The informational value of environmental taxes

Abstract

We propose informational spillovers as a new rationale for the use of multiple policy instruments to mitigate a single externality. We investigate the design of a pollution standard when the firms’ abatement costs are unknown and emissions are taxed. A firm might abate pollution beyond what is required by the standard by equalizing its marginal abatement costs to the tax rate, thereby revealing information about its abatement cost. We analyze how a regulator can take advantage of this information to design the standard. In a dynamic setting, the regulator relaxes the initial standard in order to induce more information revelation, which would allow her to set a standard closer to the first best in the second period. Updating standards, though, generates a ratchet effect since the low-cost firms might strategically hide their cost by abating no more than required by the standard. We provide conditions for the separating equilibrium to hold when firms act strategically. We illustrate our theoretical results with the case of NOx regulation in Sweden. We find evidence that the firms that are taxed experience more frequent standard updates.