Taxing Externalities Under Financing Constraints

We consider an economy where production generates externalities, which can be reduced by additional firm level expenditures. This requires firms to raise outside financing, leading to deadweight loss due to a standard agency problem vis-a-vis outside investors. Policy is constrained as firms are privately informed about their marginal cost of avoiding externalities. We first derive the optimal linear pollution tax, which is strictly lower than the Pigouvian tax for two reasons: First, higher firm outside financing creates additional deadweight loss; second, through redistributing resources in the economy, a higher tax reduces average productive efficiency. We analyze various instruments that achieve a more efficient allocation, in particular, nonlinear pollution taxes, which can no longer be implemented through a tradable permit scheme alone, and grants tied to loans, which are frequently observed in practice.