Compare and contrast emission taxes and tradable
permits systems for the control of pollution.
What are the strengths and weaknesses for each?
Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
Compare and contrast emission taxes and tradable permits systems for the
control of pollution. What are the strengths and weaknesses for each?
I. Thesis
Emission taxes and tradable permit systems are two contrasting market-based mechanisms
used to reduce pollution emissions. This paper will examine both the advantages and
disadvantages of using emission taxes to control pollution levels and the advantages and
disadvantages of using a tradable permits system to reduce total emissions. Both strategies
will then be compared, leading to the conclusion that the tradable permits system is the more
effective market-based mechanism to control pollution.
II. Introduction
Although both emission taxes and tradable permit systems aim to reduce overall pollution,
they do this in different ways. Emissions taxes internalize the pollution externality by
increasing the cost of a product by a lesser proportion than the tax (Chen 2011). This increase
in the price of production, due to the mandatory emissions taxes imposed, encourages a
movement towards cleaner production technologies which incur less emission taxes and
reduce overall emissions (Goulder et al. 2013). A commonly used example of an emissions
tax is a carbon tax, which is currently in place in countries such as the UK and Sweden and
the Canadian province of British Columbia (Goulder et al. 2013). Tradable permit systems,
on the other hand, allocate permits to production plants, allowing them to produce a fixed
quantity of emissions and freely trade these allowances/permits between plants (known as
cap-and-trade) (Chen 2011). These permits control the overall amount of pollution that firms
are ‘allowed’ to collectively emit and therefore the tradable permits system reduces the
overall quantity of emissions, regardless of the emissions distribution between individual
producers. An example of a cap-and-trade system currently in effect is the European Union’s
Emissions Trading Scheme (Goulder et al. 2013). Both pollution control systems encourage
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Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
polluters to change their production processes so that less emissions are emitted for each
product or unit of a good they produce. This consequently results in an increased price of the
goods that a create a higher amount of pollution when produced. This means that consumers
choose to purchase less carbon-intensive products, which are now more expensive, and the
demand for the carbon-intensive goods decreases, reducing the quantity of output that the
highly polluting firms now produce. In this case, further emissions reductions take place
(Goulder et al. 2013).
III. Emissions Taxes
Using emissions taxes as a way to reduce pollution has both strengths and weaknesses. The
main advantage of an emissions tax is the same as the principle aim and reason behind
implementing an emissions tax. This is the incentive that an emissions tax provides to
production plants to reduce their pollution emissions. Obligatory emissions taxes, such as
carbon taxes, increase the costs of production for a firm and therefore encourages production
plants to invest in research and development activities and adopt cleaner production
technologies which incur less emission taxes and costs for the firm. This reduces overall
emissions (Goulder et al. 2013).
Another notable advantage of emissions taxes includes the possibility of revenue recycling
(Rosen et al. 2012). Rosen et al. state that an emissions tax can improve efficiency in the
presence of an externality, known as a Pigouvian tax. This tax encourages polluters to reduce
the overall amount of emissions that they emit during product production and the revenues
collected from these emissions taxes can be used to reduce and offset other taxes, such as
income taxes (Rosen et al. 2012). This recycled revenue therefore increases the efficiency of
the markets distorted by income taxes, as well the efficiency of the market with the polluter.
This concept is known as the double-dividend hypothesis (Rosen et al. 2012). Goulder et al.
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Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
have studied how the revenue collected from emissions taxes can also be used by the
government to finance other pre-existing distortionary taxes and therefore reduce the
deadweight costs that would otherwise be present with the pre-existing distortionary taxes
(Goulder et al. 1996). Their research suggests that revenue recycling improves efficiency
since the revenues are returned to society through marginal tax rates cuts, unlike those
environmental taxes that are returned to society as one lump-sum tax cut and do not utilize
the revenue recycling effect (Goulder et al. 1996). A lump-sum tax cut is viewed as
inefficient because most people would agree that it is not fair for everybody, regardless of
their economic situation, to pay the same amount of tax (Rosen et al. 2012). The revenue
raised from the introduction of a carbon tax appeals to decision makers because they can use
the revenue for a broader tax reform, as previously described, or to reduce the budget deficit
of a country (Goulder et al. 2013).
A lack of price volatility, resulting in known carbon prices is another strength of emissions
taxes (Goulder et al. 2013). An emissions tax implemented on the pollution that production
plants produce is set by a control authority and therefore is not affected or altered by
individual firms (Goulder et al. 2013).
One of the main disadvantages of emission taxes is the spill over effect named carbon
leakage (Fischer and Fox 2007). When a carbon tax is introduced, the production of goods
becomes more expensive, raising the price of domestically produced goods and consequently
decreasing the demand for domestically produced goods. Consumers may then choose to
import goods from countries who are not implementing a carbon tax and production of the
goods in a foreign country increase. This increase in emissions in the foreign country is
known as carbon leakage. This means that although a carbon tax may reduce the total
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Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
emissions of one domestic country, the increase in emissions in another country counteract
this benefit and contributes to the overall amount of greenhouse gases present in the world.
Another disadvantage of an emissions tax is the lack of certainty in the actual reduction of
emissions (Goulder et al. 2013). Previously introduced as a strength of the emissions tax
system, when emissions taxes are implemented, there is a lack of carbon price volatility,
since the carbon price is equal to the carbon tax and the prices are specified exogenously
(Goulder et al. 2013). Therefore, with a carbon tax, the carbon price is guaranteed but the
guaranteed quantity of emissions is uncertain. The amount of emissions that production
plants emit is dependent on each individual firm’s willingness to pay emissions. Some firms
may find that it is more cost effective to invest in new cleaner production technologies which
do not create so much pollution and therefore do not incur as much carbon tax. However,
other firms may conclude that it is cheaper for them to pay more carbon taxes and make no or
fewer changes in their production process. Therefore, a carbon tax doesn’t necessarily
guarantee a reduction in emissions but just encourages a decrease in pollution levels.
IV. Tradable Permits Systems
Using the tradable permits system as a way to reduce pollution also has both strengths and
weaknesses. One significant strength of using a tradable permit system to control pollution is
the incentive for producers to invest in clean technologies (Tietenberg 1985). When using the
tradable permits system, the regulatory authority sets the overall amount of permitted
pollution emissions ‘allowed’ across firms (limiting total pollution), but it is up to polluters
(who have more knowledge about their individual abatement cost functions) to take the
necessary actions to reduce their emissions and to meet the strict regulations and emission
limits imposed by the control authorities (Tietenberg 1985).
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Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
Another possible strength of the tradable permits system is that it often has lower control
costs than an emissions tax and can result in a cost-effective allocation since the emissions
permits granted to each firm do not have to be utilized by that particular firm. Since permits
can be sold and transferred between polluters, those producers who can reduce their
emissions at a lower cost are incentivised to do so and sell their allocated emissions permits
to other firms, with higher costs of abatement, for additional revenue (Tietenberg 1985). For
some producers it may be more cost effective to invest in cleaner-production technologies,
but for others it may be cheaper to buy emissions permits from other producers with excess
permits than to install more emission control equipment (Tietenberg 1985). Therefore, the
emissions trading system is often cost efficient and permit trading will continue until there is
allocative efficiency of the emissions permits (Tietenberg 1985). Robert N. Stavins however
opposes this statement that a cap-and-trade system can be used to achieve a cost-effective
allocation of tradable permits, due to the transaction costs incurred during the trading of
permits between individuals and firms (Stavins 1995). To achieve allocative efficiency, every
firm needs to have the same marginal cost of control of emissions. This situation is almost
impossible for a government to achieve and, even if this was possible, it would come at an
extremely high cost for the control authority due to scale of information needed about the
costs that each and every individual polluter incurs.
With tradable emissions permits, firms can trade between themselves and still emit the
overall amount of emissions permitted by the government (regardless of the distribution of
emissions across firms). The cost-effective allocation of emissions permits can therefore be
reached without the high control costs associated with obtaining information about each
individual firm since the individual firms known their own costs of changing their production
plants to use more clean-technologies versus the cost of emissions permits (Stavins 1995).
Using the tradable permit system guarantees and limits the quantity of emissions that the
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Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
firms within a country produce collectively, however the carbon price is volatile. Since the
supply of permits is perfectly inelastic, and demand can have a large impact on the emissions
price (Goulder et al. 2013), the price of the emissions permits is determined by the
negotiations and bargaining between firms.
Although cap-and-trade systems tend to have less control costs than emissions taxes
(Tietenberg 1985), Stavins suggests that significant transaction costs are still incurred in the
tradable permits system (Stavins 1995). As previously mentioned, the transaction costs that
arise during emissions permit trading stops a complete cost-effective allocation of permits.
Transaction costs are not often taken into account when examining models of tradeable
permits (Stavins 1995). These transaction costs arise from the three different stages of
emissions permits trading between polluters. These stages include ‘search and information’,
‘bargaining and decisions’ and ‘monitoring and enforcement’ (Stavins 1995). However, as
discussed earlier in this paper, a cost-effective allocation of emissions can still be achieved if
all firms control emissions at the same marginal cost of control, which requires the details of
all the control costs that individual producers incur when trading permits rather than permit
allocation from a government who could not acquire such information without considerably
high costs (Stavins 1995). Stavins also suggests that transaction costs decrease welfare, since
they use resources that could otherwise be directly used for production and suppress trading
that would have mutually beneficial between two firms anyway (Stavins 1995). When
transaction costs are high, control costs are high. Those markets in which there are many
firms and transactions are taking place frequently have more information available, leading to
reduced uncertainty and improved conditions for a tradable permits system (Stavins 1995). In
permit markets with transaction costs, permits need to initially allocated in a way that the
total costs (control costs and transaction costs) are minimized in order to achieve an efficient
market (Stavins 1995).
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Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
A common misconception is that free allocation of permits means that there is no incentive
for a firm to reduce its pollution emissions, but when permits are auctioned off there is a
strong incentive for firms to reduce their emission levels (Goulder et al. 2013). This
misunderstanding is based on the idea that firms in auctioned permits systems (permits add
significant costs to a firm) are more willing to reduce their emissions than firms in
grandfathered permit systems (where permits are distributed to firms without a fee) because
this will benefit them directly in the form of reduced spending on emissions permits.
However, Goulder et al. state that even when permits have been allocated to firms without
cost, every extra unit of pollution emitted has an opportunity cost. These opportunity costs
involve a reduction in the number of permits that the firm can now sell or how many more
permits the firm now needs to buy to adhere to the government emission standards set
(Goulder et al. 2013). This also implies that firms incur less costs with grandfathered
emissions permits than auctioned emissions permits.
The possibility of revenue-recycling is another advantage associated with those tradable
emission permits that are auctioned or sold by a regulatory agency, but not when the
tradeable emissions permits are grandfathered or initially distributed for free (Goulder et al.
1996). There are a number of different ways for control authorities to initially allocate
emissions permits. These include grandfathered emissions permits, auctioned permits and
output based allocations. Grandfathered emissions permits allow incumbent firms to pollute,
but do not allow any expansion in the pre-existing firms’ production or new entrants to begin
polluting. Output based allocations involve permits being distributed to firms depending on
their production quantities. Auctioned permits are sold off in an auction, with firms bidding
for the emissions permits (raising revenue). The revenue raised can be used to offset other
pre-existing distortionary taxes, as did the revenue raised from a carbon tax (Goulder et al.
1996).
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Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
Relief to lower income households is another positive outcome of the tradable permits system
(Tietenberg 1985). The emissions trading system has lower control costs (Tietenberg 1985)
and leads to smaller increases in the price of the products produced (in comparison to carbon
taxes). The smaller the price increase in products due to the strict emissions policy, the more
money that low-income households have left to spend on necessities such as housing and
food (Tietenberg 1985).
As with carbon taxes, carbon leakage is also a disadvantage often present when using the
cap-and-trade system. Since the costs of permits in the tradable permits systems are passed
onto consumers, the resulting higher product prices lead to carbon leakage (Fischer and Fox
2007). As described before, the increase in product prices in the domestic country due to the
additional cost of permits that firms are now forced to purchase, leads to a decrease in the
demand for such products. Consumers then switch to foreign producers, which increases the
demand for foreign production and consequently increases the amount of pollution that
foreign countries emit (carbon leakage). However, the increase in the price of products
depends on the type of emission permit system that has been used to distribute and allocate
the permits. Those permits that have been auctioned off raise the price of production more
than grandfathered permits.
Price volatility is the final weakness of a tradable emissions permit system. With this
pollution control mechanism, a regulatory authority allocates the emissions permits and
therefore establishes the overall amount of emissions that a country can emit. This then leads
to the carbon price being indirectly established through the cap-and-trade market (Goulder et
al. 2013), which means that the price of emissions is unknown and unlimited.
9
Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
V. The Similarities Between Emissions Taxes and Tradable Permits Systems
It is evident that both the emission tax system and tradable permits system have a number of
similarities. Both emissions taxes and tradable permits reduce pollution emissions and
encourage investment in future technology innovation of plants that produces less pollution
(Denicolò 1999). Both systems also offer polluters incentives to actively invest in research
and development activities, with the aim of establishing dynamic efficiency and finding costsaving abatement options (Chen et al. 2011). Vincenzo Denicolò explains in his paper that
taxes provide a larger incentive for a firm to innovate than tradable permits do when the
incentive to innovate increases with the tax rate (Denicolò 1999). Likewise, grandfathered
emissions permits may not impose the same incentive for firms to innovate as auctioned
emissions permits do, since grandfathered emissions permits are allocated to firms for no fee.
However, Goulder et al. states that the marginal incentives to reduce emissions are the same
for both pollution control systems, even when permits are distributed freely (Goulder et al.
2013). But when the zero-tax monopoly output is higher than the competitive output with a
high tax rate, the incentive to innovate will decrease with any increase in tax and a permit
system provides more incentives to innovate than emissions taxes (Denicolò 1999).
According to Vincenzo Denicolò, emissions taxes are more appropriate to use when there is a
smaller environmental externality and the tradable permits system is better suited to
situations in which there are large environmental externalities (Denicolò 1999).
Additionally, both emissions taxes and some tradable permit systems can recycle the
revenues raised through these systems and use them to offset and reduce pre-existing tax
distortions, such as double dividend (Chen et al. 2011). The double-dividend hypothesis
describes a situation in which the efficiency of the market distorted by the income tax as well
as the efficiency of the polluters’ market are both increased (Rosen et al. 2012). However, in
a study of the US with an auctioned permits system in place suggests that the double dividend
10
Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
hypothesis does not hold as losses abroad outweigh any welfare increases (Fischer and Fox
2007). Grandfathered emissions permits are an example of non-revenue raising regulations
which means that there are no revenues available to offset the tax-interact effect (Rosen et al.
2012). Auctioned emissions permits, on the other hand, generate revenue and therefore the
revenue that is collected can be used to offset other distortionary-taxes (Fischer and Fox
2007). In the case of a carbon tax imposed by a control authority, such as the government, the
revenues can also be collected and then be used for a purpose that the government deems as
the most important way to spend the collected funds. However, it is always questionable as
to how this revenue spent and how much of a benefit that it has on society. Goulder et al.
conclude that those mechanisms that generate revenue, such as emissions taxes and select
tradable emissions permits, have lower costs of reaching cost efficiency (Goulder et al.
1996). Distortions in prices appear to be largest for grandfathered emissions permits (Fischer
and Fox 2007).
Both systems also incur carbon leakage as a negative spill-over effect due to the higher
product prices resulting from the emissions taxes or tradable permit systems (Fischer and Fox
2007). The costs of permits that producers incur are passed onto consumers and the higher
prices of products encourage carbon leakage (Fischer and Fox 2007). This is the same for
emissions taxes which encourages domestic consumers to turn to cheaper imports from
foreign countries, increasing foreign production and foreign pollution. However, the scale of
carbon leakage is not necessary the same for both pollution control systems.
VI. The Differences Between Emissions Taxes and Tradable Permits Systems
However, there are also some key differences in the emission tax system in comparison to the
tradable permits system. Both systems incur the same price of emissions, but each system
establishes the price of carbon through a different process. With an emissions tax, the carbon
11
Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
tax rate is set by the regulatory authority, however, with the tradable emissions permit
system, the permitted quantity of emissions is stated by the regulatory authority, which then
leads to the carbon price being indirectly established through the cap-and-trade market
(Goulder et al. 2013). Hence the carbon tax system leaves uncertainty over the amount of
emissions that are produced and the cap-and-trade system leaves uncertainty over the price of
emissions (Goulder et al. 2013). Therefore, under the absence of uncertainty, both strategies
would be equal. As Goulder et al. acknowledge in their paper, the problem with the
uncertainty of a carbon tax system is that there is no guarantee that the quantity of emissions
is actually reduced (Goulder et al. 2013). If firms have a large source of funds, they may be
prepared to pay significant amount of carbon taxes to continue polluting at the same rate as
they were previously. On the other hand, with the cap-and-trade system the amount of
emissions is strictly limited and therefore a reduction in emissions is guaranteed as a certain,
pre-decided number of emissions permits are distributed to firms. When a carbon tax is
imposed, this means that firms which create emissions are obligated to pay a fee for the
pollution that they emit. However, this tax only encourages and incentivises the plant to
reduce its emissions and invest in cleaner production technologies and does not force the firm
to do so. If the firm can afford to pay high carbon taxes or deems it less expensive to pay the
emissions tax than invest in a production process that produces less pollution, then the firm
may not reduce its emissions. A carbon price is set by the control authority when an
emissions tax is in place, but a carbon price is determined by the permits trade market when a
tradable permits system is in place. However, Goulder et al. state that if firms are costminimizing, both market-based systems will lead to equalization of each firm’s marginal
abatement cost and the common emissions price (a state that direct regulations cannot reach)
(Goulder et al. 2013).
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Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
Price volatility is not a problem encountered with a carbon tax, however, price volatility is a
significant problem with the tradable permits system (Goulder et al. 2013). The higher price
volatility/ fluctuations of permits in the tradable emissions permit system encourages
producers to take actions to avoid carbon risks and uncertainty in advance. Chen et al. state
that the volatility of the permit price set by polluters/ the market in the tradable permits
system might lead to an increase in a firm’s output and smaller deadweight loss than would
be seen under the effect of a carbon tax (Chen et al. 2011).
It has also been stated that emissions taxes initially distribute the burden of each policy more
evenly and fairly between polluters and consumers. Which also preserves international
competitiveness (Goulder et al. 2013). In particular, grandfathered permits lead to larger price
distortions (Fischer and Fox 2007). However, there is a potential for the same redistributions
to be reached through permit trading (Goulder et al. 2013). Additionally, both pollution
control mechanisms have a similar potential to preserve the competitiveness of domestic
firms with high carbon emissions internationally (Goulder et al. 2013).
Finally, the transaction and control costs of the tradable emissions permits system are
typically lower than those control costs for carbon taxes (Tietenberg 1985). The lower control
costs lead to smaller price increases of products produced under a tradable permits system
than a carbon tax system and therefore more relief for lower income households (Tietenberg
1985). Although both systems lead to carbon leakage, this smaller price increase of goods
would result in less carbon leakage under a tradable emissions permit system than an
emissions tax (Fischer and Fox 2007). Output based allocations lead to smaller price
increases than grandfathered and auctioned emissions permits (Fischer and Fox 2007).
13
Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
VI. Conclusion
In conclusion, both emissions taxes and tradable permit systems have attractive
characteristics and negative qualities. The question over which mechanism to implement in a
country is of significant interest to a number of economists and several of the articles written
by these economists have been analysed in this paper. Both strategies encourage investment
in cleaner production technologies and investment in research and development activities to
develop new, more sustainable and less polluting, production methods. Both strategies also
benefit from the revenue-recycling effect but lead to the negative spill over effect named
carbon leakage. However, the main difference between the two policies is the way in which
they are implemented. In a tradable emission permits system, the control authority sets an
overall limit on a country’s emissions level. Permits are initially allocated to firms at no cost
(grandfathered or output-based permits) or through an auction and then re-distribution of the
permits takes place through trade depending on a firm’s most cost-efficient way continue
producing. This system therefore guarantees a reduction in the overall quantity of pollution.
However, a carbon tax guarantees the emissions price but not the total quantity of emissions.
Firms that are prepared and able to pay the carbon tax and find this a more cost-effective
option than investing in cleaner production technologies will do so. Therefore, this system
does not guarantee a reduction in total emissions. Emissions taxes initially distribute the
burden of costs more evenly; but tradable permit systems incur less control costs, leading to
smaller product price increases and more relief to lower income families. In conclusion and
after analysing the strengths and weaknesses of both pollution control mechanisms, evidence
suggests and supports the thesis stated at the beginning of this paper that the tradable permits
system is more effective at reducing pollution. In reality however, it is important to
remember that implementing pollution control systems can present significant challenges
ethically and politically.
14
Student Name: Amelia Collins
Student Number: 300095281
ECO4136 Research Paper
University of Ottawa, Department of Economics
References
Chen, Yihsu and Chung-Li Tseng, 2011. “Inducing Clean Technology in the
Electricity Sector: Tradable Permits or Carbon Tax Policies?”. The Energy Journal
32(3): 149-74.
Denicolò, Vincenzo, 1999. “Pollution-reducing innovations under taxes or permits”.
Oxford Economic Papers 51: 184-99.
Fischer, Carolyn and Alan K. Fox, 2007. “Output-Based Allocation of Emissions
Permits for Mitigating Tax and Trade Interactions”. Land Economics 83: 575-99.
Goulder, Lawrence H., and Andrew R. Schein, 2013. “Carbon Taxes versus Cap and
Trade: A Critical Review”. Climate Change Economics 4(3): 1-29.
Goulder, Lawrence H., Ian W.H. Parry and Dallas Burtraw, 1996. “Revenue Raising
Vs. Other Approaches to Environmental Protection: The Critical Significance of Preexisting Tax Distortions”. National Bureau of Economic Research Working Paper
Series, Working Paper 5641: 1-24.
Rosen, Harvey S., Jean-François Wen, and Tracy Snoddon, 2012. Public Finance in
Canada (McGraw-Hill Ryerson), ch.15 Taxation and Efficiency: 300-11.
Stavins, Robert N., 1995. “Transaction Costs and Tradeable Permits”, Journal of
Environmental Economics and Management 29: 133-48.
Tietenberg, T.H., 1985. Emissions Trading: an Exercise in Reforming Pollution
Policy (Resources for the Future), ch.2 “The Conceptual Framework”: 14-22.
Tietenberg, T.H., 1985. Emissions Trading: an Exercise in Reforming Pollution
Policy (Resources for the Future), ch.5 “Distributing the Financial Burden”: 93-113.
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