Taxing Externalities under Financing Constraints

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Taxing Externalities under Financing Constraints

We consider a production economy with externalities, which can be reduced by additional firm-level expenditures. This requires firms to raise outside financing, leading to deadweight loss due to a standard agency problem vis-á-vis investors. Policy is constrained as firms are privately informed about marginal abatement costs. We show that the optimal tax on externalities is nonlinear, thus, not implementable through tradable pollution rights alone, and lower than the Pigouvian tax for two reasons: First, higher outside financing creates additional deadweight loss; second, tax-induced re-allocation of resources reduces average productive efficiency. Combining taxes with grants tied to loans as often implemented by public finance institutions can improve resource allocation and, thus, efficiency.


Florian Hoffmann, Roman Inderst, Ulf Moslener
Release date: 
February, 2016
Number of pages: 
Research papers
File size:
276.86 KB