Taxing externalities under financing constraints

We consider a production economy with externalities, which can be reduced by additional firm-level expenditures. This requires firms to raise additional outside financing, leading to deadweight loss due to a standard agency problem vis-a-vis investors. Policy is constrained as firms are privately informed about marginal abatement costs. The optimal tax on externalities is non-linear, thus, not implementable through tradable pollution rights alone, and lower than the Pigouvian tax for two reasons: first, higher outside financing creates additional deadweight loss; second, tax-induced reallocation of resources reduces average productive efficiency. Combining taxes with grants tied to loans improves resource allocation and, thus, welfare.

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