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Stochastic environmental policy, risk-taking, and growth: discretion versus commitment

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This paper analyses the question of whether discretionary environmental policy or binding policy rules are more capable of promoting individual abatement activity. An endogenous growth model is considered where pollution is essential for production and causes disutility. Accidental pollution introduces uncertainty into the model. Furthermore, the extent to which the agents perceive their individual influence on aggregate pollution is parameterised. Recursive preferences allow for the separation between inter-temporal substitutability and risk aversion. Two different environmental policy regimes are distinguished: a stochastic pollution tax is compared with a pure deterministic tax regime. For a sufficiently volatile pollution tax and a sufficiently low elasticity of inter-temporal substitution, discretionary environmental policy is shown to be more efficient than commitment to policy rules. Due to the motive for precautionary savings, an unpredictable pollution tax may lead to more abatement effort than an environmental policy that is known with certainty in advance.

Keywords: endogenous growth, pollution, taxation, uncertainty, stochastic pollution, stochastic endogenous growth, discretionary policy, tax shock, recursive preferences, perception, risk taking, environment policy

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