Lapan, Harvey E.; Sikdar, Shiva

Review of Development Economics Vol. 15 no. 1 (February 2011): 1-18.

 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 off. 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.

JEL Classification: D62, F18, H23, Q56

Keywords: Free trade; Transboundary pollution; Strategic environmental policy; Carbon leakage; Race to the bottom.

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