Pollution abatement investment when environmental regulation is uncertain

In a dynamic model of a risk-neutral competitive firm which can lower its pollution emissions per unit of output by building up abatement capital stock, we examine the effect of a higher pollution tax rate on abatement investment both under full certainty and when the timing or the size of the tax increase is uncertain. We show that a higher pollution tax encourages abatement investment if it does not exceed a certain threshold rate - a "Laffer-curve" phenomenon. When the size of the tax increase is uncertain, at the time of the tax increase the abatement investment path may shift upward or downward depending on whether the actual tax rate is higher or lower than the firm's expected rate. But, when the time of the tax increase is uncertain, the abatement investment path always jumps upward. Further, the ad hoc practice of raising the discount rate to account for the uncertainty leads to underinvestment in abatement capital. We show how the size of this underinvestment bias varies with the future tax increase. Finally, we show that a credible threat to accelerate the tax increase can induce the firm to undertake more abatement investment.