Political internalization of economic externalities and environmental policy

This paper derives the characteristics of endogenous environmental policy in a common agency model of politics, and proceeds to show that competition between lobby groups is an important source of internalization of economic externalities. Our analysis generalizes Bhagwati's principle of targeting to the case of distorted political markets. Moreover, we show that the politically optimal structure of environmental taxes incorporates a Pigouvian adjustment. However, since lobby groups care about the distribution of income as well as about efficiency, the equilibrium structure of taxes differs considerably from the Pigouvian rule. (C) 1998 Elsevier Science S.A.