Controlling Brazil's Pollution: Federal versus State Taxes and Fines

This paper presents an analytical framework and numerical policy simulations that assess the relative role of federal and state governments in pollution control management in decentralized economies. The framework is designed as a multilevel Stackelberg game. It reproduces the hierarchical structure of pollution control policies in Brazil where the federal environmental protection agency (FEPA) relies on the State Environmental Protection Agencies (SEPAs) to ensure that federally defined minimum ambient standards are met locally. It is the replication of this incentive structure that makes this study Brazil-specific. This paper makes the case for a federal role in monitoring SEPAs pollution control performance as states face a trade-off between the desire to raise revenue from taxes on local output and the need to limit pollution due to production. It also shows to what extent fines and pollution taxes, assigned respectively to federal and state governments, can improve compliance of firms and SEPAs, and environmental quality without damaging or improving states' revenue. A model is applied to the food industry (as a representative of a clean industry) and the printing and publishing industry (as a representative of a dirty industry). The results of the model, however, have broader implications for pollution control of water systems in general.