The Federalism Project

American Enterprise Institute

AEI Book Summary

Using Federalism to Improve Environmental Policy
By Henry N. Butler and Jonathan R. Macey
American Enterprise Institute Press, October 1996
67 pages; ISBN: 0844739634

This book is a study of ways to improve environmental policy by changing the allocation of authority for environmental regulation within the U.S. federal system. Mr. Butler is the Fred and Mary Koch Distinguished Teaching Professor of Law and Economics at the University of Kansas. Mr. Macey is the J. DuPratt White Professor of Law at Cornell University.

More than twenty years of intensive federal regulation of environmental risks have demonstrated the severe drawbacks of centralized environmental policy. The command-and-control regulatory strategy that currently dominates environmental policy has squandered resources, discouraged environmentally superior technologies, and imposed unnecessary penalties on innovation and investment.

This study considers whether environmental policy can be improved by changing the allocation of authority for environmental regulation within our federal system. We argue that a greater reliance on market incentives, economic property rights, and state and local responsibility would lead to a larger net benefit by providing stronger incentives to find the lowest-cost methods of reducing pollution and protecting the environment.

Federal Domination of Environmental Regulation

Virtually every form of productive activity creates some amount of unintended waste. The fact that producers often consider only their private costs of production and ignore the costs to society that are not directly priced by the market system (externalities, in economic jargon), leads to overproduction or an inefficient overallocation of resources to the production of the particular good. The economic goal of governmental regulation of pollution, therefore, is to force polluters to bear the full costs of their harmful activities.

It is far from clear, however, that the presence of an externality is sufficient to justify governmental intervention. In reality, externality is a slippery concept; virtually everything that anybody does is an externality when viewed from somebody's perspective. Since one of the costs of producing more manmade goods is the sacrifice of some environmental quality, we are constantly forced to make trade-offs.

The common law of torts provides several causes of action for parties harmed by others' environmentally harmful actions. Yet the common law, although it provides several avenues for forcing polluting firms to internalize their externalities, has proved to be an ineffective constraint on excessive pollution. One reason is the free-rider problem: many individuals attempt to receive the benefits of others' efforts without bearing any of the costs of private litigation. A second reason is that the judicial system has neither the technical expertise nor the resources necessary to monitor and enforce its rulings in private nuisance cases.

Legislation did not begin to displace common-law responses to environmental problems until long after the Industrial Revolution. The growing awareness of a scientific connection between pollution and health led local interest groups to demand corrective legislation, but it did not take long for industry groups to begin to offset the environmentalists' victories at the state and local levels. The first major federal effort to combat pollution was the passage of the National Environmental Policy Act (NEPA) of 1969. A year later Congress created the Environmental Protection Agency (EPA) to administer federal laws governing air, water, land, and noise pollution, toxic substances, and pesticides.

In its early years, the EPA adopted very strict standards for pollution abatement. As a result, the agency was criticized for imposing compliance costs on businesses that far outweighed the benefits to society from reducing pollution. Congress responded to these criticisms by requiring the EPA to use some form of cost-benefit analysis in the setting of pollution emission standards.

Although states still occupy a major role in implementing federal policies, this role is merely an administrative function designed to avoid some of the diseconomies of federal regulation. States are permitted to enact environmental statutes that are stronger than the federally imposed mandate but are preempted from experimenting with statutes of less stringent standards or with alternative implementation policies--a strategy that some critics believe wastes billions of dollars each year.

The Case for Federal Regulation

Federal domination of environmental regulation came about in part because environmentalists and others articulated persuasive arguments in favor of federal control. The presence of interstate externalities means that states with pollution sources will not take all costs into account when formulating their environmental policies, so neighboring states must bear the costs of pollution coming from outside. Nonetheless, acceptance of the interstate-externalities justification for federal environmental regulation does not dictate a specific type of regulatory response. The current regime of command-and-control regulation is no more justified under this analysis than are alternative, market-based approaches, such as a property-rights framework.

Another common rationale for federal domination of environmental regulation is to prevent states from competing for economic growth opportunities by lowering their environmental standards in a so-called race to the bottom. But since localities have different preferences for environmental quality, for a variety of economic and aesthetic reasons, it is by no means clear that competition between jurisdictions will lead to a lower level of environmental quality than would be preferred by a national median voter model.

State environmental regulations that impose financial costs on out-of-state producers are also cited as a justification for federal intervention. Federal regulations that preempt stringent local environmental regulation of local externalities may be justified on the ground that the local regulations impose tremendous costs on businesses' national marketing strategies. Of course, the obvious problem with allowing federal regulations to restrain state activities is that it could result in a cure worse than the disease. Furthermore, the presence of political cost externalization does not mean that there has been a political market failure. The fact that a particular cost-externalizing regulation is adopted means simply that the legislators decided that the political benefits were greater than the costs.

It is often asserted that state and local regulation is inadequate because states and localities usually lack sufficient administrative and enforcement resources. We argue that if the external costs allowed by the inadequate administration and enforcement resources are purely local, then the failure of the local politicians to allocate resources to deal effectively with the pollution is a local problem.

Federal regulators never have been and never will be able to acquire and assimilate the enormous amount of information necessary to make optimal regulatory judgments that reflect the technical requirements of particular locations and pollution sources. State regulations, of course, would be subject to similar problems, albeit on a smaller scale. Nevertheless, there appear to be considerable potential gains available from tailoring regulations at the state rather than at the federal level, even if the result is to have uniform technical regulations within each jurisdiction.

One final argument for federal regulation of even strictly local externalities is that the federal level is the one best suited to reflect the moral obligation of U.S. citizens to one another. But this justification is based on the flawed presumption that it is moral for the federal government to force people to pay for goods they do not want. Anybody can argue that his version of a particular law is more legitimate than his rival's, on the grounds that his is more consistent with the moral ideals of the nation. The most reliable guide for the moral ideals of a polity as diverse as that of the United States lies in the revealed preferences of its citizens--that is, the willingness of its citizens to pay for environmental quality.

The Efficient Allocation of Environmental Regulatory Authority

In most areas of economic activity, competition produces the efficient or optimal allocation of resources. It is at least plausible that competition among states for environmental quality may generate the optimal combination of environmental regulations across the country. Competition among political jurisdictions is likely to generate optimal laws if four conditions are fulfilled:

1. The economic entities affected by the law must be able to move to alternative jurisdictions at a relatively low cost.

2. All the consequences of one jurisdiction's laws must be felt within that jurisdiction.

3. Lawmakers must be forced to respond to adverse events that result from inefficient regulations.

4. Jurisdictions must be able to select any set of laws they desire.

We note that the second condition is violated where a state has lax environmental regulation that allows pollution to spill over from one jurisdiction to another. State regulations and policies can prevent local governments from playing this game, and federal regulations or policies can prevent states from so doing. But the presence of interstate externalities does not imply that they must be corrected by federal regulation that completely usurps the role of local initiatives. Consider the case of two neighboring states, where industrial air pollution from state A lowers the quality of air in state B. State B might be assigned the legal right to be free of pollution coming from state A. A property rule would allow state A to negotiate with state B for the right to pollute state B. State A could raise revenues for this right by taxing polluting industries in state A. Taxing the polluting industry would give some polluters the incentive to reduce pollution.

A potential objection to such a scheme might be the inability of poor states to purchase the right to pollute in rich neighboring states. But poor states are better off with the ability to trade pollution rights than they would be without them if they are willing to accept a bit more pollution in exchange for additional money.

Frequently, several states have common environmental interests because they are part of the same regional environmental system. Here, the failure to define property rights means that each state's policies affect the common resource and each state is hesitant to act independently. The federal government can play an important role as a catalyst for regional agreements, and it can also safeguard against certain regions' forming alliances against other regions. Although determining the optimal federal policy when federal regulation is appropriate is beyond the scope of this study, there can be little doubt that federal policy would be better informed if it could draw on the divergent experiences of the states in dealing with other environmental problems.

Restructuring Environmental Regulation

The analysis presented above suggests that determining the efficient division of regulatory authority within a federal system is not very complicated. In general, regulatory authority should go to the political jurisdiction that comes closest to matching the geographic area affected by a particular externality, so that regulations reflect the environmental-quality preferences of the affected parties and allow for jurisdictional competition and diversity. Primarily local and state externalities should be regulated by local and state governments, while the federal response should be limited to problems of interstate externalities--primarily air, water, and land pollution--that the states cannot resolve among themselves.

Air pollution: Air pollution has numerous causes and numerous effects. It is often difficult to identify the polluter, and even when the polluter's identity can be determined it is not always easy to identify the extent of the harm. Nonetheless, most of the solutions to local air pollution can be implemented with local or state regulations. Implementing regulations at nationwide uniform levels of intensity means that local areas with little or no smog bear the same costs for cleaning up the environment as polluted areas, but they do not receive the same benefits, because their air is already clean.

The Clean Air Act amendments of 1990 recognize that different areas have different levels of air pollution but still do not acknowledge that different communities may place different values on clean air. Thus, reliance on centralized decrees and standards effectively limits the individual state's ability to fashion its own innovative techniques to combat smog and local air pollution while completely ignoring the context of the state's fiscal and political situation. A federalist model of environmental policy suggests that physical externalities across state lines could be dealt with through regional compacts between the affected states.

Water pollution: Because water pollution is often easier to identify, trace, and quantify, many economists have suggested that marketable permits, giving owners the right to specified levels of pollution, be used as devices for improving the efficiency of regulation. Those firms that could reduce their emissions at low cost could sell their permits to firms that cannot reduce their emissions as efficiently. Obviously, some states have locational advantages over others when it comes to polluting. It should therefore be the role of the federal government to establish property rights in clean water, so that downstream states could assert claims against their upstream neighbors.

Land pollution: The control of land pollution through the regulation of the disposal of solid wastes has traditionally been a state or a local issue. But as in air and water pollution, the federal government's regulation of land pollution has increased, often coupled with unprecedented federal involvement in local land use decisions and draconian liability provisions.

Because land pollution and the potential for groundwater contamination are localized phenomena, our federalism model leads to the argument that these externalities should be regulated exclusively by state and local jurisdictions. Unlike EPA officials, state officials actually live where landfills and toxic waste sites are located. They clearly have greater incentives to see that funds allocated for cleanups are used for cleanups and not wasted in costly and unproductive litigation.


One of the most important attributes of a properly functioning federal system is that local governments are given autonomy to tailor regulatory solutions to local problems and concerns. Different states and localities are likely to have different preferences and concerns. They will compete to attract new jobs and businesses and to offer residents better environmental quality. By contrast, the centralized command-and-control apparatus of the federal government does not offer citizens the benefits of competition, even though it encourages local officials to lobby for environmental policies that produce local benefits, regardless of the consequences for the nation as a whole.

Clearly, not all environmental problems should be addressed by local authorities. Where one state is producing environmental hazards not contained within its borders, a national response may be called for. In most instances, however, that response should be limited to the assignment of property rights and the facilitation of bargaining. A federal response is appropriate on occasion, but it should be tailored to particular environmental and federalism concerns.