TIME CONSISTENCY AND INVESTMENTINCENTIVES IN ENVIRONMENTAL POLICY

We study environmental policy for a polluting firmthat can invest in extracapacity. The optimal levels of allowed output as well as the tax rate are increasingin investment. With divisible investment, commitment always leads to the first best,under direct regulation and taxation. Time-consistent policy results in overinvestmentwith direct regulation and underinvestment with taxation. With indivisible investmentand direct regulation, commitment leads to the first best. With taxation however,commitment may not lead to the first best and time consistency can lead to higherwelfare. This remarkable result occurs because the firm can influence the tax rate.