying political influence by shortening the time horizon of politicians (e.g., by imposing term limits).