Socially Optimal Royalty Design and Illegal Logging Under Alternative Penalty Schemes

We study the socially optimal design of forest royalty and enforcement instruments in the case where concessions are allocated by a government, illegal logging incentives are present, and the government has available both area-based and value-based royalty instruments. When harvesters are risk neutral, the optimal policy mix depends on the presence of negative externalities and on the type of penalty scheme. For risk-averse harvesters the results differ. When the penalty is assessed on undeclared income, a royalty based subsidy is not optimal, but when penalties are levied on evaded royalty payments, the optimal royalty system may be progressive or regressive depending on the importance of the government's revenue constraint. Auditing is optimal regardless of the penalty scheme or presence of externalities, although its level differs. Accounting for negative externalities in the social welfare function implies a higher optimal royalty rate, but lower progression in the rate, and increased auditing.