Environmental Policy and Technical Change : Pollution Taxes , Access to Finance , and Firm Absorptive Capacity ∗

Firms respond to higher taxes on air pollution by increasing R&D and hence their capacity to absorb new technology. The R&D response to pollution taxation only appears after the taxes are introduced and is concentrated in sectors with higher pollution intensity and relatively immobile production technologies, suggesting a causal linkage. However, the R&D response is substantially weaker in the firms most likely to face financing constraints; small firms only adjust R&D when they have demonstrated access to external financing. Taxing activities with high environmental costs can encourage technical change, but these policies have heterogeneous effects across different types of firms.