Tax Audit by Government, and Optimal Air Pollution Tax Rate

Abstract

This paper uses two-stage game theory to analyze the relationship between tax evaders and government regarding air pollution emissions. The production function of a firm in a perfectly competitive market was first considered. Then, the backward induction method and the Cramer rule method to determine the optimal subgame perfect equilibrium in the two-stage game and investigate the relationship between firms' tax evasion behaviour and tax variables. This study discovered that the stronger the spillover effect on firms engaging in air pollution control, the higher the tax rate levied by government should be. When firms are in a perfectly competitive market and the financial policy instruments (i.e., air pollution tax and subsidy rate) are known, the conditions for economic stability can be established.