Optimal environmental taxation and enforcement policy

We study the optimal environmental taxation and enforcement policy when (i) the regulator does not know the firms’ abatement costs, (ii) penalties for tax evasion are limited, and (iii) monitoring of pollution is costly. We show that the threat of being audited alter the usual firms’ incentives to over-estimate their abatement costs. In particular, depending on the firms’ abatement costs, the optimal policy may involve over or under-deterrence compared to the full information outcome. We then investigate the properties of a pollution standard. We show that this policy comes close to an environmental tax once the economic incentives of the accompanying enforcement policy are considered.