Pollution Abatement Investment When Environmental Regulation Is Uncertain

Abstract:     
In a dynamic model of a risk-neutral competitive firm which can lower its pollution emissions per unit of output by building up abatement capital stock, we examine the effect of a higher pollution tax rate on abatement investment both under full certainty and when the timing or the size of the tax increase is uncertain. We show that a higher pollution tax encourages abatement investment only if it does not exceed a certain threshold rate - a "Laffer-curve" phenomenon. When the size of the tax increase is uncertain, at the time of the tax increase the abatement investment path may shift upward or downward depending on whether the actual tax rate is higher or lower than the firm's expected rate. But, when the time of the tax increase is uncertain, the abatement investment path always jumps upward. Further, except in very special cases, there is no certainty-equivalent discount rate that the firm can use to optimally handle the timing uncertainty. We identify the direction of the abatement investment bias resulting from such an erroneous practice. We show that a credible threat to accelerate the tax increase can further boost the firm's abatement investment.

JEL Classifications: H32, D81, Q28

Working Paper Series