Strategic pollution control under free trade

Highlights

• We develop a reciprocal dumping model to control industrial pollution between identical trading partners.

• We compare non-cooperative emissions tax decisions to the globally efficient cooperative solution.

• Strategic behaviors may endogenously lead to asymmetric tax rates in equilibrium.

• The tax rate under cooperation can be larger or smaller compared to the non-cooperative case.

• A country’s payoff in the non-cooperative case can be higher than in the cooperative case.

Abstract

This paper designs a reciprocal dumping model to address the control of industrial pollution between two trading partners. Firms generate transboundary pollution from production and environmental taxes represent the pollution control instrument. We ask whether environmental taxes implemented in a non-cooperative setting are more stringent than the globally efficient level. Relative to the globally efficient case, we find in the linear Markov Perfect Nash Equilibrium (MPNE) context that the tax rate for both countries is smaller and individual emissions are larger. However, these results may not hold in the non-linear MPNE case depending on market structure and environmental conditions. Unlike the symmetric equilibrium case, the tax rates are always discontinuous under asymmetric MPNEs. The asymmetric equilibrium scenario can give rise to higher individual payoffs relative to the symmetric equilibrium case.

Introduction

Are unilateral environmental policies aligned with free trade incentives? Those concerned with environmental outcomes often worry that competition from free trade will induce governments to soften environmental policies so as to gain a competitive advantage over their trading rivals. Such an inefficiency would be exacerbated by the tragedy of the commons in the context of transboundary pollutants. However, strategic policy decisions may work in the reverse way if countries strengthen environmental policies to enhance environmental quality or phase out polluting goods.

This paper attempts to formally address such a concern. Specifically, we investigate how non-cooperative pollution tax decisions affect environmental quality as compared to the globally efficient case in which countries coordinate in setting pollution taxes. We focus on the standard setting in which international firms produce a single homogenous good. In their production process, firms generate transboundary pollution (an international externality) that harms well being. The relevant authority of each country levies a pollution tax on local firms to control pollution. In this context, we address three main research questions. Do coordinated pollution tax decisions necessary induce a lower emission level? Is the pollution tax rate resulting from non-cooperative tax decisions smaller than that of the cooperative case? What are relative effects of coordinated and non-cooperative tax decisions on consumption and the pollution stock?

This paper builds on canonical dynamic pollution control models (e.g., Long (1992), Benchekroun and Ray Chaudhuri (2014), Dockner and Long (1993), and Nkuiya (2015)).¹ Such papers consider emission quotas as the pollution control instrument, concentrate on symmetric equilibria only, do not explicitly account for market structure, and assume that countries operate in autarky. This paper differs from these earlier contributions in three key ways. First, we consider the case where countries are involved in international trade and taxation is the pollution control instrument. Pollution taxes are important to consider because they involve different incentives than quotas for governments and firms. Taxes provide governments with revenue and producers with flexibility in balancing environmental effects and economic returns. Second, in addition to investigating the symmetric equilibria case, we also examine scenarios in which strategic interactions lead to asymmetric equilibria. Third, we consider an array of market structures ranging from international monopoly to oligopoly. We find that asymmetric equilibria or these alternative market structures give rise to novel equilibrium outcomes.

Our analysis is closest to the seminal papers by Hung (1994) and Kennedy (1994). These authors introduce taxes and a pollution externality to the model in Brander and Krugman (1983) to examine in a static setting how non-cooperative tax decisions affect environmental quality as compared to the cooperative case. Relative to the non-cooperative case, they find that for a transboundary pollutant the tax rate under cooperation is always greater and, correspondingly, environmental quality is higher. Duval and Hamilton (2002) later show that those findings remain valid even if firms in different countries have different production costs. Although these results are appealing, they are derived in a static framework and, thus, may not apply to stock pollutants such as carbon, methane, nitrous oxides, and other greenhouse gases. In these cases, pollutants accumulate in the environment over time and damages are a function of the cumulative stock.

To appropriately model a stock pollutant, we adopt a dynamic approach within a continuous-time framework. More precisely, the pollution stock evolves over time as a function of current emissions and natural decay.² We explicitly consider discounting, which allows decision makers to balance current and future net benefits of emission decisions and the relevant authority in each country to make inter-temporal tax decisions. We formally examine whether these new features of the model, unrepresented in static models, affect the outcome of non-cooperative tax decisions relative to the cooperative, or globally efficient, case.

We first derive tax rates, emissions, and pollution stocks under the cooperative policy, which serves as a benchmarkfor our analysis. We next characterize non-cooperative tax decisions when countries commit to linear tax strategies. This approach technically corresponds to the linear Markov Perfect Nash equilibrium in pollution taxes. Our analysis shows that for linear strategies, marginal damages are higher under cooperation compared to the non-cooperative case and, thus, that the tax rate under cooperation is larger. This implies that consumption, emissions, and the pollution stock are lower under cooperation. However, we show that the difference in emissions between the cooperative solution and the non-cooperative linear Markov Perfect Nash equilibrium may decline as the discount rate or the natural decay increases.

A striking and novel result emerges in the case where countries behave non-cooperatively using non-linear tax strategies. We show there are equilibria in which the tax rate under non-cooperation can be higher than under cooperation, at least in the short term. The key to this result is that non-cooperation can drive countries to equilibria in which they punish themselves with high taxes and low production, even when the pollution stock is relatively small. The case of non-linear tax rules is important to consider for two reasons. First, Jacobs and De Mooij (2015) note that non-linear taxes are commonly used for polluting consumption goods such as energy, citing examples from the Netherlands. Second, Tasneem et al. (2017) provide experimental evidence that the steady states in common property resource games are commonly within the range supported by nonlinear Markovian strategies.

Our analysis complements earlier papers that examine pollution taxes in a dynamic setting. For instance, the seminal paper by Benchekroun and Long (1998) derives (in a model where trade is ignored) the pollution tax policy that induces polluting oligopolists to adopt the socially optimal pollution path. In addition, Yanase (2010) examines the impact of trade on environmental policies by contrasting policies under autarky and trade. To our knowledge, our paper is the first effort to examine potential departures of non-cooperative pollution tax decisions from cooperative decisions in a setting where the stock of pollution is time-dependent.

The paper unfolds as follows. Section 2 presents the model, and Section 3 derives tax decisions under cooperation. Section 4 focuses on the non-cooperative case, producing results for linear and non-linear strategies and comparing these to cooperation. Section 5 concludes.