Controlling Stock Externalities: Flexible Versus Inflexible Pigovian Corrections

This paper examines the use of inflexible Pigovian taxes/subsidies to correct a stock externality. An optimal control framework is first used to characterize the first-best path for a Pigovian correction that varies continuously. This first-best path is then contrasted with inflexible second-best paths in which the level of the correction can be set only once or twice. The optimal timing of a fixed one-time correction is also studied. A deferment of this correction is desirable when the initial state of the environmental stock is less deteriorated than the first-best steady state or the adjustment costs are sufficiently great.