Payment for environmental services and environmental tax under imperfect competition

This paper designs the second-best Payment for Environmental Services (PES) when it interacts with a Pigouvian tax under market imperfections. Following Lankoski and Ollikainen (2003. "Agri-Environmental Externalities: A Framework for Designing Targeted Policies." European Review of Agricultural Economics 30 (1): 51–75), we study the optimal allocation of land between two crops with different environmental impacts and fallow land. The regulator sets a Pigouvian tax on the agricultural production generating environmental damage and a PES on uncultivated land, as fallow buffer strips promote biodiversity. We assume an economy with market power and distortionary taxation. We show that the second-best level of the Pigouvian tax is higher than the marginal damage, contrary to Barnett (1980. "The Pigouvian Tax Rule Under Monopoly." The American Economic Review 70 (5): 1037–41) whereas the PES is lower than the marginal benefit. The Pigouvian tax increases with the marginal social cost of public funds while the PES decreases with the marginal social cost of public funds provided that demand for the environmentally damaging agricultural good is inelastic. We thus highlight a contributory component of the environmental incentive tax. This paper also identifies specific cases where the PES is ineffective in promoting biodiversity.