This chapter analyzes the choice between taxes and cap-and-trade systems as methods of controlling greenhouse gas emissions. It argues that within a single country, commonly discussed differences between the two instruments are due to unjustified assumptions about design. In the climate change context and within a single country there is sufficient design flexibility that these differences can be substantially eliminated. To the extent that there are remaining differences, there should be a modest preference for taxes, but the benefits of taxes are swamped by the benefits of good design; even though the very best tax might be better than the very best quantity restriction, the first order of business is getting the design right.

In the international context, however, taxes dominate more strongly. The design flexibility available within a single country is reduced in the international context because of the problems of coordinating systems across countries and minimizing holdouts. Moreover, the incentives to cheat and the effects of cheating are not equivalent for the two instruments in the international setting. Because climate change will require a global system for emissions, these considerations mean we should favor taxes for controlling greenhouse gas emissions. Nevertheless, the preference should be modest; substantial flexibility remains even internationally, and taxes also have coordination and enforcement problems.

Section 4.1 provides basic definitions. Section 4.2 considers the arguments attributed to Weitzman (1974) that taxes and permit systems are different when the government is uncertain about the marginal costs of abatement.