19 be optimal, it is useful to<sup>see the extent to which the fine level matters.</sup> s<sup>5</sup> A3 set of simulations shows how changes<sup>in the level of federal fines, expressedasa</sup> percentage of the VAT revenue without<sup>pollution control, affects the main variableo of</sup> the economy.

First of all, it iQ clear that<sup>if the fine in trivial, the FEPA might aswell</sup> not monitor the states. In other words,<sup>if the federal government was to consider fining</sup> states as a policy instrument<sup>to improve the environment, it has to be willing to pay</sup> for this activity and include<sup>into its budgetary requests even if it is only somewhat</sup> averse to pollution.

Assuming that the fine level is<sup>directly linked to the cost of monitoringz-say</sup> 10 times for the purpose of simulations--,<sup>inspections will generally cost more than</sup> they will yield. The larger the<sup>cost, the larger the optimal fine to achieve zero</sup> pollution, but also the lower<sup>the effective fine as the threat increases and state</sup> compliance improves. Hence the<sup>largerthe</sup> federal deficit from its inspection operations. Fines do not have to be<sup>related to cost and if this were not the case, the</sup> FEPA may end losing less that suggested<sup>by Table 4. But it is likely to lose when state</sup> compliance improves as a result of<sup>perfect federal inspections. The social welfare</sup> payoffs of the changing combination<sup>of pollution and output increase with the fines</sup> levels. But the states end up worse<sup>off as the fines level increase.Thedeterioration</sup> is not due to an increase in the<sup>effective costs of penalties but to the reduction in</sup> net revenue. When federal fines are<sup>optimal, even pollution tax revenue is not enough</sup> to offset the loss from value added<sup>tax revenue and states net revenue drop to 94% of</sup> their original value. The absence<sup>of fines does not mean however, that the states will</sup> not do anything in terms of pollution control. In fact,<sup>as the next section will</sup> illustrate more clearly, the mere<sup>existence of the pollution tax, even atamodeet</sup> rate, is sufficient to lead to an<sup>improvement in the environment. For the specific case</sup> illustrated by Table 4, even when<sup>the federal government does not inspect the states,</sup> state revenue is 144% of what it<sup>would have been without the pollution tanand</sup> pollution is only 57% of its<sup>original level.</sup> From a practical aspect, fines can<sup>take several form. One form that it could take</sup> in Brazil would be a reduction<sup>i% Federal Transfers. This is particularly interesting</sup> in the context of pollution as the<sup>Federal government is cofinancing various operations</sup> with the states. This cofinancing<sup>often takes the form of a matching grant. Introducing</sup> 15 From an **dnistrativpoint** of view, the fine will hav to be unique or t wors be differentiated ccording th pollution tnity of capital of the setor and to pollution level. To derive<sup>the corresponding inimum rate of inspection required, take equation (24),</sup><sup>**at**the =to</sup> monitoring level to the minimum required to have **finns**<sup>invest in abatement</sup><sup>**and**the fine level selected, then</sup><sup>**aolve**for eta.</sup>