Efficient Environmental Taxation Under Worker-Firm Bargaining

We study an economy with free firm entry and unemployment due to firm-worker bargaining over each firm's surplus, and where firms cause pollution that can be reduced by initial investments. An uncompensated increase in the pollution tax reduces pollution but increases unemployment, implying a tradeoff between the two. When tax revenues are used to subsidize either firms' hiring or investments, employment may also increase, creating a double dividend from the pollution tax. A pollution tax increase used to subsidize current employment is always less effective than a hiring subsidy, and is totally ineffective when subsidies equal pollution tax revenues for each individual firm. We show that the (hypothetical) pollution tax implementing the first-best solution exceeds the Pigouvian tax. The second-best tax exceeds this first-best tax when we have a double dividend, and is below it when we do not.