Efficient environmental taxation under worker-firm bargaining

We study an economy with free firm entry and unemployment due to firm-worke r bargaining over each firm's surplus, and where firms cause pollution that can be reduced by initial investments. An uncompensated increase in the po llution tax reduces pollution but increases unemployment, implying a tradeo ff between the two. When tax revenues are used to subsidize either firms' h iring or investments, employment may also increase, creating a "double divi dend" from the pollution tax. A pollution tax increase used to subsidize cu rrent employment is always less effective than a hiring subsidy, and is tot ally ineffective when subsidies equal pollution tax revenues for each indiv idual firm. We show that the (hypothetical) pollution tax implementing the first-best solution exceeds the Pigouvian tax. The second-best tax exceeds this first-best tax when we have a double dividend, and is below it when we do not.