Welfare Effects of the Tax Reforms in Two Vertically-Related Oligopolies with Environmental Externality

Abstract

In this paper, I examine the welfare effects of various revenue-neutral tax reforms in the case of two vertically-related oligopolies (downstream and upstream), where the upstream industry is polluting. I show analytically when and how government can improve welfare by initiating various tax reforms, regardless of either the feasibility of a lump sum transfer or the availability of a tax on pollution. The profit wedge that is the difference between the unit price and the unit cost and the marginal environmental damages (MED) becomes important to decidethe direction of a tax reform and is crucial to determine the direction of welfare-improving tax-subsidy schemes. I also show that a tax on pollution (Pigouvian tax) is superior to a tax on intermediate good even in the case of vertically-related oligopolies, because the former always brings in positive welfare effect from the upstream firms`input substitutability, which a tax on intermediate good cannot provide. Some policy implications for ‘reducing environmentally-harmful subsidies’ are also discussed.