DP16448 Corrective Regulation with Imperfect Instruments

Author(s): Eduardo Davila, Ansgar Walther
Publication Date: August 2021
Keyword(s): corrective regulation, financial regulation, leakage elasticities, Pigouvian taxation, policy elasticities, regulatory arbitrage, second-best policy
JEL(s): D62, G21, G28
Programme Areas: Public Economics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16448

This paper studies the optimal design of second-best corrective regulation, when some agents or activities cannot be perfectly regulated. We show that policy elasticities and Pigouvian wedges are sufficient statistics to characterize the marginal welfare impact of regulatory policies in a large class of environments. We show that the optimal second-best policy is determined by a subset of policy elasticities: leakage elasticities, and characterize the marginal value of relaxing regulatory constraints. We apply our results to scenarios with unregulated agents/activities and with uniform regulation across agents/activities. We illustrate our results in several applications.