In this paper we propose a leader – follower dynamic model of taxation with the government imposing a tax to internalize externalities caused by polluting firms. As expected the Stackelberg games with the government acting as leader yield time inconsistent outcomes. We first show how time inconsistency can be avoided adopting specific utility functions. We then propose a pollution model that uses abatement as the value of accumulated pollution stock and find that the outcome of the proposed Stackelberg model is time consistent with an open – loop informational structure.
