The challenge of addressing consumption pollutants with fiscal policy

Abstract

The authors develop a theoretical model that elucidates the relationship between the quality of governance, the composition of government spending and pollution as a by-product of the consumption process. In particular, they determine the impact of government spending that alleviates market failure such as subsidies to the poor which reduce credit market failure and environmental regulations to correct for pollution externality. It is found that a shift in government spending towards goods that alleviate market failure has countervailing effects - consumption pollution rises due to increases in income, but consumption pollution also falls due to increasing environmental regulations. Conditional on the government adopting a democratic regime, the effect through environmental regulations outweighs the effect through income leading to lower consumption pollution. The authors estimate an empirical model and find that the results support their theoretical predictions.