Taxation and Environmental Innovation

This paper analyses the effects of environmental taxation on firms’ innovation activity. A regulator is assumed to introduce an environmental tax Firms may react both by changing output and by adopting a new, environment-friendly technology Conditions under which the latter option is firms’ optimal choice are provided. The paper shows that firms’ innovation decisions are not simultaneous even when firms are identical (there exists diffusion). Moreover, firms have an incentive to delay the time of innovation, because the new technology can only be achieved through costly R&D. Hence, there exists room for incentives that move firms to the socially-optimal timing of innovation. These incentives have to account for the presence of asymmetric information (the regulator is assumed not to observe firms’ innovation costs). The paper shows that there exists a family of contracts defined by a pair (time of innovation, innovation subsidy) such to induce firms to behave optimally The proposed policy-mix (environmental tax and innovation subsidy) is shown to reduce emissions more, and to reduce output less, than environmental policies based on a single policy instrument.