A Damage Based Tax Mechanism under a Peer Pressure Environment

Abstract

Damage-based taxation is an effective policy tool in controlling nonpoint source poliution. In this paper we introduce a “peer pressure” environment in which agents can monitor and sanction each other for pollution abatement. Our purpose is to analyze optimal damage-based taxation and cooperative behavior among the agents in this environment. It is known in the literature that the optimal tax is to let agents fully compensate for the damage when there is no peer pressure. We observe that this is not the case in our peer pressure environment, where partial compensation is more socially desirable than full compensation. The presence of the peer pressure does not affect the incentives for cooperation, but it changes the level of effort put into abatement when cooperation occurs. This effort level depends on the situations of the agents before cooperation, thereby suggesting the importance of paying attention to such situations in determining the optimal tax.