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We study the effect of environmental regulation (taxation) on emissions when the only available abatement method consists of product-mix changes. Firms choose to produce one or both varieties of a product-a pollutionintensive (dirty) and a non-pollution-intensive (green)and compete in a differentiated Cournot duopoly. We characterize the equilibrium market structure as a function of the tax rate and show that increases in the tax can promote product-mix changes that lead to a jump in emissions for some tax range, an effect we call the perverse effect of taxation. Our work emphasizes the key role horizontal product differentiation in this process and shows that the perverse effect does not require the presence of vertical product differentiation. Further, the perverse effect of taxation is especially strong in the presence of incomplete regulation, that is, when only one of the markets is subject to taxation. | INTRODUCTIONCan environmental regulation increase pollution? Command-and-control and market-based environmental policies provide incentives for polluting sources to reduce their pollution. 1 1 These incentives are borne out in both theoretical and empirical studies. For example, studies find that carbon taxes reduce CO 2 emissions (see Lin & Li, 2011 for a thorough review of the literature), that monitoring and enforcement of the Clean Water Act reduce effluent violations and discharges (see, e.g., Laplante & Rilstone, 1996;Magat & Viscusi, 1990;Shimshack & Ward, 2005), and more recently, that increases in the stringency of environmental regulation account for the majority of emissions reductions in the US manufacturing sector between 1990 and 2008 (Shapiro & Walker, 2018).