2 .

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negotiated between polluter and state environmental agencies and may be one of the sources of deterioration of Brazil's environment. 3 The _paler_ presents some reforms in the design of this decentralized pollution control management that could result both in improvements in pollution control and in state revenue. It shows how federal inspection of the states' environmental protect'on agency (SEPAs) performance could reduce the incentive for states to minimize the importance of pollution control. If SEPAs' poor monitoring allows the firms to pollute more, the SEPAs should be penalized by the federal government or its representative, the federal environmental protection agency (FEPA). The penalty could be a fine or could be a reduction in federal transfers. Another reform that should be considered is the introduction of a pollution tax to be collected by the states. The tax would not only increase the incentive of firms to comply with environmental regulation but also that of the states as pollution revenu3 would offset the loss from production taxes.

This interpretation of the interactions among agents is essentially impossible to test econometrically as data on the actual behavior of regulated firms, states or federal government in Brazil, as in most countries, are scarce. However, these strategic interactions can be illustrated and analyzed within a game-theoretical framework. It identifies circumstances under which the federal government can induce the firms and the states to comply with its requirements. A priori, these circumstances vary from sector to sector with factors such as pollution intensity of the production activity and the effectiveness of the abatement technology used by the firms. But there are additional factors that contribute to the success of decentralized pollution management. These are illustrated by some simulations discussed in the paper. For instance, since federal monitoring is not costless either, the federal government has to carefully assess circumstances under which it wishes to inspect the states. Firms know it and are likely to adapt their compliance efforts to the likelihood of being audited and to the federal monitoring efforts. Since the federal and states governments are aware of the firms' behavior, they adjust their policies to the firms' reactions.

The rest of the paper is organized as follows. Section 2 explains the choice of the analytical framework reproducing the strategic interactions between the three levels of decisionmakers: FEPA, SEPAs and the firms. It also provides an overview of the major "policy" implications of this framework. Section 3 presents the simulations for two sectors (Paper and Printing and Food) of the various forms of federal 3 **.** Other issues Include instrument selection **and** policy coordination across ministries. The issues raised by instrument selection are not addressed **here** specifically although somc of the simulations illustrate the potential or fines **and** pollution taxes to achieve pollution control objectives. A useful survey on instrument slection is provided by Eskeland and Jimenez (1991). Other aspects **of** policy coordination are reviewed in Jack (1991).