Should We Impose Emissions Taxes That Firms Evade?

Most of the theoretical literature on enforcing environmental policies focuses on situations in which pollution sources are noncompliant. However, some recent work suggests that these situations will very often involve suboptimal policy designs. Thus, the circumstances under which it is efficient to implement policies that do not motivate full compliance appear to be more limited than most of the literature would imply. In this paper, I identify several circumstances under which regulators may conserve enforcement costs by implementing emissions taxes that firms evade. I demonstrate that a regulator can use a firm’s tax evasion to reduce monitoring effort, but only if its monitoring strategy can be made an increasing function of the firm’s emissions, if the probability of sanctioning a violation is increasing in the size of the violation, or if the firm’s manager is risk averse. Whether an optimal tax/enforcement policy should allow noncompliance under these circumstances depends on the value of reduced monitoring effort set against the increase in expected sanctioning costs, and the costs of dealing with the added regulatory uncertainty that is produced by imperfect compliance.