Taxing Pollution: Agglomeration and Welfare Consequences

This paper demonstrates that a pollution tax with a fixed cost component may lead, by itself, to stratification between clean and dirty firms without heterogeneous preferences or increasing returns. We construct a simple model with two locations and two industries (clean and dirty) where pollution is a by-product of dirty good manufacturing. Under proper assumptions, a completely stratified configuration with all dirty firms clustering in one city emerges as the only equilibrium outcome when there is a fixed cost component of the pollution tax. Moreover, a stratified Pareto optimum can never be supported by a competitive spatial equilibrium with a linear pollution tax that encompasses Pigouvian taxation as a special case. To support such a stratified Pareto optimum, however, an effective but unconventional policy prescription is to redistribute the pollution tax revenue from the dirty to the clean city residents.