Downstream Environmental Taxes and Upstream Innovation

In this article a model is studied that analyses a downstream environmental tax in the setting of two vertically related monopolists. The upstream firm supplies intermediate inputs to the downstream firm and can innovate in order to make these inputs cleaner in use, which decreases the tax downstream. This upstream innovation is effective in a decreasingly decreasing manner. This paper shows that for all relevant levels of taxes on emissions or inputs/production, the upstream firm will always choose to innovate. This result is not found for an environmental tax on value added. The innovation increases with the tax, up to a certain level of this tax. When a downstream firm has higher initial emissions per unit of production the upstream firm innovates more. Besides the innovation that the tax induces, it also decreases the production in the vertical chain more when the initial pollution downstream is higher. Competition downstream increases the amount of upstream innovation whereas the inclusion of an upstream tax besides the downstream tax decreases the innovation. The result of this paper provides insights for policymaking as the analysed tax captures both the static and the dynamic goal of environmental policy. Furthermore, it shows that taxes do not only have influence on the taxed firm itself, but also on a related firm.