metadata: authors: 0: author: Estache, Antonio
1: author: Zheng, Kangbin
count: Brazil
docna: 0: docna: Managing pollution control in Brazil : the
            potential use of taxes and fines by federal and state governments
docty: Policy Research Working Paper
subtopic: Environmental Strategy,Social Policy,Legal Products,Environmental & Natural Resources Law,Judicial System Reform,Environmental Management,Pollution Management & Control,Labor Markets,Disability,Services & Transfers to Poor,Economic Assistance,Legal Reform,Access of Poor to Social Services,Legislation,Regulatory Regimes,Brown Issues and Health,Global Environment
teratopic: Water Resources
abstracts: cdata!: The authors make a case for federal
            monitoring of state environmental agencies'
            (SEPAs') performance because of the tradeoff for the
            states between the need to raise revenue from taxes on local
            output and the need to limit pollution.  They also show that
            fines and taxes assigned respectively to the federal and
            state governments can improve firms' compliance and
            SEPA's performance, and hence environmental quality,
            without damaging state revenue, and perhaps even improving
            it.  For their analysis, the authors rely on numerical
            policy simulations based on an analytical framework designed
            as a multilevel Stackelberg game.  This framework reproduces
            the hierarchical structure of pollution control policies in
            Brazil, where the federal environmental protection agency
            relies on SEPAs to ensure that federally defined minimum
            ambient standards are met locally.  The numerical
            simulations are based on a case study of the food, and the
            printing and publishing industries.
geo_reg_key: 119228,517191
repnme: repnme: Managing pollution control in Brazil : the
            potential use of taxes and fines by federal and state governments
display_title: Managing pollution control in Brazil
            : the potential use of taxes and fines by federal and state governments
listing_relative_url: /research/1992/07/699644/managing-pollution-control-brazil-potential-use-taxes-fines-federal-state-governments
topicv3: Pollution Management m1326210 601,Environmental Laws and Regulations
            m1326889 849,Social Assistance m1327201 1466,Environment, Natural Resources and Blue
            Economy m1327391 566,Jobs m1503931 2670
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Water Resources
origu: Latin America and Caribbean: Country
            Department I
no_of_pages: 51
model_extractions: s~~~~~~~~~~~~

-rt9

<!-- Start of picture text --> : ~~Polley Research<br>Country Operations<br>WPS 929<br><!-- End of picture text --> This paper a product of the Infrastructure Division, Country Department I, Latin America and the Caribbean - is part of a larger effort in the region to design specific reforms that can assist governments in decentralized economies, such as Brazil or Venezuela, in dealing with unusual sources of policy failures in the area of pollution control. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Antonio Estache, room El0-081, extension 81442 (July 1992, 46 pages).

Estache and Zheng make a case for federal monitoring of state environmental agencies' (SEPAs') performance - because of the tradeoff for the states between the need to raise revenue from taxes on local output and the need to limit pollution.

They also show that fines and taxes assigned respectively to the federal and state governments can improve firms' compliance and SEPA's - performance and hence environmental quality -without damaging state revenue, and perhaps even improving it.

They rely for their analysis on numce wal policy simulations based on an analytical framework designed as a multilevel Stackelberg game. This framework reproduces the hierarchical structure of pollution control policies in Brazil, where the federal environmental protection agency relies on SEPAs to ensure that federally defined minimum ambient standards are met locally.

The numerical simulations are based on a case study of the food and the printing and publishing industries.

ThePolicy Research Working PaperSeries disseminates the findings of workunder way in theBank. Anohiectiveofthe series is to get these findings out quickly, even if presentations are less than fully polished. The findings, terpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced by the Policy Research Dissemination Center
Table of.Content*

|l.<br>Introduction.........<br>#<br>........................<br>e<br>v§*evo<br>v¢o*|_1_|
|---|---|
|2.<br>A Game-Theoretical<br>Framework to Assess Decentralized Environmental<br>Policy-making<br>...<br>0<br>..<br>0...000........0.....|3|
|2.1 Motivating the Choice of the Analytical Framework ..............<br>2.2 An Overview of the Model and of its Theoretical<br>Policy Implications<br>..** .......................................<br>|<br>3<br>4<br>|
|i.The firm's perspective<br>.....<br>....<br>..<br>...............|S|
|ii. The SEPA's perspective<br>.... .......................<br>iii. The FEPA's perspective<br>.......<br>.......<br>.<br>.<br>...........|8<br>.....<br>10|
|3. Numerical Policy Simulations for Brazil<br>........................|1....<br>l|
|3.1 Comparing Optimal Policies for "Dirty" and<br>"Clean"Industries<br>....<br>**.** ...........................................|13|
|3.2 Implications of Reforms for the Printing and<br>Publishing Sector<br>..<br>.*.......................<br>|17:|
|3.2.1 Which Government Level Should Try<br>to Improve Abatement Efficiency?<br>.......................<br>3.2.2 Do States React to Changes<br>in FederalFines?. **........**<br>...... ........ ...........<br>..|..<br>17<br>18|
|3.2.3 Why do Pollution Taxes Matter So Much<br>to All Levels of Government**....**<br>..............<br>**.**<br>......|21|
|4. Policy Lessons for Brazil<br>....O#**................<br>*...........|26|
|ANNEX: An Analytical Presentation of the Model .......<br>O**..*<br>............|...<br>29|
|_APPENDIXt Data_Issues ...<br>.....................................|44|

> * The authors wish to thank Gunnar Eskeland, James Falk, Asif Faiz, Anthony Fiacco, Cheikh Kane, Billy Jack, Sudhir Shetty and Vinaya Swaroop for their helpful suggestions and discussions. Salahuddin Ahmad provided competent research assistance.
**1. Introduction**

Pollution control is highly decentralized in Brazil. state governments are e~xpected to ensure that local water and air quality meet federal minimum ambient standards. This decentralization aims at greater autonomy in the implementation of federal guidelines. States can then select and design instruments, within boundaries defined by the Constitution, to achieve federal objectives. Most states rely on regulations such as licenses or standards to achieve their objectives. Fines on polluters are used commonly by the states but are generally not directly related to the level of pollution. In practice, the success of current policies has been limited as in most of Brazil, pollution is increasing. I Differences in decentralized implementation of federal requirements across states may reflect differences in administrative or financial resources available to monitor polluters. Weak implamentation may result from weak effective commitment to the pollution issue by the state or federal governments. States may have multiple objectives and their role as an agent of the federal government may be only one of those objectives. Other goals may include fiscal revenue targets or local jobs creation for. instance. Strong enforcement leads to lower output and hence reduces tax revenue, at least in the short run, by reducing the tax base and cutting jobs. Davis and Lester (1989) and Taylor (1990) provide surveys, respectively of the political science and the economic literature, analyzing evidence for the U.S. on the importance of interstate competition for investment or tax revenue based on the degree of enforcement of pollution laws. They show competition is not widespread but that when it occurs, its impact on resource allocation and mobilization is such that it cannot be ignored.

since the Brazilian experience of the eighties provides ample evidence of tax competition among states to attract jobs and investment across states, the interstate regulatory competition issue in Brazil deserves particular attention. In fact, as in many other decentralized economies, many in Brazilian states administrations would be willing to argue that they face a tradeoff between revenue and environmental quality. The underlying reasoning is as follows. The better a state's enforcement of federal requirements, the less polluted the state is but the lower is state net revenue. Net revenue is lower because output is cut, at least in the short run as capital has to be diverted from production to pollution control. 2 But net revenue is also lower because monitoring is costly and currently only yields trivial penalty returns. This sort of reasoning may explain why the degree of enforcement of pollution laws is often

**1. Foran** t erviewofissuesraisedbypollutioncontrolpoliciesinBazil, seestache(1990).

2. Since thenmodel focunseon the sitort rmnany output effect of technological improvementsbrought about by investment in pollution control is suted out.
2 .

-

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).
3 government intervention aiming at improving states<sup>and firms compliance with federal</sup> requirements. Section 4 summarizes the main<sup>policy conclusions and discusses their</sup> generality. An analytical prese$tation of<sup>the actual framework is provided az an Annex</sup> 0

# 2. A Game-Theoretical Framework to Assess Decentralixed<sup>Environmental Policy-iankiag</sup>

# 2.1. Motivating the Choice of the Analytical<sup>Framework</sup>

The institutional organization of pollution<sup>management in Brazil involves three</sup> levels of agents: the FEPA, the SEPAs and<sup>the firms aa illustrated by Figure 1. The</sup> FEPA relies on SEPAs to enforce federal environmental<sup>regulation. SEPAs supervise firms</sup> for.the FEPA but also see the firms as the<sup>source of tax revenue based on their output.</sup> Under the current institutional set up in<sup>Brazil, better enforcement of federal</sup> requirements implies, in the short run, lower<sup>output and hence state revenue. This</sup> assignment of responsibilities has then a<sup>built-in conflict of interest. In practice,</sup> the SEPAs do not collect directly the revenue<sup>from sales or production taxes, but their</sup> resources, including salaries, are paid from<sup>these sources of revenue. This is why the</sup> incentive structure of the three levels<sup>of agents needs to be carefully designed.</sup> <!-- Start of picture text --> _ ~~Federal EPA's .<br>Envlronmental Policy<br>SEPAs<br>Responses<br>Firm's SEPA's<br>output Environmental PoliCy<br>Level<br>and<br>Pollution Flrm's<br>Generation Responses<br>Firm's Behavior on<br>Pollution Control<br><!-- End of picture text -->

# Fiour. 1 The Policy Design System with Action Responses and Information Feedback

A key aspect of the incentive structure<sup>requires an assessment of information</sup> asymmetries. There are various sources of<sup>information asymmetries among the actors that</sup>
4 would require a careful aosessment. The source we focus on is the degree of monitoring-i.e how much is the FEPA going to monitor the SEPAs, and how much are the SEPAs going to monitor the firms?--.<sup>4</sup> Because of these asymmetries, Brazil's institutional structure for pollution control can be modeled as a set of multilayer hierachized principal-agent relationships. As pointed out by Tirole (1986), this hierarchal structure does not necessarily boil down to a compounding of the basic production inefficiency built in every pair of principal-agent relationship.<sup>5</sup> This is because this more complex structure introduces the possibility of common interest between the SEPAs and the firms.6 When the SEPAs perform well as agents for the FEPA, firms' profits are cut and so is states tax revenue. Conversely, the SEPAs can improve both their lot and that of the firms by cutting on enforcement. The design of the incentive structure is further complicated by the fact that there is a limit on the pollution control effort that can be imposed on the firms. The exact limic depends on the extent to which the federal government in willing to trade-off environment quality and growth. Excessive punishment will close bubini=as altogether which the federal government does not want either. In other words, there has to be a restriction on the size of the fine and on the monitoring efforts.7 To figure out the desirable design of pollution management, the federal government has to take the initiative in gathering information on the behavior of the SEPAs and of firms. In game theoretical jargon, the FEPA is a Stackelberg leader, the states and the firms are followers in their relation with the FEPA and the three actors are playing a hierarchical Stackelberg game. Similarly, the SEPA is a Stackelberg leader in its relation with the firms.

2.2, **An** Overview of the Model and of **its** Theoreticr1 Policy Implications The model focuses on the vertical behavioral relationship between the FEPA, a representative SEPA and a representative firm. The FEPA is assumed to know the objectives of the states and firms. States maximize their tax revenue and firms maximize their after-tax profits. These "followers" may know little about the FEPA's 4. See Russell (1990a, 1990b) for other sources of information asymmetry relevant to the structuring of monitoring and enforcement isues.

**5.** Holmstrom and Tirolc (1989), pp 106-126, provide an overview of the very limited literature on hierarchies in the theory of the firm.

**6.** Tirole (1986) deals explicitly with collusion. We do **not** directly but implicitly **as** without changes in FEPA's behavior, the SEPAs would have an incentive to altnr its behavior in a way that also benefit firms. Laffont (1990) **also** adds the possibility of the ability of some players to design games with other members of the hierarchy **that** are not observable to the principal.

7. See Calvo nd Wellisz (1978) for a discussion of this limit in the context of the punishment of shirking workers.

8. A full description and discussion of the model is provided in the annex.
itention. They react to the FEPA's strategy selection and then deuign their optimal response. This reaction process is known to the leader, who take. it into account when it optimizes its own strategy. Through such an independent decision system, the leader res its own positional advantage to influence the follower's strategy selection and makes i' consistent with its o.in objectives. A similar reasonLng is applied to the role of the SEPA as a Stackelbe:g leader in its relation with firms.

iL The **firm's** perspective The firm's problem is as follows. It has a fixed capital stock **as** this is a short term model. It can use it either to produce or to abate pollution. **Its** production technology is associated with a pollution function. This function depend. on the output level and on the abatement intensity and technology. The "dirtier" the industry and the lower its abatement efficiency, the larger the investment in abatement required to satisfy the environmental protection legislation. Finally, the last component of the firm's problem is the profit function. The firm's profits are affected by two taxes: a value added tax and a possible pollution tax. The pollution tax is based on emissions and can only be levied if the SEPA checks the firm. In sum, it is the "effective" pollution tax that matters. This effective tax is the pollution tax corrected by the probability of the firm to be monitored. If the state never monitors a firm. Its effective tax rate is zero. In practice this is somewhat how fines work in many states in Brazil. A major difference is that fines are not directly related to actual emissions in Brazil. They are more related to the frequency of violation than to the intensity or toxicity. A better solution, currently under consideratLon in some Brazilian states, could be to relate the tax to potential pollution as derived from the composition--i.e. age, model, ...--of the capital stock. Firms would then get penalized for not adopting a cleaner technology.

Within this framework consisting of the fLrm's production function, pollution function and profit function, the firm is making a portfolio selection: how to allocate its fixed amount of capital to two different ends to maximize its expected profit? Shifting one unit of capital from production to pollution control has two effects: (a) it generally lowers the firm's output and thus its sales revenue; but (b) it reduces pollution and thus its potential pollution tax.

The firm chooses its investment in abatement by comparing the _marginal_ cost (MC) of abating pollution with the _marginal benefit_ (MB) of doing so. The marginal benefit is essentially the savings in pollution tax liability stemming from the investment in pollution control. it in determined by the pollution tax and the pollution intensity of the firm. The _marginal cost_ is reflected in the loss in after-tax profits **due** to
**6**

diversion of resources for pollution abatement. It is determined by the effective pollution tax and the investment in abatement.

The solution of the firw.'s problem leads to the following--many of them very intuitive--theoretical policy implications: I Policy Impilcation _is Xf the marginal cost of abatement is greater than the marginal benefit, then the firm will abate less._ <!-- Start of picture text --> MB, MC<br><!-- End of picture text --> <!-- Start of picture text --> , MC<br>MB<br>MB'<br>0 K C<br><!-- End of picture text -->

**Figure** 2 The Firm's Optimal Choice of Investment for Pollution Control

Figure 2 illustrates geometrically this policy implication. The marginal cost curve is linear in abatement investment (C) with a positive slope while the marginal benefit curve turns out to be horizontal since it does not change with the level of C. The firm's spending for environment protection will be zero if its marginal<sup>costis</sup> greater than its marginal benefit--e.g. the marginal benefit curve is MB'. This case will happen if: (a) the pollution tax rate is very low; (b) the SEPA does<sup>not comply</sup> with the environmental law frequently; (c) the environmental protection expenses<sup>are</sup> not efficiently used; or (d) the firm's production pollutes the environment<sup>inanot-</sup> easy-to-monitor way. In this case, the SEPA's environmental policy does not affect the firm's behaviors in aspending fundq for envirnnmental protection.<sup>This prompts</sup> corrections in either the firm's technical set-ups or the SEPA's inspection<sup>structure.</sup> The direction of policy changes, which affects the firm's behavior through its own optimization process, can be either increasing the marginal benefit or<sup>decreasing the</sup> 9 **.** Their **fonnsl** derivation is also provided in the Appendix.
_7_ marginal cost of pollution control as they Lncrease the marginal cost of polluting. These two options to change the behavior of the firm lead to the next six policy options: Poicvllication 2 _Given the firm's technical parameters (production technology, pollution intensity and abatement efficiency), the effectiveness of the SSPA's environmental policy is determined by the effective pollution tax_ rate _rather than by its nomin_l pollution tax_ rate. A _low inspection rate dirwounts the firm's liability on pollution tax._ Policy Implication 3: _If the SEPA has a maximum pollution tolerance level, the SEPA will have a minimum pollution tax rate. This rate should differ with the firms' production technology, pollution intensity and abatement efficiency._ Policy implication _4: With_ a _positive pollution tax rate, the more frequently the SEPA inspects the firm, the more the firm will allocate to pollution control._ Policy Imolication 5: _An increase in the VAT will also lead to short term reductions in pollution._ <!-- Start of picture text --> MC, MB MC, MB<br>MC~~~~~M<br>MB~~~~~M<br>l - -- -- X/f// MB' j/e < - MC'<br>MB ...... MB<br>0 ~C* C 0.. .<br>° ~C* C** C C* C*** C<br>(a) Increase in Emission Tax (b) Increase in Sales Tax<br><!-- End of picture text --> Fiouri 3 The Firm's Response to Policy Changes
8 Poligy ImpLi_a_ktIon 6: _If the structure of fines is proportiona) to the amount of pollution, subsidizing research projects on environmental protection or subsidies_ to _the purchase of more efficient abatement technology by firms, would improve the incentive of firms to invest in abatement._ P-olicy lmlication 7: Tax _rates, inspection frequency and research subsidie3 can b. used an substitutes to induce the firm to cut_ pollution.

Figure 3 compares the effects of a sales tax and of a pollution tax on the decision to invest in abatement. This result is driven by the short term nature of the model and full employment assumption of the model does not say much about the ranking of the instruments--a firm could react by cutting capacity utilization. Once capital becomes variable the policymakers -hould not view the two types of taxes as equivalent. The pollution tax dominates as it clearly addresses the externality.

# ii. The SEPA's perspective

The state government is assumed to emphasize its tax revenue which reflects employment, local output and regional development. It considers environmental quality as secondary to these macroeconomic objectives. Knowing the whole process of the firm's decision making, the SEPA decides an inspection frequency to monitor the firm's performance on environmental protection. Its optimal monitoring choice is determined by a comparison of its marginal costs and its marginal benefits of monitoring as shown in Figure 4 (ii).

-

The marginal cost consists of three elements: the marginal (and average) cost of conducting inspection, the marginal reduction of the value-added tax revenue, and the marginal tax loss due to shrinking of the pollution tax basis. The marginal benefit of inspection comes from two sources: the increase of pollution tax actually collected, and the savings of the otherwise-paid expected penalty to the federal government.

The trade-off the SEPA faces is that on one hand, a harsh monitoring scheme induces the firm to reduce its productive capital and its output level and thus decreases the SEPA's value-addeL wax revenue. It also reduces net revenue as monitoring costs increase. On the other hand, it may increase the SEPA's tax collection from pollution tax and avoid possible penalty to the federal governr,ient if the FEPA finds out that the SEPA does not monitor the firms. The importance of thic cost depends on the federal inspection efforts.
9 If the pressure from the federal government is small--i.e. the FEPA ignores completely how well the SEPA doee its job-- as is currently the case in Brazil, the SEPA's marginal cost of inspection will surpass the corresponding marginal benefit. This is represented in Figure 4 (i). It means that the SEPA should not spend any time monitoring the firms. At the other extreme, if the marginal cost of monitoring is very small, the SEPA should do a perfect monitoring job as shown by Figure 4 (iii).

<!-- Start of picture text --> MB, MC MB, MC MB, MC<br>< MC \ j MC MC<br>~~MB M8D M 1MB ~ ~ ~ M<br>0 I0 0 0 IOO 10<br>(i) Complete Ignorance (ii) Interlor Sele^tion (iil) Complete Compliance<br><!-- End of picture text --> Fiaure 4: The SEPAs' Monitoring Choi'ze How the FEPA could react to this set of possible of outcomes, is summed up in the next three policy implications of the model and illustrated in Figure 5: Policy Implication 8: An _increase in the federal penalty or inspection level will raise the SEPA incentive to comply with its_ obligations _and increase its own monitoring frequency--thus reduce pollution.-_ Policy ImDlication _9: Subsidies to cut the states' monitoring costs would lead the SEPA's to monitor more frequently and would hence reduce pollution._
10 <!-- Start of picture text --> MB, MC MB. MC<br>Iv MC IIMC<br>N 1X'MB<br>MB M<br>0 0 1 0 o 0 01<br>(I) An Increase In the penalty level (il) A reduction in tMe regional<br>or the federal authoritys authority'smonltorlnt cost<br>inspection frequency<br><!-- End of picture text --> Figure S: Impact of Changes in Federal Fines and Monitoring Costs on the SEPAs Policy Selection Now consider the case in which the federal government has an<sup>upper bound for the</sup> level of pollution it is willing to live with. Just like a pollution<sup>ceiling had an</sup> effect on the optimal effective pollution tax rate for<sup>the states, a federal pollution</sup> ceiling has an impact on the optimal federal fine.<sup>More specifically:</sup> Policy Imolication 10: _If the FEPA has a maximum standard for the pollution Intensity In the environment, it can define a set of appropriate penalty level and inspection rate such that its target on environment protection can be achieved through changes in the behavior of states and hence of firms._ iii. The FEPA'. perspective The Federal government--represented by the FEPA-- wants to promote growth but also wants to keep pollution under control. The model allows to simulate<sup>various levels</sup> of distaste for pollution. This can be used to simulate the changes in the expected behavior of the FEPA that would result from changes in pressure intensity from the
11 population or from organized<sup>lobbies. It relies on the SEPAs to ensure that the firms</sup> comply at least with the minimum<sup>federal environmental requirements. To ensure that the</sup> SEPAs do their job, it needs<sup>to inspect the states and may consider to oomehow fine the</sup> poor performing states.<sup>The FEPA picks its monitoring rate by comparing its marginal</sup> costs of inspection to its marginal<sup>benefits.</sup> The FEPA's marginal cost<sup>of monitoring is composed of (i) its marginal (and also</sup> average) cost of conducting<sup>monitoring, (Ui) marginal utility loss from reduction of</sup> the firm's output, and (iii)<sup>the reduction of the expected penalty collection from the</sup> SEPA. The FEPA's marginal<sup>benefit includes the marginal utility from the reduction of</sup> pollution level and the marginal<sup>increase of the expected penalty collection due to its</sup> harsher monitoring. The<sup>understanding of the composition of the marginal cost and</sup> benefits leads to the last two--and<sup>rather obvious-- policy implications:</sup> Policy Implication 11: _The_<sup>_more the FEPA dislikes pollution, the more often the_</sup> _FEPA will monitor the SEPA's_<sup>_performance and hence the lower pollution will be._</sup> Policy Implication _12: Reducing_<sup>_the FEPA's inspection cost will contribute to_</sup> _alleviate environmental pollution._ Therefore, a smaller inspection<sup>cost will reduce the PEPA's aggregate marginal</sup> cost of inspection<sup>and thus raise theFEPA's optimal inspection rate.</sup> In response to this federal policy change,<sup>the SEPA will adjust its monitoring</sup> frequency. Consequently, the firms'<sup>portfolio is altered and the pbllution intensity levelis</sup> reduced.

# 3. Numerical Policy Simulations<sup>for Brazil</sup>

This section presents<sup>numerical simulations illustrating the practical importance</sup> of some of the policy<sup>conclusions derived from the theoretical model. The PimulatLons</sup> focus on sectoral data<sup>at firm level data are not available. They require data on</sup> sectoral capi_al stocks,<sup>outputs and an indicator of the pollution intensity. These</sup> data are not available<sup>for all sectors as discussed in the Appendix. The data</sup> available, however, allow<sup>a rough (OLS) estimate of the production function for a few</sup> sectors. This provides<sup>the basic technical parameters representing the efficiency of</sup> productive capital. The<sup>abatement rate of the pollution control investment canbe</sup> selected exogenously<sup>to reflect its reduction efficiency. The policy parameters are the</sup>
12 value-added tax rate, the pollution tax rate, the mc.nitoring costs for the SEPA, the inspection costs for the FEPA, the federal penalty level and a coefficient reflecting the relative level of the federal government aversion to pollution.

The weakness of the data base implies that the specific numerical results obtained here are not robust enough to be able to make specific recommendations on policy decisions such as the optimal federal fine or inspection rate or on the optimal pollution tax or monitoring rate. The numerical results are however robust enough to illustrate the importance of some specific aspects of the design of pollution control policies such as the size of fines or of the pollution tax, the differences in monitoring and inspection requirements of dirty and clean industries or the potential role of subsidies to the firms or to the states.

The illustration focuses on the Printing and Publishing sector as a representative dirty industry and on the Food sector as a representative cleaner industry as shown by Table 1. For these two sectors, the coefficients of the production functions were statistically significant. They are likely to be somewhat outdated however as they are based on data for the seventies. For pollution intensity, we relied on series prepared by David Wheeler and his team in the Environmental Department of the World Bank. The series provide measures of toxicity per sector in the U.S. When applied to Brazilian production data, they provide an indicator of the absolute level of pollution generated by each sector in the sample.1<sup>0</sup> The estimates suggest that Printing and Publishing is a much more polluting industry than the food industry per unit of capital. However while it is also much more polluting per unit of output, it is actually somewhat less polluting that the Food sector when production levels are accounted for. The Food industry is indeed much larger than the printing and publishing industry in the country. In absolute termsg both sectors are in the top 5 polluting sectors for the sample selected.

This section is organized as follows. It first presents a detailed discussion of the optimal inspection and monitoring policies for the two case studies. Next, focusing on the dirty industry, Printing and Publishing, it provides simulations of the importance of fines, VAT rates, pollution tax rates and abatement efficiency levels for the success of pollution control.

10. **The** selection of **the** sample **was** based on the infonnation available to estimate the capital **stock.** Only those sectors in the SffC categories for which capital stock could be estimated were rtined.
13

# Table 1: Rankins of Pollution<sup>Intensitv for a Samnle of Industries</sup>

(1980)

|.*..*...<br>*.................:~~~|~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~::..|. ...<br>:...<br>.. .|
|---|---|---|
|Leather & Products|1|6<br>|
|Plastic Products|2|2<br>|
|Printing & Publishing|3|5<br>|
|Other Paper Products|4|1<br>|
|Drugs & Medicine|5|11<br>|
|Non-Ferrous Metal|6|3<br>|
|Furniture|7|9<br>|
|Wood Product|8|7<br>|
|Other Textile Products|9|8<br>|
|Rubber Products|10|10<br>|
|Transport Equipment|11|12<br>|
|Food Products|12|4<br>|
|Tobacco|13|14<br>|
|Beverages|14|13|

# 3.1 Comparing Optimal **Policies**<sup>for "Dirty"</sup><sup>**and**"Clean" Industries</sup>

This section illustrates<sup>the differences in the optimal federal and state</sup> behavior in the treatment of<sup>clean and dirty industries. The abatement efficiency is</sup> supposed to be twice the value<sup>of pollution intensity (w</sup><sup>_-_</sup> 2 4' in the notation of the Annex) in each one of the sectors.<sup>This arbitrary choice does not affect thecore</sup> of the results as will be clear by<sup>the end of this section. This means--from equation (4)</sup> in the Annex--, that to completely<sup>eliminate pollution in either sector, the maximum</sup> share of investment in pollution<sup>control in total capital should be 33.3%. In addition</sup> to the difference in terms of 4,<sup>the sector differ in the productivity of capital and</sup> in the level of output. A summary<sup>comparison the results is provided in Table 2.</sup> The discussion focuses on<sup>the impact of optimal inspection and monitoring</sup> policies on private investment<sup>in abatement, output, pollution and on federal and</sup><sup>**state**</sup> revenue implications of pollution<sup>control. Most cases are normalized to the valuetaken</sup> by that variable when there<sup>is no federal inspection and no state monitoring.</sup> The model is solved for each<sup>one the three agents. First, the utility of the</sup> federal government, a proxy for<sup>the economy's social welfare, is computed asafunction</sup> of the SEPA's inspection of the firms. In the<sup>model, the inspection rate increases from</sup> 0% to 100%, steppLng with 5%.<sup>Since the federal utility level varies with its degree</sup> of aversion, X, the utility is calculated<sup>for three degrees of aversion to pollutions</sup> no aversion (X=O), low aversion (X= 0.1), high aversion (X=1). For food, the optimal
14 no aversion (X=O), low aversion (X= 0.1), high aversion (X=1). For food, the optimal degree of federal inspection varies with X from 10% to 100%. It reaches 100% for a high degree of aversion. For Printing and Publishing, it requires less than perfect inspection only when there is no aversion to pollution. Thia suggests that even at very low levels of aversion, the federal government should allocate more resources to inspecting the states' monitoring of dirty industries.

To every degree of federal inspection corresponds an optimal degree of state inspection. This optimal degree of inspection does not necessarily match the first best policy for the state. In fact, states revenue will be less when SEPA's choice of monitoring efforts is constrained by the federal leadership as shown by Table 2. For Food, it will be at least 10% less (167%/186%), for Printing & Publishing, it will be 48% less (75%/143%). In the case of the clean industry, the revenue from the pollution tax can however be sufficient to offset the loss from VAT revenue. Only when the FEPA is very averse to pollution will it lead to a lower revenue than without any monitoring. This is precisely why when the FEPA is very averse to pollution or when the industries are very dirty, federal inspection rates have to be perfect (100%). In addition, if the FEPA does not monitor the SEPAs, they will tend to monitor more frequently clean industries than dirty industries. The unconstrained optimum state monitoring is 45% for food but 40% for Printing and Publishing.

Similarly to every degree of state monitoring corresponds an optimal firm behavior which leads to a specific combination of output and pollution. This combination is in fact driven by the effective pollution tax rate. For a given nominal tax rate, a minimum level of state monitoring is required to ensure that the firms start investing in pollution control. It is 44.9% for the clean industry and 3.4% for the dirty industry. This is due to the much larger revenue payoff of a control of the dirty sector. It also reflects the fact the optimal federal fine on states for failing to monitor firms is larger the dirtier the industry." The process just described is known to the FEPA. Hence, based on the impact of its inspection efforts on the states and on the firms, behavior, the FEPA picks the inspection rate that will lead to a combination of pollution and output that maximizes the social welfare function. The optimal degree of firms monitoring by the states is the degree at which federal utility is maximized. Once more it depends on the federal aversion to pollution. The stronger the federal aversion to pollution and the dirtier the industry, the larger the monitoring effort required from the state. The state's 11. **Tne optinuI** federal fine is defined **as** the fine level **such** that if federal inspection b perfect, it will induce perfect monitoring of **firms** by the sttes.
is posltion reflects a combination of the impact of federal fines, and net revenue from states VATs and pollution taxes. The share of capital allocated to pollution control by the flrm iL then based on the degree of state monitoring and the pollution tax rate. These influence the output level that will maximize profits. The output level and the abatement efficiency of capital then determlne the new pollution level.

In addition to the lmpact on profits, pollution control reforms would also change states' revenue and have implications for the federal budget. The implications on the state's budget depend on VAT revenue, net pollution tax revenue and the fine levels. VAT revenue are offset by the lncreased net revenue from a pollution tax. Revenue needs to be considered on a net basis as monitoring is not free. There _is_ however no rellable data on monitorlng cost at this stage and these are not considered important in the simulations presented above. We define an optimal penalty level instead. Flnally, the effective fine set by the FEPA also contributes to determine the states' choice. It reflects both the level of the fine and the monitoring efforts discussed above. In general, the level of the optimal fine will also depend on the polluting nature of the sector. Assuming flxed common standards for all industries, the dirtier the industry, the larger the fines should be. This holds even if in absolute terms the Food sector generates more pollutlon than the Printlng and Publishing sector. In budgetary terms, it means that if the federal government is even mildy averse to pollution, lt wlll need to accept a deficit in its monitoring activities--i.e. pollution control has to be subsidized. _32_ In sum, Table 2 shows that the federal government should focus its inspection efforts on the quality of State's monitoring of dirty industries. This reflects the importance of federal averslon to pollution. But more importantly, it reflects the fact that to maximize net revenue and minimize the output losses implied by stronger monltorlng, without federal supervision, the SEPAs are more likely to focus on large clean lndustries than on dirty industries because of the combined VAT and pollution revenue is higher for those industries. To achieve this objective, the federal government may need to allocate resources to assume the cost implied by inspection as for dirty industries and/or high pollutlon aversion, inspection cost are generally larger than fines revenue.

12 **.** 'Me federal mnonitoring cost picked in the model **is** arbit;rily set at 10% of the value of the optimal federal fine.
16

# Table 2: Com2arino OntImal Policies for Dirty and Clean industries (Policies that Maximize the Federal Welfare)

|Optimal Federal Inspection|.......<br>.......<br>.<br>....<br>.|....<br>...<br>. . ....<br>. ....<br>.. . ....<br>...<br>...<br>**:...**<br>. . . .. . . . .. . . . .|
|---|---|---|
|<br>Rate for Various Degree of<br> <br>|||
|Averson<br>to Polution OM|||
|noaversion|10%|15%|
|lowaversion|45%|100%|
|highaversion|100%|100%|
|Ootimapl<br>StteMonitoring Rate|||
|With Federal Intervention|||
|no federalaversion|52%|100%|
|low federal aversion|71%|100%|
|high federal aversion|100%|100%|
|With noFederalIntervention|4S%|40%|
|InvextMgnt<br>in Pollution Control|||
|withFederalInterventionand|||
|no aversion|_5.5%_|19.7%|
|low aversion|14.3%|33.2%|
|highaversion|30.0%|33.2%|
|with no Federal Intervention|0%|12.6%|
|Minimum State Monitoring Required for|||
|<br>a Non-zero Investment in Pollution Control|44.9%|3.4%|
|Pollution Level (as % of current)|||
|<br>with Federal Intervention**and**|||
|no aversion|88%|49%|
|low**aversion**|_58%_|I%|
|high aversion|10%|I%|
|with noFederalIntervention|100%|62%|
|Value Added (as % of current)|||
|withFederalIntervention and|||
|no aversion|97%|93%|
|low aversion|88%|75%|
|highaversion|68%|75%|
|with noFederal Intervention|100%|96%|
|Stats Net Revenue**(s**_Y_of current VATrevenuel|||
|<br>with Federal Intervention and|||
|no aversion|167%|75%|
|lowaversion|101%|_75%_|
|highaversion|87%|75%|
|withno Federal Intervention|186%|143%|
|Feder Net Revenue<br>**(as**% of current VAT revenu|||
|<br>with Federal intervention**and**|||
|no aversion|14%|15%|
|<br>lowaversion|32%|-24%|
|high aversion|-37%|-24%|
|withno FederalIntervention|0%|0%|
17

# 3.2 Implications **of Reforms for the** Printing and Publishing Sector

# 3.2.1 Which Government Level Should Try to Improve Abatement Efficiency?

Abatement efficiency is a critical variable for the success of pollution control policies. Improvements in abatement efficiency could be a very successful policy as illustrated by Table 3. A tenfold increase in abatement efficiency could reduce pollution by 23% more while reducing output, as compared to a situation without pollution control, by only 3% instead of 21%. This stems from the fact that the maximum share of capital to be allocated to pollution control is cut from 67% to 17%. Social welfare will be maximized at levels of investment in abatement somewhat lower: 28% for an X of 0.5 and 11% for an w of 5.

These results suggest that the government should consider subsidies to the research in this area or assist the firms in acquiring more efficient abatement technology. It is unlikely, however, that the states will be willing to make the effort. Table 3 shows that, assuming that states only care about revenue, states would be better off with low efficiency abatement technology. A tenfold improvement in technology would cut the combined net VAT and pollution tax revenue to just over a third of what it would be without the improvement. In fact, the new revenue would be even somewhat lower than without any investment in abatement. This revenue erosion mostly reflects the reduction in pollution and in the optimal pollution tax rates."3 If state monitoring Costs were also important, they would further erode revenue as the optimal monitoring rate implied by the FEPA's position is more than twice the original requirement.

In sum, if a subsidy could contribute to the improvement of abatement efficiency available to firms, it should be considered by the Federal government rather than by the states. It should, however, compare the degree of improvement in technology to the cost of the subsidy. Doubling abatement efficiency would not achieve much in absolute reduction in pollution. But if the cost of a subsidy represents less than 8% of the current value added, it may be worth to consider it because doubling the original abatement efficiency would increase output by 8%.14

**13. Tho optimal** pollution **tax** rte is the rate rquired to cut pollution to 0 whenthc SEPAs are monitoring perfectly (100%).

14. An additional, mnybe nore audacious, conclusion from the samne data would recommend an approach to the selection of firms to monitor within a specific sector. Asunme that the technical coefficients-i.e. the marginal productivity of capital-for all the firms in the sector are the samt. Asme aloO that **fiwns** only **vary** in **terms** of pollution intensity. Ten **Table** 3 implies that the **firns** for which the increase in abatement efficiency can be the largest should be more likely to **be monitored** because **stte** monitoring requirements increase with abatement efficiency. In practical terms, this means that the SEPAs should keep firms with older capital in closer check than firms with more recent capital if it is likely to be less polluting. It also implies that if a subsidy is to be allocated for investment, they should go to the older firms first if they have the same narginal productivity of capital as the tnore recent firms.
18

|,e.,'<br>i.<br>'<br>in<br>'Aat.|ntEffic|ienc<br>R|at<br>:||
|---|---|---|---|---|
|Abatement**Efficiency Rate as**% of<br>**(C,ast **of<br>**P)**<br>|Pollution<br>|/capital<br>|||
|**50%**|100%|200%|500%||
|Foderal Xncpmaction<br>Required**(for**<br>**10094**<br>low pollution aversion; X-.1)|<br>100%|<br>100%|<br>100%||
|Federal<br>Penalty Level Required**an**<br>30.7%<br>**%**of originalVATrevenue|30.7%|**30.7%**|<br>**30o7%**||
|Net Federal Fine Revenue as % of<br>13.5%<br>original<br>VATrevenue (for a<br>conetant<br>fine)|<br>13.3%|<br>11.8%|<br>5.8%||
|Reculting State Monitorlng<br>**46%**|**48%**|<br>51%|<br>**71%**||
|Minimum Monitoring<br>required<br>**for**<br>firm toinvest**in**control<br>1.7%|2.3%|3.4%|6.6%||
|Net State<br>Revenue**as %**of<br>original<br>VAT**revenue**<br>251%|179%|<br>128%|<br>**98%**||
|Nominal Pollution Tax required to<br>reduce pollition to 0 with<br>perfect<br>SEPAmonitoring<br>10.4cts/lb|5.9cts/lb|2.6cte/lb|.7cts/lb||
|FlRM (at<br>the<br>level<br>of monitoring<br>implied<br>by the<br>**federal attitude)**|||||
|Inveotment<br>**in**Pollution<br>Control<br>as**%**oftotal capital<br>**28%**|**24%**|**16%**|<br>11%||
|Max.investment<br>**in**control<br>as a**t**|||||
|of total<br>capital<br>**67%**|50%|33%|<br>17%||
|Pollution Level am%of original<br>**55%**|55%|51%|<br>32%||
|Value added**am**%**of original**<br>**79%**|**87%**|**93%**|<br>**97%**||
|<br>3.2.2. Do States React to**Chanoes in**Federal F<br>The previous set of simulations establ|ines?<br>ished that|for dirty|industries|, the|
|federal government should monitor the states pe|rfectly whe|n the fines|are set at|**their**|
|optimal<br>level.<br>**But what**if the<br>fines<br>cannot<br>**be**|**set**at the|optimal<br>leve|l?<br>**This**im|plies|
|that the effectivefine,<br>considering<br>both inspe|ction andfin|e<br>levels,|will**also**be|**sub-**|
|optimal.<br>**This**will<br>**reducethestates'**<br>**incentive**|**to**adopt<br>the|<br>monitorin|g rate that|will|
|manituite<br>**social**welfare.**Since ltis**generally|**unrealistic**|to assume|that<br>**fines**|will|

. 3.2.2. Do States React to **Chanoes in** Federal Fines?
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>
20 conditionality for the disbursement of the grant could be related to the monitoring efforts of the states. The reduction in the grant amount for non-compliance would be equivalent to a fine. Now, it in politically unrealistic to asaume that the fine could wipe out state revenue or even anything close to half these revenue. But the magnitude ot' the costs of some of the projects--think of Guanabara in Rio de Janeiro or Rio Tiete in Sao Paulo-- is so impressive, that the federal grant component could easily reach a third of the tax revenue of a state for any given year. In those cases, fines would be in the range defined by the second and third column of the Table. However, the improvements in pollution levels achieved by the fine are not significantly higher than those achieved from the pollution tax only.

|.<br>Table<br>4:<br>atofh|<br>**e.in**|<br>**te;ede**|**ral li**<br>**_i_**|**_._**the**_Stt:_**||
|---|---|---|---|---|---|
||F|ederal Fine a|s % of origin|al States'|VAT Revenue|
||**Q**|L0.0515.3%|30 7|315%.3%|<br>246.1%|
|Utility Naximizing<br>Inspection level for low<br>pollution aversion|0.0%|100%|<br>100%|100%|<br>100%|
|Social Welfare (% of Case<br>with Fine-0)|100%|163%|223%|592%|<br>746%|
|Net Federal Fine Revenue<br>as % of original VAT<br>revenue|0.0%|6.4%|11.8%|16.9%|<br>-24.5%|
|STATE||||||
|Resulting State Monitoring|44%|48%|51%|79%|<br>100%|
|Net State<br>Revenue<br>as% of<br>original VAT revenue|144%|135%|128%|85%|<br>92%|
|Nominal Pollution Tax<br>requiredto cut<br>pollutlon<br>to 0 w/ perfectSEPA<br>monitoring|2.6cts/lb|2.6ctu/lb|2.6cts/lb|2.6ct5/lb|2.6cts/lb|
|Investment in Abatement (%<br>of total capital)|14t|15%|16%|26%|<br>33%|
|Pollution (% of original)|57%|55%|51%|32%|<br>5%|
|Production (% of original)|95%|94%|93%|84%|<br>75%|
21 In sum, fines are necessary to establish the credibility<sup>of the federal</sup> government penallzation of states that do not assume their<sup>monitoring role with enough</sup> conviction. However, to cut the pollution levels significantly<sup>below the reduction</sup> achieved by the pollution tax, fines may have to reach<sup>levels politically unrealistic.</sup> Their value is hence somewhat limited and mostly complementary<sup>to the impact of the</sup> introduction of a pollution tax at the state level.

# 3.2.3 Why do Pollution Taxes Matter So Much to All Levels<sup>of Governments?</sup>

The discussion has so far shown that the pollution tax<sup>is a crucial component of</sup> the success of decentralized pollution control. But previous<sup>results have shown that</sup> the optimal pollution tax will vary across rectors. For instance,<sup>the larger the degree</sup> of abatement efficiency available to the firms, the lower<sup>the required optimal tax</sup> rate.1' The optimal rate also varies with the pollution intensity<sup>of the sector. The</sup> cleaner the industry, the larger the "legal<sup>"</sup> tax rate required.17 For instance, the optimal federal inspection level would lead to an optimal pollution<sup>tax rate in the</sup> Food sector about 4 times larger than in the Printing and Publishing<sup>sector. This is</sup> driven by the lower minimum monitoring requirement for the cleaner<sup>industry. But since</sup> in practice the pollution tax rate is likely to be uniform,<sup>it is useful to see what</sup> happens when the rate is not optimal. This is illuntrated<sup>by Table 5."8</sup> The most interesting result of Table 5 is that, for a given constant federal fine level equivalent to about 15% of VAT revenue, the optimal<sup>inspection rate for the</sup> federal government is 0 for very low pollution tax rates.<sup>This is because the FEPA</sup> knows that to maximize revenue, the states would<sup>have to monitor perfectly. This</sup> 16. Relying on the Inteipretation of abatement efficiency given in **footnote** 21. **It** suggest that the older the capital<sup>stock,thelarger the</sup> abateenw efficiency Is likely to be to have the firm meach levels of emission per unit of capital comparable to firms relying on newer technolosy. If this Interpretation holds, it Inplies that the older fimsm should be taxed<sup>lessthat the newer firms.Thismeans that when firms have to make</sup> _new_ investment decisions, they'd better consider the fact that they<sup>will be more penalized that in the pact for not being up tosndardswith the</sup> latest development in pollution reduction built in capital.

17. Togetthis optiml taxrate,takeequatiot (i1),etthetalOO%andP=Oandthensolveforthepollutiontax. Remebertatths firm isnfluenceby the effective tax rate which correspondsto the nominal tax<sup>fate weighted by the degee of monitoring. When monitorng is perfect,</sup> the effective tax rate is equal to the sttutory tax rate.

18. The reults are convuted for an abteent efficiency of 2 and a Federl Piinc level of<sup>_IS.3%_the originalsalestax rvenue.</sup>
22 results obtains because monitoring costs are asoumed to be small. Larger costs would qualify these conclusions."1 These results however also give food for thoughts if the federal government is willing to consider suboidies of the monitoring activities. Table 5 suggeots that, for a given level of sales tax revenue, as long as monitorlng costs do not offset the revenue from pollution taxes, the states will have an incentive to monitor to capture the potential pollution tax revenue. While this is not addressed explicitly in this version of the model, this implies that the federal government should compare the costs of inspecting the states against the cost of subsidizing monitoring by the states.

|Tib**l**e.5:<br>Y c<br>o.rcnce-ofrPollut<br>tiiio'n'Tes<br>f'or<br>|<br>"POAlut<br>Po<br>|ins<br>Cotr<br>llution**T**<br>(in cts|**ax**Rate<br>/lb)|
|---|---|---|---|
|2.63|0.10|1.00|10|
|Utility Maximizing Federal Inspection<br>level for low pollution aversion<br>100%|0%|0%|<br>100%|
|Net Federal Monitoring Revenuae<br>as % of<br>state revenue)<br>6.4%|0%|0%|12%|
|STATB||||
|Federally mandated State Monitoring<br>48%|100%|100%|<br>11.3%|
|MLnimum monitoring required for firms to<br>3.4%<br>invest in abatement|89.2%|8.9%|0.9%|
|NetState<br>revenue as %oforiginal VAT<br>revenue<br>135%|107%|143%|127%|
|FIRM (at the level of monitoring implied<br>by the federal attitude)||||
|Investment in Pollution Control as % of<br>total capital<br>15%|0.14%|11.88%|11.89%|
|Pollution Level as % of orLginal<br>55%|99.58%|64.37%|56.72%|
|Value added as % of original<br>94%|99.99%|96.35%|94.78%|

19 . This will be addresed in a follow-up paper which will include a diacuaion of eltemative modes or fuuncing of thea **cos** and their incidence on the federal and stte budgets.
23 Table 5 also shows that leaving the selection of the pollution tax rat- to the state may not be in the best interest of the environment. Setting the tax at I cts/ lb of pollutant for instance would lead the state to monitor perfectly but would not provide the incentive for the firm to curb pollution as much an it could. The firms will invest less in pollution control than under an optimal tax of 2.6cts/lb. The reason why there is a risk to leave the choice of the tax rate to the state is that by choosing a low rate, the state can collect more revenue than by choosing the optimal tax rate while still. complying with the 100% monitoring requirement of the federal government. This leads to more saleo tax revenue for the state but also to higher pollution levels because a lower than optimal effective tax rate is equivalent to a lower than required incentive for firms to invest sufficiently in pollution control. In other words, the marginal benefit of investment in abatement in terms of reduced pollution tax liability is lower than the marginal cost driven by the reduction in value added and hence profits.

There is however an additional important consideration for the design of the pollution tax. It is unlikely that the federal government will be able to set the tax at its optimal level for every sector. In general, the pollution tax should be a single flat rate tax to maintain it manageable. The effective tax rate will be adjusted by diversifying the monitoring effort. As mentioned earlier, thls monitoring effort can be oriented by the federal inspection rate. The process however depends on the statutory tax rate defined in the law. What happens to those setors for which the legal rate is higher than the optimal tax rate? Setting the tax rate too high as compared to the optimal may also cut the SEPA's incentive to perform well a monitor of the firms as shown by the last column of Table 5. But more importantly it cuts so much into profits that it reduces both the tax base for the VAT and for the pollution tax.

Take the case of the dirty industry when the federal fine is set at about 15% of the state revenue level and the abatement efficiency is twice the pollution intensity. The optimal pollution tax is then 2.63cto/lb. The revenue from the pollution tax increases very quickly with the monitoring rate but then starts declining when the monitoring rate reaches 50%. Total revenue starts declining when monitoring is around 40%. However, if the pollution tax is lOcts/lb, both pollution tax and total revenue starts declining when monitoring rate reaches 10%. The only cases in the Aimulations discussed so far where this phenomenon is not observed was when the pollution taxes were very low. The peak pollution tax revenue was then reached for 100% SEPA monitoring of firms. When this "Laffer curve" of pollution tax revenue is observed, it is due to the
24 increase in investment in abatement that results from increased monitoring.<sup>While the</sup> Federal government may be satisfied by the existence of such a curve as it shows that the pollution tax base is shrinking fast, the states may not be as enthusiastic as their VAT base is shrinking and is not compensated by an increase in the pollution tax<sup>base.</sup> In fact, when the pollution tax rate is too high, the state never has an incentive to do more than what the Federal government wants it to do. Monitoring more than required cuts its revenue and may end up closing business as profits may turn negative at excessive tax rates. This observation contributes to justify the need for federal inspection. This last point is crucial because the dirtier an industry, the lower the required legal tax rate (as monitoring will be large), so the more likely that<sup>any the</sup> legal tax decided is likely to be excessive. In practice, it could also mean that<sup>the</sup> firm will start replacing investment in abatement by reduction in output as a mean<sup>of</sup> cutting pollution and hence the pollution tax base. In other words, the higher the tax rate, the more likely dirty firms are likely to drop out of the market.

The firm's switch from investment in abatement to plain reduction in output is however very slow. To be able to achieve a significant change in the firm's<sup>behavior as</sup> compared to the nnt-imal tax rate, the statutory rate had to be set at almost five<sup>time</sup> the optimal rate. This is because the elasticity of most of the important variables<sup>such</sup> as value added, investment in pollution control and pollution level<sup>with respect to the</sup> pollution tax rate are much larger at low levels of monitoring that at levels that go beyond the optimal rate as shown by Table 6. In other words, the tax starts working<sup>very</sup> fast on the firms' and states' behavior and then its effect starts<sup>to decline as</sup> illustrated by the last column of Table 6. It shows that the elasticity<sup>of the pollution</sup> tax revenue with respect to the effective tax rate changes sign as the<sup>effective tax</sup> rate reaches 50%.2 In practice, this is why penalties currently<sup>applied by Brazil's</sup> SEPA's are so successful but not quite enough. Indeed, most<sup>states rely on fines to</sup> penalize firms for non compliance. These fines work like pollution taxes in<sup>many states.</sup> Their level changes with the level of pollution observed during<sup>the random monitoring</sup> of the firm. In sum, it means that the state governments are in<sup>the right direction but</sup> thev are not going far enough. They could raise much more<sup>revenue by increasing</sup> monitoring efforts and at the same time achieve improvements in<sup>the environment.Their</sup> behavior is driven by the mistaken belief that stronger effective<sup>tax rates, reflecting</sup>

**20. bis holds for the assumptionsbuilt** in the Table which represent the optimal **situation for a** fine Ievel of I5% of _VAT_ revenue and abatement efficiency of 2.
25 higher fines or better enforcement would lead to less tax revenue. In fact, as shown by Table 5, they are more likely to err by setting the effective rate too low than by setting it too high.

A last important aspect relating to the pollution tax **is** also provided by Table 6. It shows how fast the pollution tax works. While its stronger impact on investment in abatement is at low effective tax rates, the major impact on value added and on pollution intensity is at high effective tax rate. This also makes the case for a combination of monitoring and statutory tax rates that is not too low if the tax is to have more than just a revenue effect but is also expected to improvement the environment.

Table 6: Elasticity of the Main Variables with respect to a 1% increase in the Effective Pollution Tax Rate

|.<br>.......**.**|......<br>~~~~~~~,..<br>.,....<br>.....|||
|---|---|---|---|
|0%|0<br>0|0|0|
|10%|1.51<br>-0.01|-0.11|0.89|
|20%|1.20<br>-0.02|-0.25|0.75|
|30%|1.13<br>-0.05|-0.43|0.57|
|40%|1.09<br>-0.08|-0.66|0.34|
|50%|1.07<br>-0.14|-0.99|0.01|
|60%|1.06<br>-0.20|-1.48|-0.48|
|70%|1.05<br>-0.28|-2.30|-1.30|
|80%|1.04<br>-0.39|-3.91|-2.91|
|90%|1.04<br>-0.52|-8.60|-7.60|
|100%|1.03<br>-0.68|-216.38|-215.38|

To sum up, the discussion so far has demonstrated the critical importance of the pollution tax to the success of pollution management in a decentralized economy such as Brazil. It will however be impossible to set the rate at an optimal rate for all sectors and hence a flat rate will be required. The states will have to adjust their monitoring rate across sectors to differentiate the effective tax rate. While setting the rate too high may be preferable to setting it low, it may be important to recognize the political economy aspects of the tax. Brazil's firms are already facing a large set of tax instruments and adding a new one now may not be feasible. One approach would be to
26 simply systematize the use of fines and to design it as a predictable source of revenue for the states, thereby increasing its value as a complement to the VAT revenue and the incentive of states to improve monitoring to ensure collection of revenue from that sources. Even a sub-optimal a tax rate could achieve a significant contribution to pollution reduction in many of the most po'luting sectors.

# 4. Policy Lessons For Brasil

The key message of the paper is that the interactive system that characterizes the multiple levels of decision makers in Brazil's institutional structure for environmental protection can be incentive-compatible, as well as financially sustainable. However, this requires that instruments be used and assigned appropriately across government levels.

The model presented highly simplifies many of the issues of concern to policymakers in Brazil.<sup>2</sup> Hence, it does not provide very specific recommendations such as what the actual optimal tax rate should be if a pollution tax were to be adopted. The model accounts however for most core institutional aspects of pollution management in Brazil and hence leads to some suggestions for reforms in pollution management that can result in improvements in policy implementation and benefit both the states and the federal government. Up to now: i. IBAMA (Brazil's FEPA) has generally not been very enthusiastic about checking how well the states are performing their Constitutional assignment as monitors of the environment. Furthermore, IBAMA has not really relied on any systematic fine system to induce improvements in poor performing states. On occasions, federal matching grants for states construction projects have been overruled but the lack of transparency of the current system does not allow to suggest that this was related to the quality of states pollution control policies; Li. States have not been very keen on IBAMA (the Brazilian FEPA) checking what they are doing. They have been using fines as the equivalent of 21. For ingance, we did not explicitly model: (a) interrgional externalities; (b) inteffegionel **tax** competition; (b) optimal subsidies for pollution control; and (d) repetition of the game.
27 pollution taxes but not nearly as much as they could have to maximize revenue or should have to improve the quality of the environment. This reflected their fear of having firms closing their doors or the fear of losing sales tax revenue as a result of excessive pressure on the firms. They have also been very unpredictable in their relation with the firms;

- iii. The firms have used, very rationally, the extreme leniency shown by the states and the lack of involvement of IBAMA, to minimize their efforts to reduce pollution. The most polluting firms have invested when public pressure was strong enough to force them to do so but without monitoring from the SEPA they are unlikely to have much incentive to minimize pollution.

To cope with these facts, the paper provides two main policy recommendations. The first is that the federal government needs to keep a closer eye on how firms deal with the dirty industries relative to the clean industries. When states care mostly about revenue, they will tend to spend more resources focusing on less polluting industries. IBAMA can rely on a combination of 3 main instruments: inspection rates, fine levels and subsidies to firms for abatement or states for monitoring. If fines are high enough the federal inspection effort required should not be excessive in terms of budget requirements. In general, as realistic fine levels are unlikely to lead to full state compliance with monitoring requirements, the net revenue from increased inspection should be positive.A The second recommendation is an endorsement of the pollution tax considered by many states as an instrument to both reduce pollution and finance pollution control policies. The tax should clearly be a state tax rather than a federal tax if the states have to have a strong incentive to perform their Constitutional assignment. To avoid possible strategic behavior by states inconsistent with federal objectives, the federal government should probably set the tax rate. The rate sho-ild not be set too iow because low rates favor dirty or old industries for which large potential improvements in abatement are possible. The rate could be a minimum that states could reinforce it if 22 isinspectionrole could actually be assigned to the privatesector and cost recovery for their service **s** hould be oneof the corponent of the design of the fine.
28 they felt it was a way for them to compensate for lack of resources to ensure the monitoring requirements imposed by the federal government. Whatever the actual design of the tax, its implementation will improve the environment even if the FEPA does not inspect the states. There may be sunk costs required to acquire the monitoring instruments and to set up the infrastructure arn these may be cofinanced with the federal government. Except for those capital costs, the pollution tax could lead to self sustained industrial pollution control as its revenue potential is generally sufficient to increase states' net revenue even when losses in VAT revenue are accounted for. In many of the Southern states such as Parana, Sao Paulo and Rio de Janeiro, pollution taxes are being considered to curb industrial pollution." It is unfortunate that many of the poorer states are not considering that instrument. However small the industrial sector, the pollution tax will help. It could be paid by the agricultural sector but also by state water companies for instance, in many states they are responsible, directly or not, for a very large share of water pollution.

In addition tc these two main recommendations, the paper also makes the case for subsidies to improvements in the degree of abatement efficiency relied upon by firms as a way to reduce the short term growth costs of pollution control. The paper points to some of the limitation of pollution taxes in the "real world" as compared to the economist's world. A single flat rate across sectors is about the only administratively realistic approach to the tax. Its adjustment through monitoring to achieve the effective tax rate is essentially impossible. The directions for differentiation of monitoring efforts are however very jlear. As expected, the less efficient the firm's abatement technology and the more polluting the firms, the stronger the monitoring effort should be, for a given statutory tax rate.

23. Misufderdandings eabout **ome** of the inWtication **of** pollution taxes on state revenue or on output levels **may** explain why in Rio **de** Janeiro, for instance, the pollution tax **has** been proposed various **times** by the **SEPA** with a clear design but has never benefitted from the conlermntafy reguhtlo required for Its Inmlementation.