Pollution, the cost of public funds and endogenous growth

Abstract

Theories of endogenous growth are used to investigate the effect of environmental policy on the rate of economic growth and the provision of public goods in a second-best market outcome. Pollution gives rise to a negative environmental externality and is modeled as an inevitable by-product of production. The government faces the dual task of, on the one hand, internalising environmental externalities, and, on the other hand, raising public funds to finance public spending. A tougher environmental policy reduces the rate of economic growth, improves environmental quality, raises the optimal tax rate, and changes the composition of public spending away from productive government spending towards public consumption and abatement. The marginal cost of public funds falls (rises) if productive government spending is negligible (substantial) relative to public consumption and abatement.