NCPA - National Center for Policy Analysis

Tradable Deficit Permits

November 13, 2001

In 1997, members of the European Union (EU) signed the "Pact for Stability and Growth," an agreement designed to guarantee the fiscal health of the Union. Under this treaty, member countries are required to keep their budget deficits to less than 3 percent of Gross Domestic Product with stiff penalties for those that do not. However, economists argue that this is inefficient and that the same market mechanism that the United States uses to reduce air pollution can be applied to restraining European deficits.

American regulators realize that certain companies can reduce sulfur dioxide emissions better than others. As a result, the regulators simply set the overall pollution limit and let companies trade permits to pollute among them. This produced significant results:

  • By 1995, sulfur dioxide emissions were down 50 percent from 1980 levels.
  • More importantly, this reduction was achieved at an impressive 25 percent to 33 percent efficiency gain, saving $300 million.

Economists say European deficit regulators should set an overall deficit limit and let individual nations trade deficit permits. Fines could still result from failure to comply, but there would be more flexibility in achieving reduced deficits. This procedure has several advantages:

  • It abolishes the arbitrary and political mechanism of granting exceptions to nations that cannot maintain the 3 percent ratio.
  • It allows flexibility to nations when they require it, say in a recession or if they require fiscal restructuring.
  • It gives incentives to "store" deficit permits for later use.
  • It restores sovereignty to individual nations and may entice Great Britain to join the EU.

In 1995, sulfur dioxide pollution levels were 40 percent below target levels in the United States. Economists say the EU could achieve similar fiscal gains.

Source: "Deficit Permits and Storable Votes," Economic Intuition, Spring 2001; based on Alessandra Casella, "Market Mechanisms for Policy Decisions," European Economic Review, May 2001, and Alessandra Casella, "Tradable Deficit Permits," Economic Policy, April 1999.


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