Voluntary internalisations facing the threat of a pollution tax

Abstract.

This paper investigates how the threat of a pollution tax fosters voluntary arrangements under private information and how such arrangements (of the take-it-or-leave-it type) will look like. The objective is (i), to address a topical and policy relevant problem, and (ii), to highlight that the optimal contracts exhibit substantial variations, degrees of complexity and uncommon features. If the pollutee offers an arrangement (and this is the more likely and also more interesting case) the spectrum of solutions covers six different cases: 'no distortion at the top', 'no distortion at the bottom', 'no distortion in the interior' and a boundary solution (a pseudo contract of duplicating the tax outcome) applicable either in all instances of the agent's benefit or coupled with one of the conventional mechanisms. If the polluter offers a contract, the optimal incentive scheme is countervailing with the consequence that the signs of the payments are reversed, that the property of no distortion holds at both ends and that the polluter's best strategy is to duplicate the tax outcome if the actual damage is around the expected value. The government's threat encourages contracting and improves the allocation beyond what an actual intervention could achieve. This provides a potential role for governments in an otherwise Coasean framework.