Environmental regulation and tax evasion when the regulator has incomplete information

This paper analyzes the dynamic interaction between an environmental regulator and a polluting firm in a stock pollution Stackelberg game, where the regulator acts as the leader and the firm as the follower. The firm must determine the emissions required for production and pay a tax based on its reported emissions. The regulator chooses this tax on emissions to induce more environmentally respectful behavior of the firm. Evasion, defined as the gap between real and reported emissions can be discouraged using a fine. A central assumption in our analysis is that the regulator has incomplete information regarding the firm's objective function. The regulator does not know, but conjectures, how afraid the firm is of the fine for fraud. Based on this conjecture, the regulator estimates the firm's best-response functions and determines the tax. We compare the results when the regulator is accurate or misguided. Interestingly we find that when the regulator overestimates the firm's fear of the fine for fraud, social welfare can be greater than when he accurately estimates it.