Soft Fiscal Policies for a Polluting Monopolist

Abstract

This paper examines optimal environmental taxation in an incomplete-information two-period model in which a monopolistic firm produces and pollutes. The firm is privately informed about its costs of production and abatement, and the regulator - which can only infer the firm’s technology after observing the output from the period 1 - has the chance to set environmental taxes in period 1 to correct the firm’s opportunistic behavior. The regulator is aware that the polluter may strategically choose a given level of production (and pollution) in period 1 in order to manipulate the regulator’s beliefs concerning its technology and, consequently, adjusts the tax paid in period 2. We show that if the regulator reduces pollution taxes in the first period below the level under symmetric information, then the clean firm will signal its type by further reducing its output. Having gathered information from the firm with respect to its technology and emissions, the regulator raises pollution taxes in the second period. In the light of the present results, soft fiscal policies based on initial low-taxes, which are later increased, may be used in the presence of asymmetric information to provide incentives for a firm to reveal its true level of emissions and mitigate opportunistic behavior.