Pollution control instruments in the presence of an informal sector.

We examines the challenges faced by the regulator in managing pollution when there is a linkage between a formal and an informal industrial sector across the stages of production. The formal sector is more productive than the informal sector and the latter saves cost by evading pollution regulation due to incomplete monitoring. This creates a natural tendency for the more polluting processes to be concentrated in the informal sector. We show the unintended effects of the standard Pigouvian tax (emission fee), which might lead to further deterioration by encouraging the shift of stages in favour of the informal sector. Instead, we propose a second-best hybrid instrument, comprised of a tax on polluting input and a subsidy on proper disposal of residual waste.