Political Internalization of Economic Externalities. The Case of Environmental Policy in a Politico-Economic Model with Lobby Groups

This paper shows how competition between interests can internalize economic externalities groups. The key feature is that some lobby groups give political voice to environmental demands. We illustrate the basic ideas in a common agency model of politics, into which we introduce a negative output externality. We show that the politically optimal structure of environmental taxes incorporates the full Pigouvian adjustment. However, since lobby groups care about the distribution of income as well as about efficiency, the equilibrium structure of taxes differs considerably from the set of Pigouvian taxes. In particular, organized sectors get a tax discount, while unorganized sectors are taxed at an inefficiently high rate. Hence, environmental lobbying has a huge beggar-thy-neighbour element