Optimal Regulation with Exemptions and Corrective Taxes

Regulation produces enormous benefits and costs, both of which are greatly influenced by myriad exemptions and preferences for small firms that contribute a significant minority of output in many sectors. These firms may generate a disproportionate share of harm due to their being exempt and because exemption induces additional harmful activity to be channeled their way. This article analyzes optimal regulatory exemptions where firms have different productivities that are unobservable to the regulator, regulated and unregulated output both cause harm although at different levels, and regulation and the exemption level affect entry and the output choices of regulated and unregulated firms. It also analyzes the optimal use of output taxation alongside such regulation — that is, optimal regulation with taxation, in contrast to the traditional comparison of regulation versus taxation. In many settings, optimal schemes involve subtle effects and have counterintuitive features: for example, incentives of firms to drop output to become exempt can be too weak as well as too strong, and optimal output taxes may equal zero despite the presence of externalities. When all instruments under examination here are admitted, a planner can achieve the first best, and in this regime optimal regulation is voluntary. JEL Classes: D61, D62, H23, J88, K20, K23, K32, K42, L51, Q58