Imperfect observability of emissions and second-best emission and output taxes

This paper studies the second-best tax design problem when emissions are publicly unobservable but can be discovered through costly monitoring. A representative firm in industry chooses its emissions and declarations to maximize its expected profits. The paper shows: The Pigouvian rule of equating the marginal private benefit of emissions in production to the marginal social damage of emissions is modified to take account of the resource costs of monitoring and enforcement; emissions from different sectors must be taxed at different rates; every polluting good must face an effective emission tax that is less than the full marginal social damage of emissions; emission taxes do not reflect standard optimal tax objectives; output taxes have a Pigouvian role so that the targeting principle fails.