Strategic environmental policy under free trade with transboundary pollution
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We analyze the effects of trade liberalization on environmental policies in a strategic setting
when there is transboundary pollution. Trade liberalization can result in a race to the bottom
in environmental taxes, which makes both countries worse. This is not due to the terms
of trade motive, but rather the incentive, in a strategic setting, to reduce the incidence of
transboundary pollution. With command and control policies (emission quotas), countries are
unable to
influence foreign emissions by strategic choice of domestic policy; hence, there is no
race to the bottom. However, with internationally tradable quotas, unless pollution is a pure
global public bad, there is a race to the bottom in environmental policy. Under free trade,
internationally nontradable quotas result in the lowest pollution level and strictly welfare-
dominate taxes. The ordering of internationally tradable quotas and pollution taxes depends,
among other things, on the degree of international pollution spillovers