Optimal Pollution Taxation and Abatement When Leisure and Environmental Quality are Complements

Abstract

We study optimal environmental policy in a world featuring multiple stable economic-ecological equilibria. There is a two-way interaction between the macro-economy and the environment. We assume that the society under consideration finds itself in a high pollution equilibrium and show that a benevolent social planner is in principle able to engineer substantial welfare gains by choosing the appropriate mix of Pigouvian (capital) taxation and abatement activities. During the initial phase of the policy, abatement is used to reduce the inflow of dirt to zero whereas the tax is employed to bring down the stock of the polluting capital input in an optimal fashion. In the long run abatement is no longer needed and the capital tax settles down at its externality-correcting Pigouvian level. For a plausible parameterization optimal abatement takes place for up to twenty-five years whilst the long-run pollution tax never exceeds seven percent of gross operating surplus. In order to escape out of the pollution trap the full force of the available environmental instruments is only needed temporarily.