This paper examines the effect of signaling on environmental taxation when each polluter privately knows whether its production cost is low or high, whereas third parties (i.e. the rival firms and the regulator) have only a subjective perception on such a cost. Consequently, there is both horizontal and vertical asymmetric information, and each polluting firm can strategically manipulate both the competitor and the policymaker's prior cost perceptions. We show that if the policymaker's ecological conscience is sufficiently high, polluters wish to be perceived as low-cost firms and, to this end, they will produce a high output level and they will emit a high emissions level. Therefore, optimal pollution taxes are higher than would be the case if firms' costs were not signaled in such a manner as to force low-cost polluters, in an attempt to distinguish themselves from high-cost polluters (by increasing their output level and their emissions level), to reduce the distortions in their production and also in their emissions levels. By contrast, if the policymaker values environmental quality less than consumption, environmental taxes become negative (a subsidy per unit of pollutant emitted), but each polluting firm continues to attempt to convince the other players (the rival firm and the regulator) that it is a low-cost supplier. In this case, if the quantity produced by each polluter signals its costs, over-subsiding holds as compared to the benchmark case of non-signaling.
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