Irreversibility, Uncertainty, and The Optimal Finance of Public Goods

This article analyzes the case where a government finances the supply of a public good via a tax on a private good which is produced and traded in a market where demand is stochastic, production requires an initial irreversible investment, and firms can choose optimally when to invest. The government problem is to find the tax rate that maximizes overall welfare, which is a composite of the welfare generated by the production of each of the two goods. The analysis reveals this optimal tax rate and enables characterizing it, as well as characterizing the equilibrium dynamics under the optimal tax rate. Of particular interest is the result that the higher the uncertainty regarding the demand for the private good the higher the optimal tax rate.

Yishay Maoz
The Open University
Israel