Pigouvian taxation under double moral hazard

Many notable pollution problems occur in industries where production is carried out under vertical contractual arrangements that are characterized by conditions of double moral hazard. In this paper we derive optimum pollution taxes under such conditions. In contrast to situations characterized by full information, we show that imposing a Pigouvian tax equal to the marginal cost of pollution on either the upstream or the downstream agent or the industry as a whole does not lead to the first best level of pollution. On the contrary, the industry should pay for less than the full cost of environmental damage. In addition, we find that under conditions of double moral hazard both agents should be taxed. This is because imposition of a tax in this setting affects equilibrium contract terms and the incentives that each agent faces at the margin. Thus imposing the tax on one agent alone cannot replicate the optimum.