Nonpoint source pollution and two-part instruments

As an alternative to the existing environmental policy instruments, recent literature proposes to combine different policy instruments (two-part instruments) which have most of the properties of a first-best Pigouvian tax while minimizing the need for monitoring and enforcement. This article explores the design and applicability of a policy based on two-part instruments to control nonpoint source pollution. Applying this approach, however, leads to a moral hazard problem, since it is not only the input itself that is responsible for the pollution but also the way it is applied. The analysis determines the optimal combinations of taxes and subsidies as a function of the ability to observe the output and the applied inputs. In an empirical illustration we determine the magnitude of the taxes and subsidies to establish the socially optimal level of nitrate emissions from livestock manure for a region in northeast Spain.