An important contribution of economics to public policy rests on the precept that price signals should force producers of externalities to internalize the welfare of other economic agents. Pigou (1920)’s celebrated insight on the taxation of externalities provided an intellectual foundation for a variety of policies from pollution taxes/permits to experience rating. Pigovian taxation’s policy appeal is limited if the polluter has insufficient resources to pay the damage when it occurs. To defend Pigovian taxation in the presence of judgment-proof agents, its proponents point at the many institutions extending liability to third parties. Yet little is known about the validity of Pigou’s analysis in this context. The paper analyzes the costs and benefits of extended liability and investigates whether full internalization is called for in the presence of agency costs between potential polluters and providers of guarantees. Its contribution is two-fold. It first shows that the better the firms ’ corporate governance and the stronger their balance sheet, the more closely taxes should track the corresponding externality. It then develops the first analysis of extended liability when guarantors themselves may be judgment-proof and the extension of liability may give rise to further externalities. Relatedly, it derives the curvature of the optimal taxation of externalities in a multiplant firm
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