Long-term versus short-term environmental tax policy under asymmetric information

Abstract

We examine the interaction between a firm that uses either a dirty or a clean technology to produce a product over two periods, 1 and 2, and an environmentally conscious regulator that chooses the environmental tax/subsidy policy. The regulator ignores with which technology the firm manufactures the product and only has a prior belief about it. In this context, if the regulator can credibly commit to the policy for both periods, social welfare is generally higher than if it cannot commit, because distortions in firm's production at period 1 for signalling purposes strongly reduces the optimality of an environmental policy of short duration. A period-by-period policy in which the regulator does not commit to the policy terms for period 2 (which will be contingent to information provided by the firm in period 1) is only optimal when clean technology is very expensive to produce with it and the regulator's environmental concern is not very high. The results highlight the importance of taking into account the time horizon in policymaking, as well as the limitations of regulatory policies that seek to elicit information about the type of technology used by firms.