Environmental Policy Choice : Pollution Abatement Subsidies

The purpose of this paper is twofold. First, we show that pollution abatement subsidies, defined as subsidies on the inputs to pollution abatement, are inefficient instruments for pollution control. Whereas these types of subsidies are used in practice, the existing literature analyses only subsidies to reductions in pollution from a base level. Second, we show how pollution abatement subsidies arise endogenously in a model with environmental and industry lobby groups, although an efficient pollution tax is feasible for the government. We predict the political equilibrium abatement subsidy and pollution tax levels, and argue that pollution abatement subsidies serve primarily as methods of redistribution. The paper employs a menu auction model developed by Bernheim and Whinston (1986) and Grossman and Helpman (1994).Industry and environmental lobby groups offer the government prospective campaign contributions corresponding to different tax-subsidy policies in order to influence the policy outcome. The intuition for how a positive equilibrium subsidy may arise despite being inefficient is the following. Imagine that we begin with the social optimum; a Pigouvian tax and a zero subsidy. If total pollution is decreasing in the subsidy rate, the subsidy benefits the environmentalists. The industrialists always gain from receiving the subsidy. The remaining groups in society pay a share of the subsidy, but derive no utility from it. Total welfare declines when we move away from the social optimum, but aggregate payoffs of the lobby groups and the government rise. Thus, the political equilibrium involves a positive subsidy. If, on the other hand, pollution is increasing in the subsidy the environmentalists are still better off if this is combined with a higher pollution tax, and cleaner production, than otherwise would emerge. However, the more distorting is the subsidy, the lower is the amount transferred in the political equilibrium