Faculty of Economics and Business Administration Publications Database

Taxing Externalities Under Financing Constraints

Hoffmann, Florian
Moslener, Ulf
Volume: 127
Number: 606
Pages: 2478 - 2503
Link External Source: Online Version
Year: 2017

We consider a production economy with externalities, which can be reduced by additional firm‐level expenditures. This requires firms to raise additional outside financing, leading to deadweight loss due to a standard agency problem vis‐à‐vis investors. Policy is constrained as firms are privately informed about marginal abatement costs. The optimal tax on externalities is non‐linear, 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 reallocation of resources reduces average productive efficiency. Combining taxes with grants tied to loans improves resource allocation and, thus, welfare.